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2/5/2023

CORPORATE FINANCE
(lecture notes)

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

CORPORATE FINANCE
(lecture notes)

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

CORPORATE FINANCE lecture notes

INTRODUCTION

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

1
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LEARNING OBJECTIVES

The subject provides:


▪ students with basic knowledge of corporate finance
principles,
▪ selecting appropriate principles to solve hypothetical
situations,
▪ interpreting the business's financial problems in
practice.
This subject also orientates students to identify and
consider the financial decision-making of businesses.

SUBJECT OUTLINE

CHAPTER 1: OVERVIEW OF CORPORATE FINANCE


Definition; The goal of financial management; Financial management
decisions; Factors affecting corporate finance
CHAPTER 2: TIME VALUE OF MONEY
Overview of time value of money; Interest rate; Future value; Present
value; Application
CHAPTER 3: RISK AND RATE OF RETURN
Returns; Risk and measures of risk; Returns and risk of a portfolio; Capital
Asset Pricing Model (CAPM)
CHAPTER 4: COST OF CAPITAL
An overview of Cost of Capital; Cost of Debt; Cost of Preferred Stock; Cost
of Equity; Weighted Average Cost of Capital; Cost of new common stocks
and flotation costs
CHAPTER 5: FINANCIAL LEVERAGE
Financial leverage; EBIT-EPS Break-Even, or Indifference points; Degree of
Financial Leverage
CHAPTER 6: THEORIES OF CAPITAL STRUCTURE
Overview; M&M Propositions I and II (No taxes); M&M Propositions I and II
(With corporate taxes); Bankruptcy Costs; The Optimal Capital Structure;
The Pecking Order Theory

SCHEDULE
CONTENT DETAILS
1 Chapter 1 Overview of corporate finance
2 Chapter 1 Continued
3 Chapter 2 Overview of time value of money; Interest rate;
3 Chapter 2 Future value

4 Chapter 2 Present value; Application

5 Chapter 2 Application
6 Chapter 3 Risk and rate of return
7 Chapter 4 Cost of capital
Financial leverage
8 Chapter 5&6
Theories of capital structure
Review all the content
9 Review Submit group assignments and take individual
tests
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ASSESSMENT

Attendance (10%)

Midterm
Personal Test (20%)
(50%)

Total Teamwork (20%)


grades

Final Multiple-choice test


(allowed to use one handwritten
(50%) A4 sheet)

ASSESSMENT
(i) Attendance

Number of sessions Grade


7-9 10
6 8
5 6
4 4
≤ 3 (without reason) 0

ASSESSMENT
(ii) Personal Test

Number of questions: 20 multiple choice questions;

Test is on http://lms.buh.edu.vn/ , therefore, students should


remember their own users and passwords on this website.

Time: 30 minutes;

Contents: chapters 1, 2, 4 according to the schedule.

Students are allowed to use one handwritten A4 sheet

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ASSESSMENT
(iii) Teamwork

Each team has a maximum of 05 (five) members. The


group will carry out the request that will be made on the
third session. The group work is handwritten on A4 paper,
firmly pressed.

10

10

CORPORATE FINANCE lecture notes

CHAPTER 1: OVERVIEW OF CORPORATE FINANCE

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

11

LEARNING OBJECTIVES

After finishing this chapter, students should be able to:

✓Understand the general concepts in corporate finance


including the goal of financial management

✓Understand financial management decisions

✓Calculate basic profit measures in finance, including


EBITDA, EBIT, EBT, EAT, EPS

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CHAPTER OUTLINE

1.1. Definition

1.2. The goal of financial management

1.3. Financial management decisions

1.4. Factors affect corporate finance

13

1.1. DEFINITION

Corporate finance
Finance is (or Financial
management)
“the system that includes the
circulation of money, the
granting of credit, the making
of investments, and the Areas of
provision of banking facilities” Finance
Capital markets
Webster’s Dictionary, Brigham &
Houston, 2016, p.4

Investments

14

1.1. DEFINITION

Corporate finance

“Every decision made in a business has financial


implications, and any decision that involves the use
of money is a corporate financial decision.”

Damodaran, 2014, p. 1

15

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1.2. THE GOAL OF FINANCIAL MANAGEMENT

Can we use the followings for the goal of financial


management?

1. Survive

2. Avoid financial distress and bankruptcy

3. Beat the competition

4. Maximize sales or market share.

5. Minimize costs.

6. Maximize profits.

7. Maintain steady earnings growth.

Ross, et al., 2018, p. 8

16

1.2. THE GOAL OF FINANCIAL MANAGEMENT

The goals we just listed can be classified in two groups:

1. Profit maximization

2. Risk control

17

1.2. THE GOAL OF FINANCIAL MANAGEMENT


Profit maximization

Measures of Profits

Profit indicators are on the income statement

▪ EBITDA: Earnings Before Interest, Taxes, Depreciation,


and Amortization.

▪ EBIT: Earnings Before Interest and Taxes

▪ EBT: Earnings Before Taxes

▪ EAT: Earnings After Taxes (or Net Income)

▪ EPS: Earnings Per Share

▪ DPS: Dividend Per Share

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1.2. THE GOAL OF FINANCIAL MANAGEMENT


Profit maximization

Measures of Profits: How to calculate?


EBITDA = Revenues (or Sales) – Operating Costs (except
Depreciation and Amortization Costs)
EBIT = Revenues (or Sales) – Operating Costs
EBT = EBIT – Interest (I)
EAT = EBT – Taxes = (EBIT – I)*(1-t)

EAT
EPS =
Common shares outstanding

Dividends paid to common stockholder


DPS =
Common shares outstanding
Notes: t is tax rate

19

1.2. THE GOAL OF FINANCIAL MANAGEMENT


Profit maximization

Measures of Profits: How to calculate?

20

1.2. THE GOAL OF FINANCIAL MANAGEMENT

Maximizing
shareholder
value
(in the lorng- term)

Risk Profit

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1.2. THE GOAL OF FINANCIAL MANAGEMENT

Another definition of corporate finance

“corporate finance as the study of the relationship


between business decisions and the value of the stock
in the business.”

Ross et al., 2018, p. 9

22

1.2. THE GOAL OF FINANCIAL MANAGEMENT

Notes of Agency costs


Agency costs occurs when:
(1) managers do not attempt to maximize firm value, and
(2) shareholders incur costs to monitor the managers and
constrain their actions
Brealey et al., 2020, p. 12

23

1.3. FINANCIAL MANAGEMENT DECISIONS

▪ Investment decisions

▪ Financing decisions

▪ Assets management decisions

(some textbooks do not list assets management


decisions as the third decision, instead they prefer
dividend decisions)

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1.3. FINANCIAL MANAGEMENT DECISIONS


Investment decisions

• Purchase real assets


• Often referred to capital budgeting
There are two types of assets: current assets and fixed assets
(non-current assets)

Current assets Fixed assets

Transforming time < 1 year Transforming time > 1 year


or 1 operating cycle or 1 operating cycle

High liquidity Low liquidity

25

1.3. FINANCIAL MANAGEMENT DECISIONS


Financing decisions
Decisions related to raising money to fund the purchase of real
assets are called financing decisions. To raise fund, firm can
issue financial securities.
• Short-term financing
• Long-term financing

Short-term financing Long-term financing


Maturing time < 1 year or 1 Maturing time > 1 year or 1
operating cycle operating cycle
Non-stable but flexible Stable but inflexible
The cost of short-term financing is often smaller than the cost
of long-term financing

26

1.3. FINANCIAL MANAGEMENT DECISIONS


Financing decisions

Debt Equity

There is maturity date There is no maturity date

Firm must pay interest expenses Paying dividend depends on


firm’s performance and dividend
policy
Interest expense is deductible for Dividend is paid after taxes
tax purpose
The cost of debt is often smaller than the cost of equity

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1.3. FINANCIAL MANAGEMENT DECISIONS

Investment and financing decisions can be observed on the


balance sheet.

28

1.3. FINANCIAL MANAGEMENT DECISIONS


Investment and financing decisions

29

1.3. FINANCIAL MANAGEMENT DECISIONS

Assets management decisions

Often related to short-term assets management, including:

• Cash

• Inventory

• Account receivables

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1.4. FACTORS AFFECT CORPORATE FINANCE

(i) Financial environment

(ii) Forms of business organization

(iii) Corporate Taxes

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1.4. FACTORS AFFECT CORPORATE FINANCE

(i) Financial environment

Source: Ross et al., 2018, p.14

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1.4. FACTORS AFFECT CORPORATE FINANCE

(ii) Forms of business organization

(1)Proprietorships

(2)Partnerships,

(3)Limited liability companies (LLCs) and limited liability


partnerships (LLPs).

(4)Corporations

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1.4. FACTORS AFFECT CORPORATE FINANCE

(iii) Corporate Taxes

All expenses that are deductible for tax purpose can generate
tax shield.

Tax shield = Expenses * tax rate (t)

Example 2: J&J Inc. has total assets of $1000. It generates revenues of

$1000. It incurs operating costs of $600 and a corporate tax rate of 20%.

Consider 4 scenarios of J&J capital structure as follows:

1. J&J has 100% equity

2. 60% equity, 40% debt (8% interest rate)

3. 50% equity, 50% debt (8% interest rate)

4. 50% equity, 50% debt (10% interest rate)

Calculate tax shield for each scenario?

34

REFERENCES

• Brealey et al., 2020, Principles of Corporate Finance

• Ross et al., 2018, Fundamentals of Corporate Finance

• Brigham and Houston, 2019, Fundamentals of Financial management

35

CORPORATE FINANCE

CHAPTER 2: TIME VALUE OF MONEY

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

36

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LEARNING OBJECTIVES

After finishing this chapter, students should be able to:

✓ Calculate and distinguish different types of interest rate

✓ Calculate the present value and future value of lump


sums, multiple cash flows and annuity

✓ Understand the application of time value of money

✓ Use financial functions in Excel

37

CHAPTER OUTLINE

2.1. Overview of time value of money

2.2. Interest rate

2.3. Future value

2.4. Present value

2.5. Application

38

2.1. OVERVIEW OF TIME VALUE OF MONEY

A dollar today is worth more than a dollar tomorrow.


Brealey et al. 2020, p. 20

Money has time value. Why?


• Money can be invested and earn interest
• Inflation
• Uncertainty or risks

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2.2. INTEREST RATE


Interest vs. Interest rate

40

2.2. INTEREST RATE

(i) Compound interest and Simple interest


(ii) Nominal interest rate and Real interest rate
(iii) Stated interest rate and Effective interest rate

41

2.2. INTEREST RATE


(i) Compound interest and Simple interest

Simple interest
Interest earned only on the original principal amount invested.
Ross et al. 2018, p. 125

Compound interest
Interest earned on both the initial principal and the interest
reinvested from prior periods.
Ross et al. 2018, p. 125

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2.2. INTEREST RATE


(i) Compound interest and Simple interest

Simple interest

FV = PV + PV×i×n
FV: the total amount (including the principal and the interest)
received in the future
PV: The initial amount invested at the present
i: interest rate earned per period
n: number of periods

43

2.2. INTEREST RATE


(i) Compound interest and Simple interest

Simple interest: Example 1


You deposit $100 in a bank saving account for 3 years with
an interest rate of 10%/year. How much will you have at the
end of year 3 assuming simple interest is used?

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2.2. INTEREST RATE


(i) Compound interest and Simple interest

Compound interest

FVn =PV×(1+i) n
FV: the total amount (including the principal and the interest)
received in the future

PV: The initial amount invested at the present

i: interest rate earned per period

n: number of periods

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2.2. INTEREST RATE


(i) Compound interest and Simple interest

Compound interest : Example 2


You deposit $100 in a bank saving account for 3 years with
an interest rate of 10%/year. How much will you have at the
end of year 3 if we assume interest is compounded annually?

46

2.2. INTEREST RATE


(ii) Nominal interest rate & Real interest rate

Nominal interest rate


Interest rates or rates of return that have not been adjusted for
inflation.

Real interest rate


Interest rates or rates of return that have been adjusted for
inflation.

Ross et al. 2018, p. 223

47

2.2. INTEREST RATE


(ii) Nominal interest rate & Real interest rate

The Fisher Effect


1+nominal interest rate
1+real interest rate =
1+inflation rate

Approximate formula
Real interest rate ≈ Nominal interest rate − Inflation rate

Example:
a. If the nominal interest rate is 15%, the inflation rate is 7%. What is
the exact real interest rate? The approximate real interest rate?

b. If the real interest rate is 5%, the inflation rate is 7%. What is the
exact nominal interest rate? The approximate nominal interest rate?

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2.2. INTEREST RATE


(iii) Stated interest rate and Effective annual rate

Stated (or quoted) interest rate is the contracted


interest rate.
Effective annual rate
The annual rate of interest actually being earned, as
opposed to the quoted rate.
Brigham and Houston, 2019, p. 177

→ Converting stated interest rate to effective annual rate

49

2.2. INTEREST RATE


(iii) Stated interest rate and Effective annual rate

Converting stated interest rate to effective annual rate


Step 1: Calculating periodic rate

If the interest is compounded more frequent than annual, for


example monthly or quarterly, then we should calculate the
periodic rate

Stated annual rate


Periodic rate rper =
Number of compounding periods per year

Example 3: Return to example 1, calculate the periodic rate and the amount you have
at the end of year 3 for the following scenarios where The interest rate is
compounded :

a. Semiannually? b. Quarterly?

c. Monthly? d. Daily?

50

2.2. INTEREST RATE


(iii) Stated interest rate and Effective annual rate

Converting stated interest rate to effective annual rate


Step 2: Calculating Effective annual rate by the formula:
M
Effective annual rate = 1+rper −1

(where: M: the number of compounding periods per year)

Note: To shorten the calculation steps, we can use the following


formula:
M
i
Effective annual rate = 1+ stated −1
M

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2.2. INTEREST RATE


(iii) Stated interest rate and Effective annual rate

Example 4: Assume a stated interest rate of 10% per year.


Calculate the effective interest rate if the interest rate is
compounded:
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily

52

2.3. FUTURE VALUE

(i) Future value of a lump sums

(ii) Future value of multiple cash flows

(iii) Future value of an annuity

53

2.3. FUTURE VALUE


(i) Future value of a lump sums

𝐅𝐕𝐧 = 𝐏𝐕 × (𝟏 + 𝐫)𝐧
FVn: Future value
PV: Present value
r: rate of return earned per period
n: number of periods
(1 + r)n : future value interest factor (or future value factor)

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2.3. FUTURE VALUE


(i) Future value of a lump sums

Example 5a: Assume that you plan to deposit $100 in a


bank that pays a guaranteed 5% interest each year. How
much would you have at the end of Year 3?
Example 5b: Assume you start to invest today with an
amount of $1,000. How much you will have in the future for
the following scenarios?
a. Invest in 20 years with a rate of return of 20% per year?
b. 30 years, a rate of return of 20% per year
c. 40 years, a rate of return of 20% per year
d. 40 years, a rate of return of 30% per year
What lessons do you learn from this example if you want to
become a billionaire?

55

2.3. FUTURE VALUE


(ii) Future value of multiple cash flows

Example 6a. You think you will be able to deposit $4,000 at


the end of each of the next three years in a bank account
paying 8 percent interest. You currently have $7,000 in the
account. How much will you have in three years? In four
years?

Example 6b: If you deposit $100 in one year, $200 in two


years, and $300 in three years, how much will you have in
three years? How much of this is interest? How much will you
have in five years if you don’t add additional amounts? Assume
a 7 percent interest rate throughout.

56

2.3. FUTURE VALUE


(iii) Future value of an annuity

Annuity
A series of equal payments at fixed intervals for a specified
number of periods.
Ordinary (Deferred) Annuity
An annuity whose payments occur at the end of each period.
Annuity Due
An annuity whose payments occur at the beginning of each
period.
Brigham and Houston, 2019, p. 161

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2.3. FUTURE VALUE


(iii) Future value of an annuity

Future Value of an Ordinary Annuity

FVAn =CF(1+r) n−1 +CF(1+r) n−2 +…+CF

1+r n −1
⇔FVAn =CF
r

58

2.3. FUTURE VALUE


(iii) Future value of an annuity

Example 8: Your grandfather urged you to begin a habit of


saving money early in your life. He suggested that you put $5
a day into an envelope. If you follow his advice, at the end of
the year you will have $1,825 (365 x $5). Your grandfather
further suggested that you take that money at the end of the
year and invest it in an online brokerage mutual fund account
that has an annual expected return of 8%. You are 18 years
old. If you start following your grandfather’s advice today, and
continue saving in this way the rest of your life, how much do
you expect to have in the brokerage account when you are 65
years old?
(see Brigham and Houston, 2019, p. 164)

59

2.3. FUTURE VALUE


(iii) Future value of an annuity

Future Value of an Annuity Due


FVAdue = FVAordinary ×(1+r)

Example 9: Assume that you plan to buy a condo 5 years


from now, and you need to save for a down payment. You
plan to save $2,500 per year (with the first deposit made
immediately), and you will deposit the funds in a bank
account that pays 4% interest. How much will you have
after 5 years? How much will you have if you make the
deposits at the end of each year?
(See Brigham and Houston, 2019, p. 165)

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2.4. PRESENT VALUE

(i) Present value of a lump sums

(ii) Present value of multiple cash flows

(iii) Present value of an annuity

(iv) Present value of a perpetuity

(v) Present value of a growing annuity

(vi) Present value of a growing perpetuity

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2.4. PRESENT VALUE


(i) Present value of a lump sums

Previously, we have:
𝐅𝐕𝐧 = 𝐏𝐕 × (𝟏 + 𝐫)𝐧
To find present value, we discount the future value back to the
present:
𝐅𝐕𝐧
𝐏𝐕 =
(𝟏 + 𝐫)𝐧
𝟏
: discount factor
(𝟏+𝐫)𝐧

Discounting: “The process of finding the present value of a cash flow


or a series of cash flows; discounting is the reverse of compounding.”
(Brigham and Houston, 2019, p. 158)

62

2.3. PRESENT VALUE


(i) Present value of a lump sums

Example 10: suppose you need $1,000 in three years. You


can earn 15 percent on your money. How much do you have
to invest today?
(see Ross et al., 2018, p. 134)

Example 11 Businesses sometimes advertise that you


should “Come try our product. If you do, we’ll give you
$100 just for coming by!” If you read the fine print, what
you find out is that they will give you a savings certificate
that will pay you $100 in 25 years or so. If the going
interest rate on such certificates is 10 percent per year,
how much are they really giving you today?
(see Ross et al., 2018, p. 135)

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2.4. PRESENT VALUE


(ii) Present value of multiple cash flows

Example 12 Suppose you need $1,000 in one year and $2,000


more in two years. If you can earn 9 percent on your money, how
much do you have to put up today to exactly cover these amounts
in the future? In other words, what is the present value of the two
cash flows at 9 percent?

(see Ross et al., 2018, p. 153)


Example 13 You are offered an investment that will pay you $200
in one year, $400 the next year, $600 the next year, and $800 at
the end of the fourth year. You can earn 12 percent on very similar
investments. What is the most you should pay for this one?
(see Ross et al., 2018, p. 154)

64

2.4. PRESENT VALUE


(ii) Present value of multiple cash flows

Example 14:

You are offered an investment that will make three $5,000


payments. The first payment will occur four years from today.
The second will occur in five years, and the third will follow in
six years. If you can earn 11 percent, what is the most this
investment is worth today? What is the future value of the cash
flows?

(see Ross et al., 2018, p. 154)

65

2.4. PRESENT VALUE


(iii) Present value of an annuity

Present value of an ordinary annuity


CF CF CF
PVAn = + +…+
(1+r) 1 (1+r)2 (1+r) n

1− 1+r −n
⇔PVAn =CF
r
Where:
1
n: present value factor
1+r

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2.4. PRESENT VALUE


(iii) Present value of an annuity

Present value of an ordinary annuity


Example 15 You just won the Florida lottery. To receive your
winnings, you must select ONE of the two following choices:
1. You can receive $1,000,000 a year at the end of each of the
next 30 years.
2. You can receive a one-time payment of $15,000,000 today.
Assume that the current interest rate is 6%. Which option is most
valuable?
(see Brigham and Houston, 2019, p. 167)

67

2.4. PRESENT VALUE


(iii) Present value of an annuity

Present value of an annuity due

PVAdue =PVAordinary ×(1+r)

Example 16: Assume that you are offered an annuity that


pays $100 at the end of each year for 10 years. You could
earn 8% on your money in other investments with equal risk.
What is the most you should pay for the annuity? If the
payments began immediately, how much would the annuity
be worth?
(see Brigham and Houston, 2019, p. 168)

68

2.4. PRESENT VALUE


(iv) Present value of a perpetuity
Perpetuity is a stream of equal payments at fixed intervals
expected to continue forever.
CF
PVperpetuity =
r

Example 17 (see Brigham and Houston, 2019, p. 171) What’s the


present value of a perpetuity that pays $1,000 per year
beginning 1 year from now, if the appropriate interest rate is
5%? What would the value be if payments on the annuity began
immediately?

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2.4. PRESENT VALUE


(v) Present value of a growing annuity

Growing annuity is an annuity that has payments


constantly grow over time
n
1+g
1−
1+r
PVgrowing annuity =CF
r−g
Where: g is a constant growth rate and r > g >0

70

2.4. PRESENT VALUE


(v) Present value of a growing annuity

Example 18

Suppose, for example, that we are looking at a lottery payout


over a 20-year period. The first payment, made one year from
now, will be $200,000. Every year thereafter, the payment will
grow by 5 percent, so the payment in the second year will be
$200,000 × 1.05 = $210,000. The payment in the third year
will be $210,000 × 1.05 = $220,500, and so on. What’s the
present value if the appropriate discount rate is 11 percent?

(See Ross et al., 2018, p. 167)

71

2.4. PRESENT VALUE


(vi) Present value of a growing perpetuity

Annuity that has payments constantly grow over time and go


to infinitely
n
1+g
1−
1+r
PVgrowing annuity =CF
r−g
n
1+g 1+g
Because 0 < <1, then when n→∞ , →0
1+r 1+r
1
PVgrowing perpetuity =CF
r−g
CF
PVgrowing =
r−g

Return to example 18, suppose the payments continue forever. What is the
present value in this case?

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2.5. APPLICATIONS

(i) Finding “r”, “n”, and payments

(ii) Amortized loans

(iii) Capital budgeting criteria

(iv) Stock and bond valuation

73

2.5. APPLICATIONS
(i) Finding r, n, and payments
Finding r with a lump sums - Example 20: a given bond has a cost
of $100 and that it will return $150 after 10 years. What is its rate of
return?
(see Brigham and Houston, 2019, p. 160)
Finding r with multiple cashflows - Example 21: An investment
costs $465 and is expected to produce cash flows of $100 at the end of
each of the next 4 years, then an extra lump sum payment of $200 at
the end of the fourth year. What is the expected rate of return on this
investment?
(see Brigham and Houston, 2019, p. 175)
Finding r with annuity - Example 22: Your uncle named you
beneficiary of his life insurance policy. The insurance company gives
you a choice of $100,000 today or a 12-year annuity of $12,000 at the
end of each year. What rate of return is the insurance company
offering?
(see Brigham and Houston, 2019, p. 175)

74

2.5. APPLICATIONS
(i) Finding r, n, and payments
Finding n with a lump sums

FVn =PV×(1+r) n

FV
ln( )
⇔n= PV
ln(1+r)

Example 23: (see Brigham and Houston, 2019, p. 161) How long
would it take $1,000 to double if it was invested in a bank that paid
6% per year? How long would it take if the rate was 10%?

75

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2.5. APPLICATIONS
(i) Finding r, n, and payments

Finding n with annuity


Example 24: Suppose you decide to make end-of-year deposits, but
you can save only $1,200 per year. Again assuming that you would
earn 6%, how long would it take to reach your $10,000 goal?
(see Brigham and Houston, 2019, p. 169)
Finding payments with annuity
Example 25: Suppose you inherited $100,000 and invested it at 7%
per year. What is the most you could withdraw at the end of each of
the next 10 years and have a zero balance at Year 10? How much
could you withdraw if you made withdrawals at the beginning of each
year?
(see Brigham and Houston, 2019, p. 170)

76

2.5. APPLICATIONS
(ii) Amortized loans

Amortized Loan: A loan that is repaid in equal payments


over its life.

Example 26: A homeowner borrows $100,000 on a


mortgage loan, and the loan is to be repaid in five equal
payments at the end of each of the next 5 years. The lender
charges 6% on the balance at the beginning of each year.
What is the payment at the end of each year? What is the
amortization schedule?

(See Brigham and Houston, 2019, p. 181)

77

2.5. APPLICATION
(iii) Capital budgeting criteria

Investing in long-term projects needs capital


budgeting proposals. The following criteria are used
to evaluate a project:

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Modified Internal Rate of Return (MIRR)

4. Payback Period and Discounted Payback Period

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2.5. APPLICATION
(iii) Capital budgeting criteria

Net Present Value (NPV)


A method of ranking investment proposals using the NPV,
which is equal to the present value of the project’s free cash
flows discounted at the cost of capital.
(Brigham and Houston, 2019, p. 389)

CF1 CFn
NPV=−CF0 + +…+
1+r 1 1+r n

79

2.5. APPLICATION
(iii) Capital budgeting criteria

Net Present Value (NPV)


Independent Projects
Projects with cash flows that are not affected by the
acceptance or nonacceptance of other projects.
→ Accept projects with NPV > 0. Otherwise reject.
Mutually Exclusive Projects
A set of projects where only one can be accepted.
→ Among the projects with NPV > 0, accept the one with
highest NPV

80

2.5. APPLICATION
(iii) Capital budgeting criteria

Net Present Value (NPV)


Example 27:

Should we accept the projects S and L using NPV rule?

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2.5. APPLICATION
(iii) Capital budgeting criteria

Internal Rate of Return (IRR)


The discount rate that forces a project’s NPV to equal zero.
Brigham and Houston, 2019, p. 392

CF1 CFn
NPV=−CF0+ +…+ =0
1+IRR 1 1+IRR n

Decision rule for Independent Projects


Accept projects with IRR > the required rate of return that is
often Weighted Average Cost of Capital (WACC). Otherwise
reject.
Decision rule for Mutually Exclusive Projects
Among the projects with IRR > WACC, accept the one with
highest IRR

82

2.5. APPLICATION
(iii) Capital budgeting criteria

Internal Rate of Return (IRR)


Example 28: Return to example 27, answer the following questions:
a. What is the IRR of projects S and L?
b. Which project should be selected, based on IRR criteria if WACC =
10% and the projects are (1) independent or (2) mutually
exclusive?
Example 29: Suppose a firm is considering a potential strip mine
(Project M) that has a cost of $1.6 million and will produce a cash flow
of $10 million at the end of Year 1. Then at the end of Year 2, the firm
must spend $10 million to restore the land to its original condition.
What is the IRR of this project?
(See Brigham and Houston, 2019, p. 396)

83

2.5. APPLICATION
(iii) Capital budgeting criteria

Internal Rate of Return (IRR)


IRR has some drawbacks:
a. Multiple IRRs
b. IRR does not tell us how much, in term of
value, the project adds to the firm.
c. IRR assumes that cashflows are reinvested at
IRR. This assumption is often unrealistic. Due
to this assumption, we need a modified version
of IRR

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2.5. APPLICATION
(iii) Capital budgeting criteria

Modified Internal Rate of Return (MIRR)


The discount rate at which the present value of a project’s
cost is equal to the present value of its terminal value,
where the terminal value is found as the sum of the future
values of the cash inflows, compounded at the firm’s cost of
capital.
Brigham and Houston, 2019, p. 399

85

2.5. APPLICATION
(iii) Capital budgeting criteria

Modified Internal Rate of Return (MIRR)


Steps to find MIRR
Step 1: Find the present value of total cash outflows
Step 2: Find the future value of total cash inflows at the end of
the last year, compounded at WACC. This future value is called
“terminal value” (TV)
Step 3: find the rate that makes the present value of terminal
value equal to the present value in step 1.
MIRR is the root of the following equation:
FV
PV of cash outflows=
(1+MIRR) n

86

2.5. APPLICATION
(iii) Capital budgeting criteria

Modified Internal Rate of Return (MIRR)


Compared to IRR, MIRR have two advantages:
(1) MIRR assumes cash flows are reinvested at the cost of
capital. This assumption is more realistic than the one of
IRR.
(2) No multiple IRRs problem.

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2.5. APPLICATION
(iii) Capital budgeting criteria

Modified Internal Rate of Return (MIRR)


Decision rule for Independent Projects
Accept projects with MIRR > the required rate of return
that is often Weighted Average Cost of Capital (WACC).
Otherwise reject.
Decision rule for Mutually Exclusive Projects
Among the projects with MIRR > WACC, accept the one
with highest MIRR

88

2.5. APPLICATION
(iii) Capital budgeting criteria

Payback Period and Discounted Payback Period


Payback Period (PP)
The length of time required for an investment’s cash flows to
cover its cost.

PP= Number of years prior to full recovery

Unrecoverd cost at start of year


+
Cash flow during full recovery year

Discounted Payback Period (DPP)


The length of time required for an investment’s cash flows,
discounted at the investment’s cost of capital, to cover its
cost.
Brigham and Houston, 2019, p. 406

89

2.5. APPLICATION
(iii) Capital budgeting criteria

Example 31: Return to example 27, calculate PP and DPP for


projects S and L

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2.5. APPLICATION
(iii) Capital budgeting criteria

Payback Period and Discounted Payback Period


➢Provide relevant information about:
(1) Liquidity of the project
(2) Risk of the project
➢Have drawbacks:
(1) No consideration for cash flows beyond the payback year
(2) Only tell when the project cost is covered. This implies that
there is no obvious decision rule with payback period.

91

2.5. APPLICATION
(iv) Stock and bond valuation

The value of any financial asset—a stock, a bond, a lease, or even


a physical asset such as an apartment building or a piece of
machinery—is the present value of the cash flows the asset is
expected to produce.
Brigham and Houston, 2019, p. 234

92

2.5. APPLICATION
(iv) Stock and bond valuation

Bond valuation

A bond is a long-term contract under which a borrower agrees to


make payments of interest and principal on specific dates to the
holders of the bond (Brigham and Houston, 2019, p. 230).

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2.5. APPLICATION
(iv) Stock and bond valuation

Bond valuation
Types of bond:
• Fixed rate bonds
• Floating rate bonds
• Zero-coupon bonds Denotation:
•FV: Face value (par value)
•i: Coupon rate
•C: Coupon payment (C = FV*i)
•n: maturity of bond
•rd: required rate of return
•Pt: bond price at time t

94

2.5. APPLICATION
(iv) Stock and bond valuation

Bond valuation – Fixed rate bonds


Bonds whose interest rate is fixed for their entire life.
Bond’s price = PV of coupon + PV of face value

At t = 0:
1−(1+rd ) −n 1
P0 =C +FV
rd (1+rd )n
At time t:
1−1−(1+rd ) −(n−t) 1
Pt =C +FV
rd (1+rd )n−t
n-t: the remaining years of bonds until maturity

95

2.5. APPLICATION
(iv) Stock and bond valuation

Bond valuation – Fixed rate bonds


Example 33: T&T issues a bond with a face value of $1000. This
bond will mature in 10 years. The coupon rate of the bond is 7%
per year and the coupon payment is paid annually. The buyers
also receive the face value at the time the bond matures.
Calculate the bond’s price at:
a. The time of issuing with the required rate of return = 14%
b. 2 years after issuing with the required rate of return = 12%

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2.5. APPLICATION
(iv) Stock and bond valuation

Stock valuation
Dividend Discount Model (DDM)
Dt: Dividend at time t
Re: stockholder’s required rate of return
P0: Stock price at the current
Pt: Stock price at time t

Stock′ s value=PV of expected future dividend

D1 D2 D∞
P0 = + +…+
(1+re ) 1 (1+re ) 2 (1+re ) ∞

97

2.5. APPLICATION
(iv) Stock and bond valuation

Stock valuation - Dividend Discount Model (DDM)


Constant growth stocks (Gordon model)
D1 D2 D∞
P0 = + +…+
(1+re ) 1 (1+re ) 2 (1+re ) ∞

D (1+g) 1 D0 (1+g) 2 D (1+g)∞


⇔P0 = 0 + +…+ 0
(1+re ) 1 (1+re ) 2 (1+re ) ∞

D0(1+g)
⇔P0 =
re −g

Zero growth stocks


D
P0 =
re

98

2.5. APPLICATION
(iv) Stock and bond valuation

Stock valuation - Dividend Discount Model (DDM)


Example 34: Firm A is expected to pay a dividend of
$1.00 at the end of the year. The required rate of return
is 11%. Other things held constant, what would the
stock’s price be if the growth rate was 5%? What if g
was 0%?
(see Brigham and Houston, 2019, p. 331)

Example 35: Firm A issue preferred stocks that pay a


dividend of $10 annually. If the required rate of return
is 11%, what is the value of this preferred stock?

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2.5. APPLICATION
(iv) Stock and bond valuation

Stock valuation - Dividend Discount Model (DDM)

Gordon model - How to calculate growth rate?

g = (1 – payout ratio)*ROE

in which: ROE (Return on Equity) = EAT/Owner’s Equity

Example 36: Firm B has a 12% ROE. Other things held constant,
what would its expected growth rate be if it paid out 25% of its
earnings as dividends? 75%?

100

REFERENCES

• Brealey et al., 2020, Principles of Corporate Finance


• Ross et al., 2018, Fundamentals of Corporate Finance
• Brigham and Houston, 2019, Fundamentals of Financial
management

101

CORPORATE FINANCE LECTURE NOTES

CHAPTER 3: RISK AND RATE OF RETURN

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

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LEANING OBJECTIVES

After finishing this chapter, student should be able to:

▪ Calculate the expected rate of return of a stand-alone stock


and a portfolio

▪ Understand and calculate the metrics of risk

▪ Understand the relation between the risk and the expected


rate of return

103

CHAPTER OUTLINE

3.1. Returns

3.2. Risk and measures of risk

3.3. Returns and risk of a portfolio

3.4. Capital Asset Pricing Model (CAPM)

104

3.1. RETURNS

(i) Dollar Returns

(ii) Percentage Returns

(iii) Average returns

(iv) Expected returns

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3.1. RETURNS
(i) Dollar Returns

Returns are what you earn from an investment. There are two
components:

(1) Dividend income (D)

(2) Capital gain (or loss) (= Pt+1 – Pt)

Total dollar returns = Dividend income + Capital gain (or loss)

Example 1: You buy 100 shares of VNM at the price of 100,000


VND/share. You hold these 100 shares for one year. During this year, VNM
pays a dividend of 3,500 VND/share. After one year, you sell these 100
shares at a price of 120,000 VND/shares. Calculate the total dollar returns
you earn from this investment?

106

3.1. RETURNS
(ii) Percentage Returns

Percentage returns (Rate of returns) includes two


components:

(1) Dividend yield = Dt+1/Pt

(2) Capital gains yield = (Pt+1 – Pt)/Pt

D + Pt+1 −Pt
Rate of returns (R)= t+1
Pt

Example 2: Recall example 1, calculate the rate of return of your


investment in VNM?

107

3.1. RETURNS
(iii) Average returns

Arithmetic average return


The return earned in an average year over a multiyear period.
(Ross et al., 2018, p. 404)

R1 +R2 +…+Rn

R=
n
Geometric average return
The average compound return earned per year over a
multiyear period.
(Ross et al., 2018, p. 404)

ഥ n 1+R ∗ 1+R ∗…∗ 1+Rn − 1


R= 1 2

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3.1. RETURNS
(iii) Average returns

Example 3: Suppose you buy shares of MM company at the


price of VND10,000 at the end of 2020. The price of MM’s
shares then reach VND11,000 at the end of 2021 and
VND9,000 at the end of 2022. Calculate:

a. The rate of return of MM’s shares for each year?

b. The average returns of MM’s shares by using arithmetic


average return and geometric average return?

109

3.1. RETURNS
(iv) Expected return

Expected return: The return on a risky asset expected in the


future (Ross et al, 2018, p. 421).
E R =P(R1 )R1 +P(R2 )R2 +…+P(Rn )Rn

⇔E R = σn
i=1 P(Ri )Ri
E(R): Expected returns of asset

P(Ri): Probability for the rate of return Ri occurs

Ri: the rate of return i

110

3.1. RETURNS
(iv) Expected return

Example 4: Consider the following circumstances:

State of Prob. Of Rate of return if state


Economy State of occurs
Economy Stock S Stock R

Depression 20% 5.5% -10.0%

Normal 30% 8.0% 10.0%

Growth 50% 10.0% 15.0%

Calculate the expected return for stocks S and R?

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3.2. RISK AND MEASURES OF RISK

(i) Definition
(ii) Measures of risk
(iii) The relationship between risk and expected return

112

3.2. RISK AND MEASURES OF RISK


(i) Definition & (ii) Measures of risk

(i) Definition
Risk is the chance that some unfavorable event will occur.
Brigham and Houston, 2019, p. 274
(ii) Measures of risk
If using forecasting data or a subjective probability distribution
Variance
σ2 =E [R−E R ]2

n
⇔σ2 = ෍ P(Ri )[Ri −E R ]2
i=1
Standard deviation

σ= σ2

113

3.2. RISK AND MEASURES OF RISK


(ii) Measures of risk
Measures of risk
Calculating the variance and the standard deviation of stock
S and stock R in example 4, we can see:

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3.2. RISK AND MEASURES OF RISK


(ii) Measures of risk

If using historical data


Variance ( variance)
σn (R −R)ഥ 2
σ2 = i=1 i
n−1
Standard deviation ( deviation)
σ= σ2

115

3.2. RISK AND MEASURES OF RISK


(ii) Measures of risk

Example 6:

Year Rate of return Rate of return


of stock A of stock B
Year 1 4% 6%
Year 2 2% 8%
Year 3 -3% -10%
Year 4 -2% -5%
Year 5 8% 16%

Calculate the variance and the standard deviation of stocks


A and B? If you are risk-averse, which one will you pick?

116

3.2. RISK AND MEASURES OF RISK


(ii) Measures of risk

Coefficient of Variation (CV)

σ
CV=
E(R)
CV is used when the expected return of the two assets are
not the same.
→ Calculate CV of Rate of return of stock A and B in the
example 6.

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3.2. RISK AND MEASURES OF RISK


(iii) The relationship between risk and expected return

Risk premium

The excess return required from an investment in a risky


asset over that required from a risk-free investment.

Ross et al., 2018, p. 394

Expected return = Risk premium + Risk-free rate

118

3.3. RETURN AND RISK OF A PORTFOLIO

(i) Portfolio expected returns

(ii) Portfolio Risk

119

3.3. RETURN AND RISK OF A PORTFOLIO


(i) Portfolio expected returns

E Rp =w1 E(R1 )+w2 E(R2 )+… +wn E(Rn )


n
⇔E Rp = ෍ wi E(Ri )
i=1
E(Rp): The expected return of portfolio
wi: the weight of stock i
E(Ri): The expected return of stock i

Example 7: Recall example 4, calculate the expected


return of a portfolio that consists of 50% of stock S and
50% of stock R.

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3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Portfolio variance

n m
σ2 2
P = ෍ ෍ wi ∗wj∗σij
i=1 j=1

Portfolio standard deviation

σP = σ2
P

wi, wj: the weight of assets i and j

σ2
ij = Cov(Ri, Rj): Covariance of returns of assets i and j

121

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Portfolio variance and standard deviation


Consider a portfolio includes two stocks A and B

Stock A Stock B
Stock A w2A. σ2
A wA.wB. σ2
AB
Stock B wA.wB.σ2
AB wb.wb. σ2
B

→ 𝛔p2 = wA2 𝛔A2+ 2wAwB 𝛔𝟐𝐀𝐁 + wB2 𝛔B2

122

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Covariance (𝛔𝟐𝐀𝐁 )
If using forecasting data (or a probability distribution)
n
σ2
AB = ෍ pi RAi −E RA ∗[RBi −E RB ]
i=1
(pi : probability that scenario i occurs)

If using historical data


σn (RAi −RA ).(RBi −RB )
σ2AB =
i=1
n−1
(n: number of years)

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3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk
Covariance

σ2AB > 0: returns of A and B are positively correlated

σ2AB < 0: returns of A and B are negatively correlated

σ2AB = 0: returns of A and B are uncorrelated

Covariance tells us how two assets move together but does


not tell us the strength of that relationship. How to fix?
=> correlation coefficient
Correlation coefficient
σ2AB
ρAB =
σA σB
ρAB∈ [-1; 1]

124

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Correlation coefficient
ρAB = 1: perfectly positive correlation => no benefits in
terms of reducing risk by diversification
ρAB = -1: perfectly negative correlation => highest benefits
in terms of reducing risk by diversification
ρAB = 0: independent relation => some benefits in terms of
reducing risk by diversification

125

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Example 8: Recall example 4, calculate:


a. the covariance and the correlation coefficient of stocks
S and R
b. the variance and standard deviation of a portfolio that
consists of 50% of each stock

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3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Example 9: (see Brigham and Houston, 2019, p. 285)

a. Calculate the covariance and correlation coefficient of


stocks W and M

b. Calculate the variance and standard deviation of a


portfolio that consist of 50% of each stock

127

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Example 9:

128

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Example 10: (see Brigham and Houston, 2019, p. 285)

a. Calculate the covariance and correlation coefficient of


stocks W and Y
b. Calculate the variance and standard deviation of a
portfolio that consist of 50% of each stock

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3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Example 10:

130

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

In the case a portfolio consists of n stocks, the portfolio


variance is the sum of all the cells in the following matrix:

1 2 3 … n
w1.w2.𝛔12 w1.w3.𝛔13
1 w12 . 𝛔12 2 2 … w1.wn.𝛔1n2

w2.w1.𝛔12 w2.w3.𝛔23
2 2 w22 . 𝛔22 2 … w2.wn.𝛔2n2

w3.w1.𝛔13 w3.w2.𝛔23
3 2 2 w32. 𝛔32 … w3.wn.𝛔3n2

… … … … … …
wn.w1.𝛔1n wn.w2.𝛔2n wn.w3.𝛔3n
n 2 2 2 … wn 2. 𝛔n2

131

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Portfolio risk includes two components:

Diversifiable Risk: That part of a security’s risk associated


with random events; it can be eliminated by proper
diversification. This risk is also known as company-specific, or
unsystematic risk.

Market Risk: The risk that remains in a portfolio after


diversification has eliminated all company-specific risk. This
risk is also known as nondiversifiable or systematic or beta
risk.

Brigham and Houston, 2019, p. 287

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6.3. Return and risk of a portfolio


Diversification
(by adding
more partially
correlated
stocks) can
reduce
unsystematic
risk but
cannot
reduce
systematic
(market) risk

133

3.3. RETURN AND RISK OF A PORTFOLIO


(ii) Portfolio Risk

Diversification (by
adding more partially
correlated stocks) can
reduce unsystematic
risk but cannot
reduce systematic
(market) risk.

134

3.4. CAPITAL ASSET PRICING MODEL


(CAPM)
Relevant risk

When a stock is held by itself, its risk can be measured by the


standard deviation of its expected returns, 𝜎. However, 𝜎 is not
appropriate when the stock is held in a portfolio. How to
measure a stock’s relevant risk in a portfolio context?

Relevant risk: The risk that remains once a stock is in a


diversified portfolio is its contribution to the portfolio’s market
risk, and that risk can be measured by the extent to which the
stock moves up or down with the market.

Brigham and Houston, 2019, p. 289

→A well-diversified portfolio is often known as the market portfolio.

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3.4. CAPITAL ASSET PRICING MODEL


(CAPM)

The CAPM model


Ri = 𝐑 𝐟 + (𝐑 𝐌 − 𝐑 𝐟 )∗ bi
Ri: the expected rate of return of stock i
Rf: the risk-free rate of return
RM: the rate of return of the market portfolio
βi: the beta coefficient of stock i
Beta coefficient, β
A metric that shows the extent to which a given stock’s
returns move up and down with the stock market. Beta
measures market risk.
Brigham and Houston, 2019, p. 290

136

3.4. CAPITAL ASSET PRICING MODEL


(CAPM)

The expected return of an asset depends on 3 things:


1. The pure time value of money: Rf
2. The reward for bearing systematic risk (Market risk
premium): R M − R f
3. The amount of systematic risk: b
Ross et al., 2018, p. 444

137

3.4. CAPITAL ASSET PRICING MODEL


(CAPM)

How to calculate beta?


Using statistical formula σ𝟐Ri,RM
𝛃𝐢 =
σ𝟐RM

In practice, use the slope of the regression line to estimate beta

𝛃 = 1: the asset is as risky as the average

𝛃 < 1: the asset is less risky than the average

𝛃 > 1: the asset is riskier than the average

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3.4. CAPITAL ASSET PRICING MODEL


(CAPM)

Example 12: (see Ross et al., 2018, p. 445)

Suppose the risk-free rate is 4 percent, the market risk premium is


8.6 percent, and a particular stock has a beta of 1.3. Based on the
CAPM, what is the expected return on this stock? What would the
expected return be if the beta were to double?

139

REFERENCES

▪ Brealey et al., 2020, Principles of Corporate Finance


▪ Ross et al., 2018, Fundamentals of Corporate Finance
▪ Brigham and Houston, 2019, Fundamentals of Financial
management
▪ Van Horne and Wachowicz, 2008, Fundamentals of Financial
Management

140

CORPORATE FINANCE

CHAPTER 4: COST OF CAPITAL

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

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LEARNING OBJECTIVES

After finishing this chapter, student should be able to:


✓Understand cost of capital
✓Understand and calculate cost of debt
✓Understand and calculate cost of preferred stock
✓Understand and calculate cost of equity
✓Understand and calculate weighted average cost of capital
✓Understand and calculate marginal cost of capital

142

CHAPTER OUTLINE

3.1. An overview of Cost of Capital


3.2. Cost of Debt
3.3. Cost of Preferred Stock
3.4. Cost of Equity
3.5. Weighted Average Cost of Capital
3.6. Marginal Cost of Capital
3.7. Cost of new common stocks and flotation costs

143

3.1. AN OVERVIEW OF COST OF CAPITAL

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3.1. AN OVERVIEW OF COST OF CAPITAL

Capital Components
One of the types of capital used by firms to raise funds.
Brigham and Houston, 2019, p. 359

Capital components can include:


• Debt
• Preferred stock
• Common Equity

Cost of Capital
The expected return on a portfolio of all the company’s
outstanding debt and equity securities.
Brealey et al., 2020, p. 229

145

3.2. COST OF DEBT


The cost of debt is the return the firm’s creditors demand
on new borrowing.
Ross et al., 2018, p. 464
Before-Tax Cost of Debt, rd : The interest rate the firm must
pay on new debt.
After-Tax Cost of Debt, rd(1-t): The relevant cost of new
debt, taking into account the tax deductibility of interest;
used to calculate the WACC.
After-tax cost of debt = Interest rate on new debt - Tax
savings
= rd – rd*t
= rd(1 - t)
Brigham and Houston, 2019, p. 361

146

3.2. COST OF DEBT

In the case of using bond, the cost of debt rd is the root of


the following equation:
n
C FV
Po = ෍ t
+ n
1+rd 1+rd
t=1
where:
P0: the current market price of the bond
n: the number of periods remaining to maturity

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3.2. COST OF DEBT

Example 1: A company has 20-year bonds with a face


value of $1,000, an 11% annual coupon, and a market price
of $1,294.54. If the company’s tax rate is 40%, what is its
after-tax cost of debt?
(see Brigham and Houston, 2019, p. 362)

Example 2: Suppose the General Tool Company issued a


30-year, 7 percent bond 8 years ago. The bond is currently
selling for 96 percent of its face value, or $960. What is
General Tool’s cost of debt?
(see Ross et al., 2018, p. 464)

148

3.3. COST OF PREFERRED STOCK

Dp
rp =
Pp
rp: cost of preferred stock
Dp: preferred dividend
Pp: current price of preferred dividend

Example 3: Allied company would issue preferred stock


that pays $10.00 dividend per share, and it would be priced
at $97.50 a share. What is Allied’s cost of preferred stock?
(see Brigham and Houstson, 2019, p. 362)

149

3.4. COST OF EQUITY

Cost of equity
The return that equity investors require on their investment
in the firm.
Ross et al., 2018, p. 460

To estimate the cost of equity, we have 2 common


approaches:
• The dividend growth model
• The Capital Asset Pricing Model (CAPM)

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3.4. COST OF EQUITY

The dividend growth model

D0 (1 + g) 𝐷1
P0 = =
re − g re − g

𝐷1
⇔ re = +𝑔
P0

Example 4: Greater States Public Service, a large public utility, paid a


dividend of $4 per share last year. The stock currently sells for $60 per
share. You estimate that the dividend will grow steadily at a rate of 6
percent per year into the indefinite future. What is the cost of equity
capital for Greater States?
(see Ross et al., 2018, p. 461)

151

3.4. COST OF EQUITY

The dividend growth model

Advantages Disadvantages
Only applicable for
companies that pay
dividends
Simple to apply Sensitive to the estimated
growth rate
Does not explicitly consider
risks Ross et al., 2018, p. 462

152

3.4. COST OF EQUITY


Cost of equity
The Capital Asset Pricing Model (CAPM)
𝐫𝐞 = 𝐫𝐟 + 𝛃(𝐫𝐦 − 𝐫𝐟 )
re: the required rate of return of shareholders or the cost of
equity
rf: the risk-free rate
rm: the rate of return of the market portfolio
rm – rf: The market risk premium
𝛽: beta coefficient, represents the systematic risk of the asset
relative to average

Example 5: Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk
premium is 7 percent, and the risk-free rate is 6 percent. Alpha’s last dividend was $2
per share, and the dividend is expected to grow at 8 percent indefinitely. The stock
currently sells for $30. What is Alpha’s cost of equity capital?
(see Ross et al., 2018, p. 463)

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3.4. COST OF EQUITY

The Capital Asset Pricing Model (CAPM)

Advantages Disadvantages
Adjust for risks The estimate of market risk
premium and the beta
coefficient might not be
correct
Applicable to most of Use data in the past
companies
Ross et al., 2018, p. 463

154

3.5. WEIGHTED AVERAGE COST OF CAPITAL


(WACC)
Weighted average cost of capital (WACC)
WACC = wd*rd*(1-t) + wp*rp + we*re
wd = (D/V): percentage of debt in capital structure
rd*(1-t): after-tax cost of debt
wp = (P/V): percentage of preferred stock
rp: cost of preferred stock
we = (E/V): percentage of equity in capital structure
re: cost of equity
t: marginal tax rate

155

3.5. WEIGHTED AVERAGE COST OF CAPITAL


(WACC)
Example 6: Allied’s target capital structure calls for 45% debt, 2%
preferred stock, and 53% common equity. Its before-tax cost of
debt is 10.0%; its cost of preferred stock is 10.3%; its cost of
equity is 13.5%; and its marginal tax rate is 40%. What is its
WACC?
(see Brigham and Houston, 2019, p. 371)

Example 7: The B.B. Lean Co. has 1.4 million shares of stock
outstanding. The stock currently sells for $20 per share. The firm’s
debt is publicly traded and was recently quoted at 93 percent of
face value. It has a total face value of $5 million, and it is currently
priced to yield 11 percent. The risk-free rate is 8 percent, and the
market risk premium is 7 percent. You’ve estimated that Lean has
a beta of 0.74. If the corporate tax rate is 21 percent, what is the
WACC of Lean Co.?
(see Ross et al., 2018, p. 467)

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3.6. COST OF NEW COMMON STOCK AND


FLOTATION COSTS

Flotation costs

Costs are paid for issuing new common stock

Two approaches to accounts for flotation costs:

1. Add flotation costs to a project’s costs

2. Increase the cost of capital

157

3.6. COST OF NEW COMMON STOCK AND


FLOTATION COSTS
(i) Add flotation costs to a project’s costs

Example 9:

Case 1: consider a 1-year project with an initial cost (not

including flotation costs) of $100 million. After 1 year, the

project is expected to produce an inflow of $115 million. What

is its expected rate of return?

Case 2: if the project requires the company to raise $100

million of new capital and incur $2 million of flotation costs.

What is its expected rate of return?

(See Brigham and Houston, 2019, p. 368)

158

3.6. COST OF NEW COMMON STOCK AND


FLOTATION COSTS

(ii) Increase the cost of capital


𝐃𝟏
𝐫𝐞 = +𝐠
𝐏𝟎 (𝟏 − 𝐅)

F: flotation costs - The percentage cost of issuing new common stock.

Example 10: Assuming that Allied intends to issue new


common stock with the price of $23.06 and a flotation cost of
10%, its expected dividend is $1.25, and analysts expect its
growth rate to be 8.3%. What is its cost of equity?
(See Brigham and Houston, 2019, pp. 367 – 369)

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REFERENCES

• Brealey et al., 2020, Principles of Corporate Finance


• Ross et al., 2018, Fundamentals of Corporate Finance
• Brigham and Houston, 2019, Fundamentals of Financial
management

160

CORPORATE FINANCE

CHAPTER 5: FINANCIAL LEVERAGE

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

161

LEARNING OBJECTIVES

After finishing this chapter, student should be able to:

▪ Understand financial leverage, financial risk

▪ Understand, calculate and interpret degree of


financial leverage

▪ Understand EBIT-EPS Break-Even

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CHAPTER OUTLINE

5.1. Financial leverage

5.2. EBIT-EPS Break-Even, or Indifference points

5.3. Degree of Financial Leverage

163

5.1. FINANCIAL LEVERAGE

The use of fixed financing costs by the firm. For example, interest
on debt, preferred dividend on preferred stock.

Van Horne and Wachowicz, 2008, p. 420

▪ Financial leverage is a choice


▪ Financial leverage concentrates the firm’s business risk on the
stockholders. (Brigham and Houston, 2019, p. 485)
▪ Financial leverage is a two-edged sword
▪ Financial leverage is the second step in a two-step profit-
magnification process

164

5.1. EBIT-EPS BREAK-EVEN

EBIT-EPS Break-Even, or Indifference points

EBIT−I × 1−t −DP


EPS=
NS

Dp: Preferred Dividend


NS: Number of common shares outstanding

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5.1. EBIT-EPS BREAK-EVEN

Example 4: TT company are considering two financing alternatives

Method 1 Method 2
What is EPS of each financing
Assets 100 billions 100 billions
method under each following
Debt 0 50 billions
scenarios?
Equity 100 billions 50 billions a. EBIT is 6.25 billions
Debt to Equity ratio 0 1 b. EBIT is 15 billions

Number of shares 10,000,000 5,000,000 c. EBIT is 37.5 billions

outstanding stocks stocks


Interest rate 0 10%

166

5.1. EBIT-EPS BREAK-EVEN

6000
EPS1 =EPS2

EBIT(1−t) (EBIT−I)(1−t) 5000


=
NS1 NS2

EBIT(1−20%) (EBIT−5)(1−20%) 4000


⇔ =
10.000.000 5.000.000
EPS

EBIT 3000
⇔ =EBIT−5
2
⇔EBIT=2EBIT−10
2000
⇔EBIT=10 billions

1000

0
0 10 20 30 40
EBIT

167

5.1. DEGREE OF FINANCIAL LEVERAGE


(DFL)

A quantitative measure of the sensitivity of a firm’s


earnings per share to a change in the firm’s operating profit
%∆EPS
DFL EBIT =
%∆EBIT
EBIT
⇔DFLEBIT =
Dp
EBIT−I−
1−t

DFL and Financial Risk


Financial risk
The added variability in earnings per share (EPS) – plus the
risk of possible insolvency– that is induced by the use of
financial leverage.

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5.1. DEGREE OF FINANCIAL LEVERAGE


(DFL)
DFL and Financial Risk
Total firm risk = business risk + financial risk.
CV(EPS) is a measure of relative total firm risk:
CV(EPS) = ∂EPS/E(EPS).
CV(EBIT), is a measure of relative business risk:
CV(EBIT) = ∂EBIT /E(EBIT).
CV(EPS) - CV(EBIT): measure of relative financial risk.

DFL and Financial Risk

CV EPS =CV EBIT ×DFLE(EBIT)

When firm only uses equity, DFLE(EBIT) = 1 => CV(EPS) =


CV(EBIT) => Total firm risk = Business risk
When firm uses financial leverage, DFLE(EBIT) will magnify the
impact of business risk on the variability of earnings per share

169

REFERENCES

• Brealey et al., 2020, Principles of Corporate Finance


• Ross et al., 2018, Fundamentals of Corporate Finance
• Brigham and Houston, 2019, Fundamentals of Financial
management
• Van Horne and Wachowicz, 2008, Fundamentals of
Financial Management

170

CORPORATE FINANCE

CHAPTER 6: THEORIES OF CAPITAL STRUCTURE

Ph.D. Quynh Du Thi Lan


Email: quynhdtl@buh.edu.vn

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LEARNING OBJECTIVES

After finishing this chapter, student should be able to:

▪ Understand the relationship between capital structure and


the firm’s value

▪ Understand the framework to determine the optimal capital


structure

▪ Understand different capital structure theories

172

CHAPTER OUTLINE

6.1. Overview

6.2. M&M Propositions I and II (No taxes)

6.3. M&M Propositions I and II (With corporate taxes)

6.4. Bankruptcy Costs

6.5 The Optimal Capital Structure

6.6. The Pecking Order Theory

173

4.1. OVERVIEW

Capital Structure
The mix of debt, preferred stock, and common equity that is
used to finance the firm’s assets.
Brigham and Houston, 2019, p. 476
Measures of Capital Structure
Debt to Equity ratio = Debt/Equity
Debt ratio = Debt/Total Assets
Equity ratio = Equity/Total Assets
Equity multiplier = Total Assets/Equity

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4.1. OVERVIEW

How to choose a debt-to-equity ratio?


Guiding principle: Choose a debt-to-equity ratio to maximize
the value of a share of stock, or equivalently, maximize the firm’s
value.

Ross et al., 2018, p. 535

What is the relationship between capital structure and the cost of


capital?
What is the relationship between the cost of capital and the firm’s
value?

Optimal Capital Structure


The capital structure that maximizes a stock’s intrinsic value or
equivalently, minimize the weighted average cost of capital
Brigham and Houston, 2019, p. 476

175

4.2. M&M PROPOSITIONS I AND II (NO TAXES)

M&M Proposition I – The Pie Model


• The proposition that the value of the firm is independent
of the firm’s capital structure.
Ross et al., 2018, p. 541
• “The size of the pie doesn’t depend on how it is sliced.”
Ross et al., 2018, p. 542

176

4.2. M&M PROPOSITIONS I AND II (NO TAXES)

M&M Proposition II – COST OF EQUITY AND FINANCIAL LEVERAGE

E D
WACC= ×RE + ×RD
V V
E D
⇔RA = ×RE + ×RD
V V

D
⇔RE =RA +(RA−RD)×
E

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4.2. M&M PROPOSITIONS I AND II (NO TAXES)

M&M Proposition II – COST OF EQUITY AND FINANCIAL LEVERAGE

178

4.2. M&M PROPOSITIONS I AND II (NO TAXES)

M&M Proposition II – COST OF EQUITY AND FINANCIAL LEVERAGE

Example 1:

The Ricardo Corporation has a weighted average cost of capital (ignoring


taxes) of 12 percent. It can borrow at 8 percent. Assuming that Ricardo
has a target capital structure of 80 percent equity and 20 percent debt,
what is its cost of equity? What is the cost of equity if the target capital
structure is 50 percent equity? Calculate the WACC using your answers to
verify that it is the same.

(see Ross et al, 2018, p. 543)

179

4.2. M&M PROPOSITIONS I AND II (NO TAXES)

Example 2: Two firms, U and L. EBIT is expected to be $1,000 every


year forever for both firms. The difference between the firms is that
Firm L has issued $1,000 worth of perpetual bonds on which it pays 8
percent interest each year. The interest bill is 0.08 * $1,000 = $80
every year forever.

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4.3. M&M PROPOSITIONS I AND II


(WITH CORPORATE TAXES)
Present value of the interest tax shield = (TC×D×RD)/RD = TC×D

VL = VU + TC × D

EBIT×(1−TC )
VU =
RU

183

4.3. M&M PROPOSITIONS I AND II


(WITH CORPORATE TAXES)

Example 3: return to example 2, suppose that the cost of capital for


Firm U is 10 percent (the unlevered cost of capital – RU). What is VU
and VL?

184

4.3. M&M PROPOSITIONS I AND II


(WITH CORPORATE TAXES)

M&M Proposition II with corporate taxes

RE = RU + (RU − RD) × (D/E) × (1 − TC)

WACC = (E/V) . RE + (D/V) . RD . (1 − TC)

Example 4: return to examples 2 and 3, calculate RE and


WACC of firm L?

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4.3. M&M PROPOSITIONS I AND II


(WITH CORPORATE TAXES)

Example 5: (see Ross et al., 2018, p. 549) You are given the following
information for the Format Co.:
EBIT = $126.58
TC = 0.21
D = $500
RU = 0.20
The cost of debt capital is 10 percent. What is the value of Format’s
equity? What is the cost of equity capital for Format? What is the WACC?

186

4.4. BANKRUPTCY COSTS

• What is implication from MM propositions with corporate


taxes?
• When the debt to equity ratio increases, the probability of
bankruptcy increase.
• Going bankruptcy is expensive!

187

4.4. BANKRUPTCY COSTS

Direct bankruptcy costs


The costs that are directly associated with bankruptcy, such as
legal and administrative expenses.
Indirect bankruptcy costs
The costs of avoiding a bankruptcy filing incurred by a
financially distressed firm.
Financial distress costs
The direct and indirect costs associated with going bankrupt
or experiencing financial distress.

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4.5. OPTIMAL CAPITAL STRUCTURE


Static theory of capital structure

The theory that a firm borrows up to the point where the tax
benefit from an extra dollar in debt is exactly equal to the cost
that comes from the increased probability of financial distress.

189

4.5. OPTIMAL CAPITAL STRUCTURE

Optimal capital structure and the cost of capital

190

4.5. OPTIMAL CAPITAL STRUCTURE

Optimal capital structure: recap

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4.5. Optimal Capital Structure

• Optimal capital structure: recap

192

4.6. PECKING ORDER THEORY

▪ Internal financing => debt => equity


▪ No target capital structure
▪ Profitable firms use less debt
▪ Companies will want financial slack

193

REFERENCES

• Brealey et al., 2020, Principles of Corporate Finance

• Ross et al., 2018, Fundamentals of Corporate Finance

• Brigham and Houston, 2019, Fundamentals of Financial


management

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