AB1201
Financial Management
Week 7: The Cost of Capital
What is the WACC formula?
What is Target Capital Structure?
Why should we use weighted average cost
of capital?
Why use market value weights instead of
book weights?
Why use marginal cost instead of historical
cost?
Why use after tax capital cost for rd?
Component Cost of Debt, rd
Component Cost of Preferred Stock, rp
Component Cost of Common Equity, rs
WACC = wdrd(1-T) + wprp + wcrs (Assuming 3 costs)
Optimal capital structure that maximise stock price or maximise WACC
Desired optimal mix of equity and debt financing that most firms attempt to maintain in the long run
Use weighted average of cost of capital that takes into account LT financing plans
Market weights are calculated using market value of stocks, bonds and preferred stocks and this is appealing because market
value of securities represent actual amount of financing risk by firm when they sell the stocks and bonds and component
costs are calculated based on current market conditions
Book weights are calculated using common values of common equity, debt and preferred stock as recorded in balance sheet
Marginal cost is the marginal cost of raising an additional dollar of capital today
The cost of capital is used primarily to make decisions that involve raising new capital so we should focus on today’s
marginal cost
The historical cost of existing financing on the firm’s books is irrelevant
Shareholders focus on after tax cash flows so we should use after tax capital costs
Only rd needs tax adjustment because debt is tax deductible. Preferred stock dividends and common stock dividends are not
tax deductible
- rd is the marginal cost of debt capital (cost of raising an additional dollar of debt today)
- The YTM (Interest Rate) on outstanding LT debt is used to measure r d (coupon rate is historical cost)
- Interest is tax deductible so we need to adjust r d
- Assume funds raised through sale of bonds and bonds pay annual coupon
Why is the YTM on existing debt a good estimate of the cost of raising new debt?
- YTM reflects current market condition therefore good proxy of cost of new debt if the firm is to go to the market and
borrow money now
- Marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock
- Use nominal rp because preferred dividends are not tax deductible
- rp = Dp / Pp (dividends per share/amount preferred stock is currently sold for)
- rs is the marginal cost of common equity using retained earnings
- Rate of return investors require on the firm’s common equity using new common stock is r e
- CAPM: rs = rRF + (rM – rRF)b

Why is there a Cost for Retained Earnings?
Why is the cost of retained earnings
cheaper than the cost of new common
stock?
Find re if issuing new common stock incurs
a flotation cost
What factors influence a company’s
composite WACC? (overall WACC for the
whole term)
Hurdle rate
Should the company use the composite
WACC as the hurdle rate for each of its
projects?
- DCF: rs = (D1/P0) + g
- Own bond yield plus risk premium: rs = rd + RP
- Earnings can be retained and reinvested or paid out as dividends
- Investors could also buy other securities and earn a return
- If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative
investments of equal risk)  investors can buy similar stocks and earn rs
- When a company issues new common stock they also have to pay flotation costs (total cost company incurred when
offering its securities to the public) to the underwriter (investment banks that help company sell shares to the public)
- To account for flotation costs:
o Add flotation costs to the initial project cost
o Adjust the cost of capital
re = [D0(1+g)]/[P0(1-F)] + g
1. Market conditions
o Affect risk free rate that goes into cost of debt and cost of equity also affect RP M and inflation premium etc
2. Firm’s capital structure and dividend policy  if firms distribute as dividends, firms will have very little internal
cash to fund investment project so they issue new common stock, hence r s = re in WACC
o Affect W (increase debt, increase default risk  rd may increase (if bond rating change), r s will also increase
as you will demand higher returns and beta increases)
o Affect cost of equity and preferred stock
3. The firm’s investment policy. Firms with riskier projects generally have a higher WACC
o Assets riskier  investors require a higher return
What happens when you increase debt?
- rd increases
- beta increases  rs increases
Projects should be accepted if and only if their estimated returns exceed their cost of capital (hurdle rate)
- riskier project  higher WACC  higher hurdle rate
No. The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only
represents the “hurdle rate” for a typical project with similar risk as the form as whole.
Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk
If low risk company is evaluating high risk project, it may adjust its composite WACC upwards

Week 8: The Basics of Capital Budgeting
Normal cash flow stream
Non-normal cash flow stream
Short term v Long term projects
Independent projects
Mutually exclusive projects
Capital Budgeting Decision Criteria
Payback period
What are the weaknesses of payback
method?
What are the strengths of payback method?
Discounted payback method
AB1201
Financial Management
Cost (negative CF) followed by a series of positive cash inflows.
- One change of sign
2 or more changes of sign
- Eg: Cost (negative CF) then a string of positive CFs, then cost to close project (negative CF)
- Eg: Nuclear power plant
Long term: bulk of the cash flows are happening towards the end
Short term: most cash flows come in at the start
If the CFs of one are unaffected by the acceptance of the other
- Can accept one, accept both or accept none
If one is accepted, the other would have to be rejected
CF of one project will affect the other projects
- Accept one or accept one only
1. Payback
o Discounted payback
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
o Modified IRR (MIRR)
Number of years required to recover a project’s cost
Calculated by adding project’s cash inflows to its cost until the cumulative cash flows for the project turns positive
Assume CF arrive uniformly during the 3rd year
To determine which project to accept:
- Mutually exclusive: Choose the one with the shorter payback
- Independent: Subjective benchmark has to be used (look at pack project to determine benchmark only project less
than bench mark accepted)
1. Arbitrary benchmark
o Benchmark set subjectively by management based on factors such as project’s perceived risk and also based
on past projects payback period  does not say anything about whether shareholder’s wealth is maximised
2. Ignores the time value of money
o Shouldn’t be adding up CFs at different periods of time
3. Ignores CFs occurring after payback period
1. Easy to calculate and understand
2. Provides an indication of a project’s risk and liquidity
Since one of the weakness of payback method is that it ignores TVM, we can use Discounted Payback Method
Calculate PV of CF by discounted the cost of capital
Net Present value (NPV)
NPV Profiles
Internal Rate of Return (IRR)
Comparing NPV and IRR methods
Sum of the PV of all cash inflows and outflows of a project
NPV = PV of Inflows – PV of Costs
= Net gain in shareholder’s wealth
- NPV indicates how much shareholders’ wealth will increase if project is taken up (Higher NPV  Higher increase in
shareholders’ wealth)
To determine which project to accept:
- Mutually exclusive: accept project with the highest positive NPV (those that add the most value to shareholders’
wealth)
- Independent: accept project as long as NPV > 0
1. Downward sloping NPV profiles
o Discount rate increases, NPV decreases due to discounting in NPV formula
2. Profiles have different slopes so NPV profiles cross
3. At crossover point, NPVL=NPVS
Discount rate that forces NPV = 0 (Present value = Investment Cost)
IRR is the expected annual rate of return that the firm will earn if it invests in the project and receives the given cash flows
If IRR>cost of capital, the project’s return exceeds its costs and there is some return leftover to boost stockholders’ returns
To determine which project to accept:
- Mutually exclusive: accept project with highest IRR provided IRR>cost of capital
- Independent:
o If IRR>cost of capital: accept project
o If IRR<cost of capital: reject project
If projects are independent, the 2 methods always lead to the same accept/reject decisions
If projects are mutually exclusive,
- If discount rate > crossover rate, the methods lead to the same decision and there is no conflict
- If discount rate < crossover rate, the methods lead to different accept/reject decisions
The conflict between NPV and IRR arises due to timing differences in cash flows and differences in project size (scale)
When there are differences in cash flow timing or project scale, this implies that the firm will have different amounts to
reinvest at various years depending on which of the mutually exclusive projects it accepts
The rate at which the intermediate cash flows are reinvested at is a critical issue
Why is NPV superior to IRR? 1. Reinvestment Rate Assumption
o NPV method assumes intermediate CFs are reinvested at the cost of capital
o IRR method assumes intermediate CFs are reinvested at IRR
o Assuming CFs reinvested at the cost of capital is more realistic

2. Projects with different scales

o Allows you to get at the question of “Which project will maximise shareholder’s wealth?”
Why do managers prefer IRR? Preference for rates of return (IRR) rather than actual dollar of return (NPV)

Modified IRR (MIRR) Discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding
inflows at cost of capital

Why use MIRR instead of IRR?
Is MIRR superior or equivalent to NPV?
Multiple IRRs
To determine which project to accept:
- Mutually exclusive: accept project with higher MIRR
- Independent: accept project with MIRR>Cost of Capital
Managers like rate of return comparisons and MIRR is better for this than IRR
- MIRR assumes reinvestment at cost of capital which is more realistic than IRR assuming intermediate cash inflows
are reinvested at IRR rate
- MIRR also avoids the multiple IRRs problem
When evaluating mutually exclusive projects, NPV is superior to MIRR but MIRR is superior to IRR
MIRR has the same problem with IRR when evaluating projects with different scale
But when evaluating independent projects, the 3 criteria give the same accept/reject decisions
Suspect multiple IRRs problem if the CFs are non-normal and if cash inflows and outflows are roughly similar in magnitude
 AB1201
Financial Management

Week 9: Cash Flow Estimation, Risk Analysis, And The Optimal Capital Budget
Why are we interested in cash flows instead In finance, cash is king. Valuation of assets is based on cash flows the asset is expected to produce.
of accounting income? Net income and operating income are not cash. They are accounting numbers. Under accrual-based accounting, revenues and
expenses are booked when they occur, not when the cash is received/paid. When evaluating projects, we are interested in the
cash flows that the project produces
Relevant cash flow Incremental cash flows that will occur if and only if the project is accepted

CF if project is accepted VS CF if project is not accepted  difference is the incremental CF

Net Operating Working Capital (NOWC) External costly finds needed to finance current assets

NOWC = Current assets – (Accrued wages and taxes + Accounts payable)

NOWC = Current assets – (Current liabilities – notes payable)
Free Cash Flow (FCF) Cash flows available to shareholders and debtholders less the need for re-investment to operate and produce future CFs

FCF = [EBIT(1-T) + Depreciation] – [Capital expenditures + Change in NOWC]

Determining Annual Depreciation Do not minus salvage value regardless of whether we are using MACRS or Straight line depreciation
Terminal Cash Flow Find after-tax salvage value
- Tax paid = Tax x (SV – remaining BV at time of sale)
- After tax salvage value = SV – Tax paid

Do we need to consider cash flows
associated with NOWC in the interim
years?
Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation
Not-So-Obvious Relevant/Irrelevant Cash
Flows 1: Interest charges
Not-So-Obvious Relevant/Irrelevant Cash
Flow 2: Sunk Costs
Not-So-Obvious Relevant/Irrelevant Cash
Flow 3: Opportunity Costs
Not-So-Obvious Relevant/Irrelevant Cash
Flow 4: Externalities
Cannibalisation
Replacement projects
Leasing
Combining with NOWC
- Recovery of NOWC + After-tax salvage value = Terminal CF
No, if there are no changes in NOWC in the interim years, then no CF is incurred in the interim years. To make life simpler,
we assume that changes in NOWC take places only at the beginning of the project (t=0) and end of the project (t=N)
Examines how sensitive NPV is to changes in each input variable. All other variables are held constant at base value
Possible alternative scenarios with different input values are proposed.
Probabilities are assigned to each scenario  Project’s expected NPV and standard deviation/CV of NPV
Simulation techniques where the NPV for many scenarios are calculated  Project’s expected NPV and standard deviation
(CV) of NPV
No. Dividends and Interest expense should not be included in the analysis. When we calculate NPV, we are dividing by cost
of capital, so financing charges are already being accounted for when we divide by the cost of capital
Relevant cash flows are incremental CF that occur if and only if you accept the project.
Sunk cost would be incurred regardless of whether you accept/reject the project
Yes. By accepting the project, the firm foregoes a possible annual cash flow of $25,000 which is an opportunity cost to be
charged for the project and this should be charged to the project. There is an incremental cash flow.
Yes. The effect on other businesses of the firm is an externality. The after-tax CF loss per year on the other business lines
would be a cost to this project.
When the new business takes away the existing business
To obtain use of assets, company can buy the asset or lease the asset
Lessor: Party owning the leased asset
Lessee: Party using the leased asset
Lease vs Borrow-and-buy FCF revisited:
FCF = [(EBIT)(1-T) + Dep] – [Capex + Change in NOWC]
= (sales – cash op exp – depreciation)(1-T) + dep
= sales(1-T) – cash op exp(1-T) – dep(1-T) + dep
= sales (1-T) – cash op exp (1-T) + Txdep  Txdep is the depreciation tax savings
Optimal Capital Budget Theory: Accept all positive NPV projects
Amount of investment that will lead to value maximisation

WACC increases as level of financing increases because as we raise more capital we will run out of retained earnings so we
will issue more common stock which is more expensive. Furthermore, as you issue more debt and preferred stock, the cost of
debt and preferred stock also increases because the likelihood of default increases with more debt being raised.

Intersection between WACC and IRR is the optimal capital budget

Leasing

Week 11: Capital Structure and Leverage
Sources of Capital: Debt
Sources of Capital: Equity
Hybrid financing
Capital Structure
Business Risk
Determination of Business Risk
AB1201
Financial Management
A firm promises to make fixed payments (interest and principal) regularly. However, when the firm defaults on payment,
bankruptcy may occur
Eg: bank debt, bonds
Equity holders receives whatever cash flows that is left over in the firm after paying the debtholders.
Equity holders have residual claims  residual claimant
Eg: Common stock, retained earnings
Eg: Convertible bonds, preferred stock, lease
Have features of both debt and equity
Percentage of debt, preferred stock and common equity that is used to finance a firm’s assets
Commonly used ratio: Debt to capital ratio = Debt/(Debt + Equity + Preferred Stock)
Risk inherent in a firm’s operations (Risk that deals with the operations of the firm)
- Uncertainty about future operating income (EBIT)
Measured using standard deviation of EBIT  Area under curve = likelihood of EBIT falling within E(EBIT) (expected
EBIT)  flatter curve shows higher risk
EBIT = Sales – Operating Cost
= Quantity*Price – Operating Cost
Hence, determination of business risk
- Uncertainty about demand (sales)
- Uncertainty about output prices
- Uncertainty about costs
- Product, other types of liabilities  potential of lawsuits

Effects of Operating Leverage on Business
Risk
Trade-off when using operating leverage
Financial Leverage
Financial Risk
Optimal Capital Structure
Determining the impact of changing capital
structure on stock price
Finding the Optimal Capital Structure:
Sequence of events in a recapitalisation
Should we set the optimal capital structure
at the debt/capital ratio where EPS is
maximised?
What effect does more debt have on a
firm’s cost of equity and EPS?
Hamada equation
2 Methods to Find Optimal Capital
- Operating leverage
Operating leverage is the use of fixed costs other than variable costs
More fixed cost  more operating leverage  more business risk (small sales decline causes a big EBIT decline)
Although operating leverage comes with higher business risk, it is also accompanied by higher E(EBIT)  Higher operating
income
Use of debt and preferred stock which incurs fixed financial charges
Additional risk concentrated on common stockholders as a result of financial leverage
- More debt, more financial risk
Higher debt  Higher profitability  Higher risk
Capital structure (mix of debt, preferred and common equity) at which stock price is maximised/ maximises shareholder’s
wealth
Stock price is affected by future CF and risk of CF so when we find optimal capital structure, we trade off higher expected
profitability against higher risk when we increase debt
Goal: Find the stock price at each level of debt and the debt level that maximises stock prices is the optimal capital structure
To find expected stock price at each debt level, we must find the EPS and appropriate r s at each debt level
EPS = (EBIT – rdD)(1-T)/Shares outstanding
Recapitalisation: financial restructuring process where firms make drastic changes to its capital structure
1. A firm announces the recapitalisation
2. New debt is issued
3. Proceeds from debt issuance are used to repurchase stock (eg firms may use shares in stockmarket and buy up shares
in open market)
o Total capital does not change
o The number of shares repurchased is equal to the amount of debt issued divided by price per share
No. When we maximise EPS  also comes with higher risk (Trade off)
Higher financial leverage
- Higher EPS (Generally)
- Higher financial risk by shareholders  Higher required return by shareholders  Higher cost of equity, rs
bL = bU [1 + (1 – T)(D/E)]
Shows how higher financial leverage leads to a higher cost of equity
1. Maximise stock price
Structure
Capital Structure in Reality
Relaxing Assumption 1: Tax benefit of debt
Relaxing Assumption 2: Bankruptcy costs
Relaxing Assumption 3: Signalling effects
Relaxing Assumption 4: Agency costs
2. Minimise WACC
- Need to make calculations as we did but should also recognise that inputs are estimates
- As a result of imprecise numbers, capital structure decisions have a large judgmental content
- We end up with capital structures varying widely among firms, even similar ones in the same industry
Interest expense is tax deductible  Pay less taxes. But distributions to shareholders eg dividends do not reduce taxes
Expected bankruptcy costs depends on:
- Probability of bankruptcy: How volatile is your future cash flow?
- Actual costs incurred when in bankruptcy: Legal and accounting fees, liquidation of assets at fire-sales, loss of
customers, suppliers, employees etc
- Indirect costs due to the threat of bankruptcy: Customers and suppliers refuse to do business with the firm because
they think that the firm may go bankrupt anytime
- Under MM’s Irrelevance Theory, shareholders and managers have the same information about a firm’s prospects
(Symmetric information)
- But in reality, managers have more information than outside shareholders
- Signalling theory suggests firms use less debt than what trade-off theory suggests
o This unused debt capacity helps avoid stock sales, which depress stock price because of signalling effects
- Conflicts may arise between managers and shareholders  agency problems
- When they have excess cash, managers tend to spend the cash on their pet projects or perquisites
- Debt can constrain managers because the managers must now make sure they earn enough to cover the regular
interest payments. Failing to do so, may force the firms to go into bankruptcy and the managers will lose their jobs as
a result

Week 12: Distributions to Shareholders
Dividend Policy
Optimal Dividend Policy
Dividend Irrelevance Theory
Bird-in-Hand Theory: Investors Prefer
Dividends
Tax Issues: Investors Prefer Capital Gains
Stock Price Reactions to Dividend Changes
Signalling (Information Content)
Hypothesis
AB1201
Financial Management
Dividend policy has to do with the decision of whether to pay dividends versus retaining funds to reinvest, and also the
decision to pay back using cash dividends or repurchase shares
Optimal dividend policy should maximise stock price
Increasing dividend has 2 opposing effects on the stock price
- Increase dividends  Increase D1  upward pressure on stock price
- Increase dividends  less is available for reinvestment  Decrease g  Downward pressure on stock price
- Proposed by Modigliani and Miller (1961)
- Stock price is determined only by the earning power and risk of its assets (investments)  dividends don’t matter
- Investors are indifferent between dividends and retention-generated capital gains
- Investors can create their own dividend policy
o If they want cash, they can sell stock
o If they do not want cash, they can use dividends to buy stock
- Implication: Any payout is okay  dividend do not affect stock price
- Investors may think dividends obtained today are less risky than potential future capital gains, hence investors prefer
dividends
- Stocks with high dividends  Less risky  Shareholders require lower return, rs  High stock price
- Implication: Set a high payout
- Avoid transaction costs from investing of dividends
- Tax advantages of capital gains:
o Capital gains are usually taxed at a lower rate than dividends but this differs depending on tax regimes
o Taxes on dividends are due in the year they are received, taxes on capital gains are due when the stock is
sold
o Favourable capital gains tax treatment on inherited stock
- To the extent that dividends have a tax disadvantage relative to capital gains, shareholders prefer capital gains
- Implication: Set a low payout
Results seem to suggest shareholder prefer dividends
Investors view dividend changes as signals of management’s view of the future
- Since managers hate to cut dividends, they will not raise dividends unless they think the raise is sustainable
- Dividend increase  Good future prospects

Clientele Effect
Other Distributions
Dividend Reinvestment Plan (DRIP)
- Dividends decrease  Bad future prospects
Therefore, a stock price increase at the time of a dividend increase could reflect higher expectations for future EPS, not a
preference for dividends
Different groups of investors, or clienteles, prefer different dividend policies. For example,
- Working adults with regular salaries may prefer capital gains
- Retired individuals without regular salaries may prefer dividends
Firm’s past dividend policy determines its current clientele of investors
Implication: Clientele effects impede changing dividend policy. Taxes and brokerage costs hurt investors who have to switch
companies
Other than cash dividends, other forms of distributions include:
- Dividend reinvestment plans
- Stock repurchases
Stock dividends and stock split are not exactly distributions but they are dividend policies
Shareholders choose to receive the cash dividends or to have the company use the dividends to buy more stock in the firm on
behalf of the investor
- Shareholders can automatically reinvest their dividends in shares of the company’s common stock
- Get more stock than cash
2 types of plans:
- Open market
- New stock
DRIP: Open Market Purchase Plan vs New Open market purchase plan: Dollars to be reinvested are turned over to the trustee who buys shares on the open market
Stock Plan - Brokerage costs are reduced by volume purchases
- Convenient, easy way to invest thus useful for investors

New stock plan: Firm issues new stock to DRIP enrolees (usually at a discount from the market price), keeps money and uses
it to buy assets
- Helps conserve cash
- Companies that need capital use new stock plans
Stock Repurchases When companies decide to pay out cash instead of retaining it, they can choose to pay cash dividends or buy back their own
stock from stockholders.
Shares outstanding is reduced. The shares bought back are held as treasury stock and can be resold in the future to raise
capital
Stock Dividends and Stock Splits
Effects of Stock Splits and Stock Dividends
on Firm’s Value
Stock dividend: Firms issue new shares in lieu of paying a cash dividend
- If a 10% stock dividend is announced, shareholders get 10 shares for each 100 shares owned
- Shares outstanding increases
Stock split: Firm increases the number of shares outstanding, say 2:1. Shareholders get more shares.
- Example: Assume a company has 100 shares outstanding and each share is trading at $10. The company announces a
2-for-1 stock split. After the split, the company would have 200 shares outstanding and each share should be worth
$5
- Market value of equity remains at $1000
Stock dividends and stock splits increases the number of shares outstanding so “the pile is divided into smaller pieces”
Unless the stock dividend or split conveys information, the stock price falls so as to keep each investor’s wealth unchanged
But splits/stock dividends may get us to an “optimal price range”
- Optimal price range for stocks is $20 to $80. Stock splits and stock dividends can be used to keep the price in this
optimal range
Stock splits and stock dividends are viewed as positive signals that the management is confident about future earnings.
Therefore stock price may increase as a result.
- On average, stocks tend to outperform the market in the year following a split
By creating more shares and lowering the stock price, stock splits may increase the stock’s liquidity and may tend to increase
the firm’s value