Business

 Finance    

Week  1  Lecture  1:  Intro  to  Business  Finance  

  Expected  cash  
  flows  
  received  at  
the  end  o f  
  period  t  
 
N  =  periods  over  which  cash  flow  is  received  
  R=  rate  of  return  required  by  investors  
 
Market  Value  of  a  Firm  (PV)  
• Magnitude  
• Timing  
• Risk  
• Efficiency  of  capital  market  
 
Simple  vs.  Compounded  Interest  
Simple:  without  accrued  interest  
 
 
Compound:  interest  accrued    
 
 
FV:  dollar  value  the  principal  grows  
PV:  invested  today    
 
Influencers  of  FV  +  PV    
1. Time  period:  n  
2. Interest  rate:  r  
3. Method  of  computing  interest  

Week  1  Lecture  2:  Intro  to  Business  Finance  &  Financial  Math  
Perpetuity:  equal,  periodic  cash  flow,  forever  (end  of  period)  
 
 
Deferred  Perpetuity:  starts  at  future  date,  forever  
 
 
Annuity:  equal,  periodic,  end  of  each  period,  n  periods  long  
Ordinary  perpetuity  –  deferred  perpetuity  
 
 
Deferred  Annuity:  equal,  periodic,  end  of  period,  first  cash  flow  at  future  date  
F  =  1st  find  for  n,  then  rearrange  the  formula  for  the  relationship  between  F  and  P  
  
Annuity  Due:  equal,  periodic,  beginning  of  each  period  
T  =  t  –  1  à  move  back  one  period    (Compounded  one  additional  period)  
 
 
Effective  Interest  Rate  
Re:  annualized  rate  
R/m:  per  period  interest  rate  
m  =  amount  of  interest  accrued  in  a  year  (i.e.  monthly  =  12)  
 
Continuous  compounding  

Week  2  Lecture  3:  Valuation  of  Debt  Securities  

Debt  Securities  
Short  term  <  year    
• No  other  payments  made    
• Simple  interest  
1.  BABs  
Short  term:  acceptor  promises  to  pay  FV  at  maturity  
 
 
 
 
 
 
 
Drawer  receives:  r  +  rfees  
Bills  traded  for:  r  
Fees  earned  by  bank:  P(r)  –  P(rfees)  
Long-­‐term  >  year  
• May/not  pay  coupons  
• Coupon  Rate:  interest  promised  (%  of  FV)    
• Coupons  periodic  
1.  Bonds  
YTM:  rate  of  return  investor  earns  
Current  Market  Price:  Interest  rate  discounts  bond’s  future  CF’s  
• Coupon  paying:  
• Zero  Coupons:  
Assume:  
1. Firm  does  not  default  
2. Coupons  received  can  be  reinvested  at  that  rate  of  return  
Valuation  Principle  
Price  of  security  today:  all  future  cash  flows  discounted  rate  of  return  
Variables:  
1. Market  price  
2. FV  &/  C  
3. Rate  of  return  
  
Reason,  Estimate:  
1. Price    
2. Required  rate  of  return  
Bond’s  Coupon  Rates  &  YTM  
Premium:  Coupon  Rate  >  YTM  
               Price  >  face  value  
Discount:  Coupon  Rate  <  YTM  
                 Price  <  face  value  
Par:  Coupon  Rate  =  YTM  
                       Price  =  face  value  
Compute  YTM:  try  out  numbers  based  on  relationship  between  YTM  and  Coupon  rate  
Sensitivity:  Longer  maturity  bonds  prices  are  more  sensitive  to  interest  rate  changes  

Week  2  Lecture  4:  Valuation  of  Equity  Securities  

Ordinary  Shares:  Infinite  stream  of  uncertain  cash  flows  
Ke  Expected  Return:  dividend  yield  +  %  price  change  
D(1  +  g)  
Pricing  Ordinary  Shares  
One  period:  sum  of  next  period’s  dividend  discounted  at  ke  
 
 
Constant  Dividend  Growth  Model  (  
 
 
Variable  growth  rate:  initial  growth  higher    
Market  Quotes  
• Bid  &  Offer:  buying  and  selling  prices  
• Last:  recent  transaction  price  
• Open:  today’s  
• High  and  Low  prices    
• Trading  volume  
• Number  of  trades  
Preference  Shares  
Preferred  &  fixed  
EARNING,  DIVIDENDS  &  PRICES  
Ratio:    Current  Market  Price:  Expected  Earnings  per  Share  
 
 
Expected:  willing  pay  now  for  future  $1.00  (P:E:  10  =  pay  $10  for  $1  future  earnings)  
Distribution:  
 
 
P/E  Ratio  Increase:  
• Required  rate  of  return  falls  (ke)  
• Growth  rate  of  dividends  (g)  rises  
• Pay  out  ratio  (alpha)  rises  
PV  of  Growth  Opportunities  
Growth  -­‐  No  Growth  Prices  (Earnings  &  dividends  don’t  grow,  all  dividends  paid  out  
 

Week  3  Lecture  5:  Risk  &  Return  

RETURNS  ON  SECURITIES:  Change  in  cash  flows  /  initial  investment  
1)  Discrete  returns  (use  this  if  not  stated  in  exam)  
Rt:  Return  
Dt:  Dividends  
Pt:  Price  
Exceed  continuous  returns,  >  volatile  over  time  
2)  Continuously  compounded  returns  
 
GEOMETRIC  VS  ARITHMETIC  AVERAGE  RETURNS  
1)  Arithmetic  one  period  
• R  =  rate  of  change    
Arithmetic  >  geometric:  difference  declines  with  volatility  declining  
2)  Geometric:  entire  time  horizon  
• Link  the  start  &  end  values:  
 
 
PROBABILITY  DISTRIBUTION  APPROACH  
Investors  can  specify  possible  outcomes  &  associate  probabilities  
• Convert  cash  flows  à  Rates  of  return  
 
 
 
 
 
 
Expected  return:  weighted  average  of  the  individual  outcomes  
Variance  &  SD:  measure  of  dispersion  (>  dispersion  =    >  risk)  
INTERPRETING  RETURN  &  RISK  MEASURES  (ND)  
 
1.  E(r):  multiple  of  the  principle  
2.  95%  confidence  boundaries  =  range  
 
 
 
 
 
INVESTOR  PREFERENCES    
Averse:  variability  worse  /  Neutral:  variability  irrelevant  /  Seeking:  variability  better  
Week  3  Lecture  6:  Modern  Portfolio  Theory  
PORTFOLIOS  &  RISK  DIVERSIFICATION  
Risk  Averse:    
• Minimize  risk  of  portfolio  for  desired  E(R)  
• Maximize  E(R)  for  desired  risk  level  
Solution:  Diversification  
• Portfolio  risk  falls,  as  Securities  increase  
• Systematic  risk  can’t  be  eliminated  
TWO  SECURITIES  
W  =  total  amount  invested  in  security/total  amount  invested  
W1  +  W2  =  1  
Variance:  covariance  between  securities  returns  
 
 
Covariance:  co-­‐movement  between  security  returns  (  <  0  negative  relationships)  
 
 
Correlation  Coefficient  standardizes  co-­‐movement:  Same  as  the  covariance  
 
RISK-­‐RETURN  TRADE-­‐OFFS  
• +  1  correlation:  
• -­‐  1  correlation  
• 0  correlation  
Diversification  benefits:  correlation  <  1  (-­‐1:  0  risk  portfolios  can  be  created)  
 

Week  4  Lecture  7:  Modern  Portfolio  Theory  2  

Portfolio  Risk  &  Return    
Leverage:  borrow  funds  at  risk-­‐free  rate  &  invest  in  risky  security  
Short  Selling:  Borrow  shares;  sell  now,  contract  buy  back:  Increases  E(R)  +  Risk    
Risk    

Limits  to  Benefits  

• Large  Portfolios:  return  covariance’s  determine  risk  
• Larger:  standard  deviation  falls  at  declining  rate  
• Systematic  risk:  can’t  be  eliminated    

Week  4  Lecture  8:  Modern  Portfolio  Theory  3  

E-­‐Front:  Risky  portfolios  Efficient  Portfolio:  lowest  risk  for  given  E(R)    
Intersection  of  CML  at  tangent:  most  efficient  E(R)  
Separation  Theorem  
• Investor  max  utility:  regardless  of  risk  preference  
• Composition  of  risky  portfolio:  separate  from  the  r-­‐f/risky  security  choice  
Market  Portfolio  
Equilibrium:  All  risky  securities  
• Stock  A  5%  of  total  risky  securities  à2%  of  portfolio  X:  Stock  A  
• 3/5th  of  A  not  held  by  anyone  
• >  Supply  à  price  falls  à  E(R)  rise  à  investors  hold  remaining  3/5th  of  A  
CML:    
• Prices  efficient  portfolios  (Equilibrium)    
• Not  individual’s:  they  are  not  efficient  portfolios  &  have  risk  
• Assumption:  Portfolios  fully  diversified  &  efficient  with  0  risk  
• Weighted:  portfolio’s  risk  proportionate  to  market’s  portfolio  risk  
• E(R)  on  MP:  per  unit  of  MP’s  total  risk  (in  excess  of  risk-­‐free  rate)  
 
Key  Concepts:  
• With  R-­‐F:  Best  portfolio  is  separate  to  investor’s  attitude    
• Optimal:  Efficient  Portfolio  with  all  securities  trading  in  the  market  
• CML:  passes  risk-­‐free  &  market  portfolio  
• All  Investors:  invest  in  risky  MP.  B/L:  move  along  CML  (attitude  dependent)  

Week  5  Lecture  9:  Asset  Pricing  Models  1  

CAPM:  Prices  individual  securities  (estimate  required  rate  of  return)  
Relates:  (higher)  required  return  to  (higher)  systematic  risk  
Total  risk  not  relevant  
CML:  Portfolio  (efficient:  perfectly  correlated  with  the  Market)  
 
SML:  Security  (any:  regardless  of  correlation  with  M  &  has  unsystematic  risk)  
 
CAPM:  Portfolio  &  Security:  same  E(R)  =  same  systematic  risk  
 
MAIN  ASSUMPTIONS  
1. Investors  identical:  risk  averse,  max  wealth  utility  
2. ND  Returns    
3. Perfect  Capital  Markets  
4. Unlimited  borrow  &  lend,  at  risk-­‐free  
5. Risky  securities  amount  fixed  &  all  traded  
 
INTUITION  
All  hold:  Efficient  portfolios  
• Market  portfolio  (M)  +  risk-­‐free  security  
• Don’t  diversify:  gain  no  E(R)  for  additional  diversifiable  risk  
• E(R)  of  Security:  contribution  to  non-­‐diversifiable  risk    (beta)  
 
Risk:  Covariance  of  security  with  M  (not  own  SD)  
 Market  Price  of  risk:  return  above  risk-­‐free  rate    
 
 
(Higher)  market  price  of  risk  à  (higher)  amount  of  risk  à  (higher)  risk  premium  
 
 
β  =  1:  Security  (portfolio)  same  risk  as  market  (0,  no  risk)  (<  1,  lower  risk)  
BETA  &  CORRELATION  
Beta  (systematic  risk):  how  accurate  it  follows  the  same  pattern  (accuracy)  
Correlation:  follows  the  trend  of  movement  (overall)  
 
Not  return  correlation  between  
security  and  market  portfolio  
 
 
 
 
 
SML:  Risky  securities  price.  In  Equilibrium  =  security  on  SML    
• Beta  <  1:  E(R)  <  M  
• Above  SML:  security  under  priced  
MOVEMENTS    
Unexpected  increase:  market  risk  premium  à  E(R)  increase  
Unexpected  decrease:  RF  rate  +  market  risk  premium  unchanged  E(R)  decrease    
Expected  increase  RF  rate  +  market  risk  premium  à  nothing  =  expected  

 
 
ESTIMATING  BETAS:  MARKET  MODEL  
Historical  betas  Experiential  (CAPM  =  theoretical)  
• Alpha:  intercept  
• Beta:  regression  slope  
• E:  error  term  
INTERPRETING  &  USING  BETA’S  
Sensitivity  of  returns  
Slope  of  best  fit:  excess  security  j  returns,  excess  M  returns  
• Sudden  drop  of  M’s  return  of  1%    =  Return  drops  by  1%  beta  
• Two  portfolios:  other  security  fall  by  same  %  beta  
Week  5  Lecture  10:  Asset  Pricing  Models  
Equilibrium  constant  dividend  growth  model  
RELATIONSHIP  BETWEEN  PRICE  &  RETURNS  
Increased  expected  beta  value  
• No  change  in  return  
• Investors  earn  the  lower  rate  
• Move  funds  to  similar  risk  securities,  offering  this  higher  return  
• Selling  pressure  =  new  price  (changed  beta)  to  be  lower  
OVER/UNDER  PRICED  
E(R)  falls  to  equilibrium  level  
Price  rises:  shares  are  under  priced  
 
Realistic:  1.  Simplification  2.  Empirical  Performance  (validity  debated)  
Testable:  
• E(R)  not  A(R)  
• All  risky  securities  à  hard  to  measure  
• Beta:  Measure  of  future:  history  not  useful  

Week  6  Lecture  11:  Asset  Price  Model  

DETERMINES  RETURN  ON  A  FIRM:  
• r:  return  at  time  t  of  security  j  
• E(r):  current  time  expected  return  
• U  =  m  +  e:  surprise  announcements  
1. Expected  Return:  true  risk  to  investments  
What  you  expected  occurs  (divorce  papers  signed)  not  surprise  
2. Unexpected  Return:  surprise  news      
Unsystematic:  appointment  of  new  CEO    (firm:  covariance  =  0,  
unrelated  to  each  other)  
Systematic:  inflation  (market:  =  beta,  related  to  each  other)  
1. Return  Increases:  increase  economic  growth:  economic  growth  beta  +  
2. Return  decreases:  increase  inflation:  inflation  beta  –  
3. Return  unchanged  increase  interest  rate:  interest  beta  0  
MODELS:  
• E(r):  returns  unaffected  by  these  factors    
• F:  unanticipated  changes  (economic  growth  etc.)  
• e:  firm  specific  return  
ARBITRAGE  PRICING  THEORY  
Arbitrage  to  relate  observed  return  of  an  asset  to  a  number  of  factors  (  
• Alpha:  risk  free  rate  
• Alpha  1  –  Alpha  n:  market  prices  of  risk  factors  
• Beta:  exposure  of  asset  to  particular  risk  factors  
Assumptions:  Markets  competitive  /  Prefer  >  wealth/  return  process  N-­‐factor  
APT  STRENGTHS    
• Multifactor  number  of  factors  but  CAPM  1  factor  only  market  index:  relevant  
• No  special  role  for  market  portfolio  
 • No  requirement  for  security  jointly  normally  distributed  
• No  restrictions:  investor  preferences  
APT  WEAKNESSES:  NOT  SPECIFY  
• Number  of  factors  
• What  these  factors  are  
• Sign/magnitude  of  the  factor  prices,  in  pricing  relation    
4  Unanticipated  Risk  priced  by  market:  
Change  inflation.  Industry  Production.  Default  Risk  Prem.  Term  structure  interest.  
OTHER  ASSET  PRICING  MODELS:  analysis  of  empirical  data  (not  theory)  
Fama  &  French:  3  factor  model:  (CAPM,  return  small  market,  high  book-­‐to-­‐market)  
• Robustness  check  
SHORT  COMINGS:  Why  firm  size  &  book-­‐to-­‐market  explain  return  +  CAPM  rev:  MF  
Carhart  4  Factor:  4th:  returns  high-­‐low  previous  12  month  return  (Mutual  Fund  Eva)  

Week  6  Lecture  12  

CAPITAL  MARKET  EFFICIENCY:  abnormal  returns  can’t  consistently  be  made(  g&a$)  
Instantaneous  Price  Reaction  Unexpected,  random,  full  reflected  in  price    
Unbiased  Price:  Market  price  neither  over/under  reacts  to  new  info  systematically  
ASSUMPTIONS  
• Profit-­‐maximizing  participants  analyze  securities  independently  
• New  information:  randomly  &  timing  is  independent  
• Market  participants:  adjust  price  estimates:  reflect  their  news  interpretation  
IMPLICATIONS:  Security  $  -­‐  their  market  risk/  Instant  equilibrium  =  no  abnormal  profit    
TYPES  OF  CAPITAL  MARKET  EFFICIENCY:  NOT  ALL  THE  TIME  &  CASES  
1. WEAK:  (MOVE  THROUGH:  ACCEPT  PREVIOUS  FORMS)  
• Past  prices  fully  reflected  in  current  (info  past  prices  not  =  excessive)  
• Implication:  best  predictor  of  tomorrow’s  price:  price  today  
2. SEMI-­‐STRONG  
• Publicly  available  information  reflected  in  current  
• Implication:  past  &  current  available  reflected  in  current  
3. STRONG  (INEFFICIENCY:  INSIDER  INFORMATION  CAN  EXPLOIT)  
• Public  &  private,  fully  reflected  in  current  prices  (not  neglect  any  relevant)  
• Implication:  all  information  used:  useless  predicting  future  
MARKET  ANALYSIS    
• TECHNICAL:  weak  form  inefficiency.  Trading  on  past  price  movements  
• FUNDAMENTAL:  weak  efficiency.  Gathering  &  analyzing  information,  
forecasting  better  than  others    
• MIDDLE  OF  THE  ROAD:  continue  analysis  make  efficient  à  anomalies:  ineff  
TESTING  MARKET  EFFICIENCY  
Weak:    Filter:  analyze  profits  from  trading  strategies  &  how  change  over  time  
Semi-­‐Strong:  Efficient  good  news:  instant  up  price  adjustment  (abnormal)    
CAR:  no  trend  
Cumulated  +  Abnormal:  observed  returns  at  announce  news  –  CAPM  predicted    
 • AR:  abnormal  returns  across  a  firms  experience  same  event  (AR)  

   
 
 
 
 
 
 
 
 
Strong  Market  In-­‐Efficiency  (Corporate  insiders:  Legal  deterrence)  
Net  purchasers  of  firm’s  shares:  earn  abnormal  return  &  mimickers  earn  
EMH  DOES  NOT  SAY:  
• No  one  should  act  on  information  
• Market  should  predicted  the  crisis  
• Stock  market  known  we  were  in  a  bubble  
• Collapse  of  financial  institutions  =  inefficient  market  

Lecture  13  Week  7:  Capital  Budgeting  

THE  BUDGETING  PROCESS:  selection  of  capital  expenditures  
Project  Evaluation  
• NPV:  Net  Present  Value  
• IRR:  Internal  Rate  of  Return  
• ARR:  Account  Rate  of  Return  
• Payback  Period  
NET  PRESENT  VALUE    
PV  net  cash  flows  from  investment  -­‐  initial  investment  outlay  (NPV  >  0:  Accept)  
Discounted:  required  rate  of  return  
Net  cash  flows:  
• Size  +  timing  of  incremental  
• CF  project  taken  –  CF  project  not  taken  
INTERNAL  RATE  OF  RETURN  
Rate  of  return  earned  over  its  economic  life  (r  >  k:  Accept)  

-­‐  Multiple  IRR:  NPV  =  0  

CONDITION  (NOT  SUFFICIENT):  >  one  sign  change  
-­‐  No  IRR:  remains  +/-­‐  regardless  of  k  
DRAWBACKS:  Multiple  &  Undefined  IRR’s  
• Undefined  IRR’s  
Lecture  14  Week  7:  Capital  Budgeting  
IRR  &  NPV    
1)  Independent  Projects:    
• Funds  for  all  available  
Decision:  Invest  in  all  positive  NPV  projects  
2)  Mutually  Exclusive  projects:    
• Competing  
Decision:  NPV  positive  +  Highest  NPV  
ACCOUNTING  RATE  OF  RETURN  
Average  earnings  after  depreciation  &  taxes,  %  of  initial  outlay  
• Straight  line  depreciation:  Initial  Investment/2  
• Average  earnings  =  Total  earnings/N    
Decision:  ARR  >  k  +  Highest  ARR  
PROBLEMS  
1. Earnings  -­‐  Not  cash  flows  
2. Biased:  against  longer    
3. Ignore  time  value  of  money  
4. Hurdle  =  arbitrary  
PAYBACK  PERIOD:    
Initial  cash  outlay  to  be  recovered  after  tax  reduction  
Decision:  PP  <  maximum  payback  period  (shortest  payback)  
PROBLEMS  
1. Not  account  after  the  cut  off  date  
2. Biased:  against  longer  (mining)  
3. Ignore  time  value  of  money  
4. Hurdle  =  arbitrary  
Lecture  16  Week  8:  Capital  Budgeting  
ISSUES  OF  CASH  FLOW  ESTIMATION  
Cash  Flow  Timing:  Affects  valuation  (assume:  end  of  period)  
Financing:  costs  not  included  
Incremental  CF:  change  if  project  is  accepted  (cannibalize,  sunk  &  allocated)  
Tax  Effects:  effects  net  cash  flow:  
1. CORPORATE  INCOME  TAX  
Included:  cash  outflow  
 
2. DEPRECIATION  TAX  
Depreciation  affects  net  cash  flows,  decreases  taxes  payable    
 
3. TAXES  ON  DISPOSAL/SALVAGE  OF  ASSETS  
Disposal  value  is  taken  into  account  after  taxes  (Payable:  Asset  sold  >  BV)  
Book  value  =  Acquisition  cost  –  Accumulated  depreciation  
INFLATION  AND  CAPITAL  BUDGETING:  Consistent:  real  discount  =  real  CF  
PROJECTS  WITH  DIFFERENT  LIVES  
Constant  Chain  Replacement:  unequal  economic  lives    =  no  technical  shift  obsolete  
1. LCM:  REPLICATE  TILL  SAME  LIVES  
2. PERPETUITY:  PROJECTS  REPLICATED  FOREVER  (INFINITE)  
 
 
Equivalent  Annuity  Value:  
1. Project’s  NPV’s  
2. EAV:  NPVs  /  PV  of  ordinary  annuity  factor  
3. PV  /  discount  rate  
Lecture  17  Week  9:  Capital  Budgeting  
WACC  Required  rate  to  evaluate  its  investments:  similar  risk  
• Business  risk:  alters  operational  risk  of  firm  
• Financial  risk:  altering  capital  structure  (D/E)  
• Dependent:  Qualitative  /  MV  alternative  funds  /  Market  costs  of  funds    

1.Financial  Components  
Debt:  externally  supplied  market  values  
 
 
 
Ordinary  Shares:  Number  of  issued  (not  reserves  &  retained  earnings)    
Preference  Shares:  Issued  shares  

2.  Valuing  Financial  Components  

Ordinary  shares:    MV  Equity  =  number  of  shares  issued  x  market  value  per  share  
Preference  Shares:  If  non-­‐redeemable  =  perpetuity  
Equity:  
 
 
 

3.  Cost  of  Components  

• Debt:  market  yield  
• Ordinary  shares:  CAPM  
Beta:  firm’s  relative  risk  compared  to  moves  in  market  portfolio  

4.  Estimate  WACC  
   
 
 

Taxes  &  WACC  Classical  Tax  System:    

• Interest:  tax  deductible  
• Dividends:  No  Tax  
 Lecture  18  Week  9:  Debt  Dividends  &  Taxes  
Corporate:  30%  =  tc  Personal:  progressive  tP  
Total  assessed  income  –  allowable  tax  deductions    
• Income:  salary,  wages,  investment  income  
• Deduction:  work  related,  managing  investments  
Capital  Gains  Taxes  Choose  lower  capital  gains  
• Individuals:  net  capital  gains  realized  in  a  year  
• Net  capital  gain:  total  capital  gain  –  capital  loss  –  unapplied  net  capital  losses    
September  20th  1985:  Before:  exempt  from  capital  gains  taxes  
September  21st  1999:  Bought  before:  CPI:  correspond  CGT  +  choice  Index/Discount  
      On/After:  CPI  123.4  
      After:  >  12  months:  discount  
      <  12  months:  capital  proceeds  –  cost  base    

Computing  Methods:    
  Indexation  Method   Discount  Method  
Capital  Proceeds   Income   Income  
             Less  Cost  Base   (Indexation  Factor  x  Cost  of  Shares)   Cost  base  
Capital  Gain   Capital  Proceeds  –  Cost  Base   Capital  proceeds  –  Cost  Base  
             Less  CGT  Discount   -­‐   50%  (Capital  proceeds  –  Cost  Base)  
Net  Capital  Gain   Capital  proceeds  –  Cost  Base   50%  (Capital  proceeds  –  Cost  Base)  

CLASSICAL  TAX  SYSTEMS  FOR  DIVIDENDS  

• 1  dollar  corporate  profits:  corporate  tax  rate  
• Dividends  received:  personal  marginal  rate  
Earnings  effectively  taxed  twice  
1-­‐dollar  corporate  profit,  shareholder  receives:  
  IMPUTATION:  marginal  personal  rate  
Tax  paid  by  firm  on  earnings:  shareholders  via  franks  attached  to  dividend  paid  
Franking  (can’t  carried):  
• Attributed  personal  income  &  taxes  paid  on  that  income  
• Offset  tax  payable  on  dividends  
• FRANKED:  imputation  credits.  UN-­‐FRANKED:  taxed  as  ordinary  income  
Marginal  =  corporate  tax  rate:  fully  franked  dividend  =  tax-­‐free  
Marginal  <  corporate  =  excess  credits  (reduce  tax  other  income)  
ASSUMPTIONS:  Firm  pays  all  after  tax  earnings  as  dividends  &  dividends:  fully  franked  

Lecture  19  Week  10  Debt  Dividends  &  Taxes    

FINANCIAL  LEVERAGE  
1.  BUSINESS  (OPERATIONAL)  RISK  
Variability  of  future  net  cash  flows:  nature  of  firm’s  operation  (within  +  between)  
Risk  faced  by  shareholders  if  Equity  
2.  FINANCIAL  RISK  
Debt  financing  additional  variation  
EFFECTS  OF  FINANCIAL  LEVERAGING  
Effects:  trade  off  between  risk  and  return  
• Expected  rate  +  Variability  of  return  equity  increases  

MODIGLIANI  &  MILLER    

1. Perfect  Capital  Markets  
2. Firms  &  individuals:  borrow  same  interest  rate  
3. No  taxes  
4. No  liquidation  costs  
5. Not  affected  by  financing  decisions  
6. CF  perpetual  &  all  earnings  paid  as  dividends  

M&M  Proposition  1:  MV  of  firm  is  Independent  of  Capital  Structure  
 
 
Changing  mix  of  debt  to  equity:    
1. Changes  income  divided  between  debt  &  shareholders  
2. Not  change:  value  of  the  firm  
Market  Value:  If  not  same  =  risk  free  arbitrage  
REPLICATE  UNLEVERAGED  FIRM:  
Homemade  leverage:  borrow  personally,  %  of  firm  borrowing  (Undo:  lending  funds)  
Lecture  20  Week  10  Debt  Dividends  &  Taxes  
Proposition  2:E(R)  on  Equity  of  Leveraged  increases  in  proportion  to  D/E  ratio  
Higher  D/E  ratio  =  higher  systematic  risk  of  equity  =  higher  required  rate  on  equity  
 
 
Value  of  the  leveraged  firm:  

MM  &  Taxes  
Tax  shield:  difference  in  earnings  to  shareholders  and  debt  holders  
PV  Leveraged  firm:  
 
 
• Corporate:  existence  of  debt  matters  =  firm  should  maximize  debt  
Issue:  with  personal  income  =  reduces  tax  advantage  with  debt  
Investors  face  higher  tax  rates  on  interest  than  shares  =  firm  level  benefit  
• Imputation:    Earnings:  taxed  personal  rate,  Debt:  personal  rate    =  neutrality  
Share:  personal  >  corporate  =  >  interest  than  shares    =  bias  towards  equity    
 
Market  Imperfections:  Non-­‐tax  factors  dependent  on  Capital  Structure  
1. Financial  distress:  Advisor/lawyer  fees,  lost  sales,  reduced  efficiency,  time    
2. Agency  Costs:  Asset  Substitution  &  Under  Investment  
Wealth  transfers:  Debt  to  Share:  
New  debt-­‐holders  gain:  require  higher  interest  rate  
Shareholders  lose:  reduce  earnings  =  higher  interest  payments    
 
Asset  Substitution:  Incentive  to  Undertake  Risky  Investments  Increase  with  Debt  
Because  of:  equity’s  limited  liability  
• Successful:  shareholders  paid  out  
• Unsuccessful:  debt  holders  paid  first  
Negative  NPV:  FV  decreases,  equity  raises  and  value  of  debt  falls  (shareholders)  
Under-­‐investment:  Reject  Low  Risk  Investment,  even  with  +NPV  
Risky  debt:  not  shareholder’s  interest  to  contribute    
Increase  FV  à  shareholders  lose:  risk  of  debt  falls  &  debt  value  increases  

Optimal  Capital  Structure  

 
Trade-­‐off  Theory:  Benefits  of  debt  financing  &  cost  of  financial  distress    
Aim:  Maintain  target  D/E  ratio  
Lecture  21  Week  11:  Debt  Dividends  &  Taxes  
Institutional  Features  of  Dividends  
• Declaration:  announced  
• Cum  dividend:  traded  with  dividend  
• Ex-­‐dividend:  trade  without  dividend  
• Record:  shareholders  receive  dividend  
• Payment:  date  paid  
DIVIDEND  PAYOUT  POLICIES  
Residual:  Optimal  
• Pay  any  earnings  it  does  not  need  to  re-­‐invest  
• Unstable:  dividends  &  pay  out  ratio  
Fixed:  
• Expected  earnings  –  expected  capital  expenditure  
• Constant  dividend  per  share  
• Stable:  dividends  
Constant  Payout:  
• Constant  ratio  per  share:  higher  Earnings  (not  costs)  à  higher  dividend  
• Stable:  pay  out  ratio  
MM’S  DIVIDEND  IRRELEVANCE  THEORY  
• Perfect  market  
• Firm  can  issue  &  sell  new  shares  when  needed  
• No  personal  taxes  
• Firm  all  equity  financed  
• Not  affected  by  change  in  dividends  
FV:  Earnings  generated  by  firm’s  assets.  Dividend  &  retained  earnings,  no  affect  SHW  
SHOULDN’T  CARE  M UCH  EARNINGS  PAID  AS  DIVIDENDS?  
Firm’s  dividend  policy  trade  off:    
• Retaining  and  paying  out  
Over  all  effect  of  paying  dividend  &  issuing  new  shares  to  replace  cash  paid  out:  
• No  change  in  firm  value  
• No  change  in  wealth  of  shareholder  
Value  of  shares  fall  by  amount  =  cash  paid  to  shareholders  
Value  of  the  firm:  
  
DIVIDEND  &  TAXES:  Shareholder  Preference:  differential  tax  treatment  D  vs.  CP  
• Classical  Tax:  Dividends:    twice  &  Capital  Gains  at  lower  rate  (approach  0)  
Retain:  share  price  rises,  rise  capital  gain  tax  liabilities  when  sold  
Clientele  Effect:  Policies  appeal  to  different  people  Tax  Rates:  
Taxed  on  Dividends  >  Capital  Gains:  low  dividend  
• Imputation  Tax:  
Franked  Dividends:  taxed  once  (personal  marginal  rate)  +  Capital  Gains:  taxed  twice  
Marginal  <  Corporate:  dividends  
Marginal  >  Corporate:  retained  (you’d  rather  the  retained  taxed  at  lower)  

Does  dividend  policy  matter?  Not  Resounding  -­‐  Yes  

Market  imperfections  taxes:  irrelevance  may  still  hold  
Flotation  costs:  related  to  other  financial  decisions  +  Signaling:  future  earnings  
Managerial  discipline:  discipline  and  lower  agency  cost  
Lecture  23  Week  12:  Derivative  Securities  
Value  derives  from  underlying  product  (commodity,  shares,  interest  rates)  
1. FORWARD  &  FUTURE  CONTRACTS  
Agree:  buy/sell  underlying.  Pre-­‐specified  price  &  date  (no  cost)  
Long  Bought  +  Short  Sold  
• Spot:  price  can  be  bought  and  sold  now    
• Delivery:  pre-­‐specified  contract  price  
• Forward:  changes  with  market  conditions  
— Maturity:  date  settled  =  short  delivers  for  delivery  price.  
— Settlement:  1.Physical  =  cash.  2.Cash  =  delivery  price  –  (market  price)(units)  
Forward   Future  
Informal   Standardized  forward  
Any  maturity   Specified  dates  
 >  1,000,000   Smaller  specified  
Maintain  minimum  deposit  in  bank   Minimum  margin:  %  FV  
Majority  settled  by  delivery   Contract  Reversal  (Delivery  is  rare)  
>  Futures   Exchange  Guarantee  
Dealer’s  bid.  Self  regulated   Traders,  brokers  fees.  External  regulated  
No  CF  till  delivery   Daily  settlements  from  margin  account  
Speculating  &  Hedging    
Hedger:  exposure  to  asset,  minimize  the  exposure  
• Long  Hedger:  hedge  short  spot  position  (Price  Rise)  
• Short  Hedger:  hedge  long  position  (Price  Fall)  
Speculator:  trades  in  futures  based  on  expectation,  no  direct  interest  in  the  asset  
• Futures  Price:  affected  by  |  Risk:  changing  futures  prices  
Pricing:    Carry  commodity  to  delivery  date:  storage,  insurance,  transport  &  financing  
  F:  future  price  
  S:  spot  price  today  
  C:  cost  of  carrying,  %  S  
Cost  of  Carry  Arbitrage:    
 
 Borrow  funds  à  Buy  asset  in  the  spot  market  now  àMake  forward  on  asset  now  
Reverse  Arbitrage:  
 
 
Sell  asset  in  spot  market  now  à  Invest  funds  received  à  Buy  forward  on  asset    
2. OPTION  CONTRACTS  
• Exercise:  pre-­‐specified  price  if  exercised  |  No  shareholder  voting  rights  
American  vs.  European  Options:  American  (any  time),  European  (expiration)  
  Buyer  (holder)   Seller  (writer)  
Call     Right  to  buy  security   Obligation  to  sell  
Put     Right  to  sell  the  security   Obligation  to  buy  
CALL  OPTIONS:  
Pay  off  buyer  (not  negative):  o  
Profit  of  buyer:  
• ST:  stock  price  at  expiration  
• X:  exercise  (pre-­‐specified  price  sold)  price  
• C:  Call  option  price  
Moneyness  
• At  the  money:  St  =  X  |  Breakeven:  X  +  C  =  0  
• In  the  money  profitable  to  exercise  now:  St  >  X  
• Out  of  the  money  unprofitable  to  exercise  now:  St  <  X  
Payoff  &  Profit  
• Long:  limited  loss    
• Short:  limited  upside  
Lecture  24  Week  12  Derivative  Securities  
PUT  OPTIONS  
Pay  off  buyer  (not  negative):  
Profit:  
• ST:  stock  price  at  expiration  
• X:  exercise  (pre-­‐specified  price  sold)  price  
• P:  Put  option  price  
Negative:  seller  
Moneyness  
• At  the  money:  St  =  X  
• In  the  money:  St  <  X  |  Out  of  the  money:  St  >  X  
• Breakeven:  X  -­‐  P  =  0  
Payoff  &  Profit  
FACTORS  AFFECTING  OPTION  PRICES  
Over  the  Counter   Exchange  Traded  
Private  negotiated,  tailored   Standardized  
Off  market  transactions   Clearing  house  =  middle  man  
Counterparty  risk  =  major   Default  risk  =  low  
Commercial  banks,  brokers   Liquid  &  easily  traded  
Option  value  =  intrinsic  value  (amount  in  the  money)  +  time  value  (value  above  IV)  
• Call:  IV  =  St  –  X  |  Put:  IV  =  X  –  St    
   Call   Put  
Spot  price   +   -­‐  
X  exercise  price   -­‐   +  
Time   +   +  
Price  Volatility   +   +  
Risk  free  interest  rate   +   -­‐  
Dividends   -­‐   +  
Put-­‐Call  Parity:  Options  can  create  the  same  position  of  holding  the  stock  
Long  call  +  short  put:  Synthetic  long  position  
Short  call  +  long  put:  Synthetic  short  position  
(Price  of  call  &  price  of  put,  that  must  hold  in  a  capital  market)  
Benefits  
• Selling  without  borrowing  underlying  security  
• Buying  with  lower  capital