Economics of Finance - Dabrowski

The publication co-financed by the European Union from the European Social Fund
Economics of Finance
Agency Problem and Risk in Corporate Finance
Ireneusz Dąbrowski
Warsaw School of Economics

JUNE 2015
This publication is the result of the project Młodzi projektują zarządzanie co-financed by the European
Social Fund within Human Capital Operational Programme, Priority IV “Higher education and science,”
Measure 4.1 “Strengthening and development of didactic potential of universities and increasing the
number of graduates from faculties of key importance for knowledge-based economy,” Sub-measure
4.1.1 “Strengthening and development of didactic potential of universities.”
Publisher:
Szkoła Główna Handlowa w Warszawie
(SGH)
Reviewer:
Tomasz Dębski
First Edition
© Copyright by Szkoła Główna Handlowa w Warszawie (SGH)

al. Niepodległości 162, 02-554 Warszawa, Polska
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to my Mother and in memory of my Father
Contents
1. Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.1 Corporate Finance and The Financial Manager . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 Long-term Financial Decisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.1 Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.2 Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2. The Agency Problem in Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.1.1 Principal-Agent Problem. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.1.2 The Objectives of Financial Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.3 Managers and Stockholders’ in Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3. Time Value of Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

3.1 Future Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.1.1 Investing for a Single Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.1.2 Investing for More Than One Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.2 Present Value and Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.2.1 The Single-Period Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3.2.2 Present Values for Multiple Periods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3.3 Present versus Future Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4. Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.1 Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4.2 Typical Cash Outflows and Inflows. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4.3 Net Present Value (NPV) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.3.1 Estimating Net Present Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4 Internal Rate of Return (IRR). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.4.1 Estimating Internal Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.4.2 Net Present Value and Internal Rate of Return. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.5 Payback Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.5.1 Evaluation of the Payback Period Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.5.2 Criticism of Payback Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
5. Risk and Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

5.1 Rates of Return. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
5.2 Variance and Standard Deviation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.3 Diversification and Risk Reducing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
5.3.1 Portfolio Weights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
6 CONTENTS
5.3.2 Portfolio Expected Returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

5.3.3 Portfolio Variance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5.3.4 Portfolio Risk and Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5.3.5 Diversification, Systematic and Unsystematic risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.3.6 Limits of Diversification. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
5.3.7 Beta. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
6. Cost of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
6.1 Required Return, Cost of Capital and Financial Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
6.2 The Cost of Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
6.2.1 The Security Market Line and Cost of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
6.2.2 Advantages and Disadvantages of the Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
6.3 The Cost of Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
6.4 The Weighted Average Cost of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
6.4.1 The Capital Structure Weights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
6.4.2 Taxes and the Weighted Average Cost of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
6.4.3 The Security Market Line and the Weighted Average Cost of Capital. . . . . . . . . . . . . . 49
7. Capital Structure and Financial Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

7.1 Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7.2 The Effect of Financial Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
7.2.1 Financial Leverage and ROE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
7.2.2 Financial Leverage and EBIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
7.2.4 Business Risk and Financial Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
7.3 Capital Structure and the Cost of Equity Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
7.3.1 Traditional View. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
7.3.2 The Miller & Modigliani Proposition I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
7.3.3 Cost of Equity and Financial Leverage: M&M Proposition II. . . . . . . . . . . . . . . . . . . . . 60
7.4 Taxation, Financial Distress and Bankruptcy Cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
7.4.1 The Interest Tax Shield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
7.4.2 Taxes and M&M Proposition I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
7.4.3 Taxes, the WACC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
7.5 Financial Distress and Bankruptcy Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
7.5.1 Cost of Capital in Practice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
7.5.2 The Static Theory of Capital Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
List of figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
List of tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
1. Introduction
Companies finance their business activities from both short-term and long-term sources.
Even if short-term financial decisions constantly involve short-lived assets, there is a link be-
tween short-term and long-term financing decisions arising from a firm’s cumulative capital
requirements. If we have a surplus of long-term financing, we would need less short-term funds.
If the company wants to run a new project, regardless of what type it has started, it must
answer two long-term questions. Long-term corporate finance, generally speaking, is the
study of following issues:
1. Long-term investments that company should undertake.
2. Sources of long-term financing of projects.
Short-term financial decisions differ from long-term ones in two important ways. First,
they may be quickly reversed in most cases. Second, there is far less risk involved in the deci-
sion parameters as we are concerned with the horizon period counted in months rather than
years. This does not mean that short-term financial decisions are any less important. Short-
term financial decisions ensure the company’s liquidity which is essential for the short-term
operating capacity of the company.
1.1 Corporate Finance and The Financial Manager
Corporate Finance means any monetary or financial action concerning a company itself and
its cash. It is the set of actions and policies that decides how capital is employed in a company.
An important problem of large corporations is that the owners are usually not directly
involved in making company decisions, especially on a day-to-day basis. The corporation
usually hires managers to represent the owners’ interests and make decisions on their behalf.
In a large corporation, the financial manager would be in charge of resolving the problems
outlined in the preceding section.
The financial management task is typically associated with a top officer of the company,
such as a vice president for finance or some other chief financial officer (CFO). Figure 1 is
a basic organizational chart that shows the finance position in a typical corporation.
Normally the vice president of finance manages the activities of the controller and the
treasurer. The controller’s office is responsible for financial accounting, tax payments, and
management information systems. The treasurer’s office is responsible for managing the com-
pany’s credit and cash, its financial planning, and its capital expenditures.
Generally, financial managers try to match the maturity of capital sources with the life of
the assets funded by them. For example, some minimum level of working capital is needed
permanently in the company and is financed from permanent sources, but the seasonal in-
crease in working capital is characteristically financed from short-term sources.
8 1. INTRODUCTION
Figure 1 Organization chart
1.2 Long-term Financial Decisions
As the preceding discussion suggests, the financial manager must be concerned with two
basic problems. We discuss these issues in greater detail next.
1.2.1 Capital Budgeting
The first long-term problem concerns the company’s new investment. The process of planning
and managing a company’s long-term investment is called capital budgeting. In capital budget-
ing, the financial manager tries to recognize investment opportunities that are worth more to the
company than they cost to obtain. In other words, we may say that the value of the cash flow gen-
erated by an asset exceeds the cost of that asset. The types of investment opportunities that would
naturally be considered depend in part on the type of the company’s industry.
In spite of the specific nature of an opportunity under consideration, financial managers
must be concerned not only with an amount of money they expect to collect, but also when
they anticipate to receive it and how likely they are to receive it. Evaluating the size, timing,
and risk of future cash flows is the essence of capital budgeting. In fact, whenever we evaluate
a business decision, the size, timing, and risk of the cash flows will be, by far, the most impor-
tant things we will consider.
1.2.2 Capital Structure
The second long-tem problem for the financial manager concerns ways in which the
company acquires and manages the long-term financing to sustain its long-term investment.
A company’s capital structure (or financial structure) is the specific combination of long-term
9
debt and equity the company employs to finance its activity. The financial manager has two
concerns in this area. Firstly, how much debt relatively to equity should the company employ,
i.e. what combination of debt and equity is optimal. The chosen capital mix will influence
both the risk and the value of the company. Secondly, what are the least expensive sources of
capital for the company?
Company’s capital structure determines the fraction of the company’s cash flow that goes
to debtholders and the one that goes to shareholders. Companies have a great deal of elasticity
in selecting their financial structure. The problem of whether one structure is better than any
other for a particular company is in the core of the capital structure problem.
Additionally, deciding on the financing mix, the financial manager has to choose how exact-
ly and where to raise the cash. The operating costs associated with raising long-term financing
can be substantial, so different possibilities must be carefully estimated. Moreover, companies
borrow money from a variety of investors in a lot of different, and sometimes peculiar, ways.
Selecting bankers and debt types is another task handled by the financial manager.
2. The Agency Problem in Corporations
In traditional (neoclassical) approach a corporation is treated as a single entity, it is often

called a holistic approach. That is one of the characteristics of a sole proprietorship. There is
no conflict of interest between owners and managers. In large corporations we almost always
have the separation of owners and managers. Financial manager is supposed to work in the
best interest of the owners by taking actions that increase the value of the company. However,
we have also witnessed that in large corporations ownership can be spread over a huge num-
ber of owners (shareholders).
If we assume that shareholders buy shares as they seek financial gain, then the answer is
obvious: good choices increase the value of the shares, and poor choices decrease the value of
the shares. Specified our clarification, it follows that the financial manager acts in the share-
holders’ best interest by making decisions that increase the current value of the shares.
On the other hand the separation of management and owners has a few advantages. It al-
lows owners to change management without interfering the business operation. It allows the
company to employ professional managers. This dispersion of ownership means that manag-
ers, not owners, can control the company, and it brings problems if the managers’ and owners’
objectives are not the same and if management do not really acts in the best interest of the
owners.
We explicitly mean that management goal is to maximize the current share value. By this
we mean that owners are only entitled to what is left after suppliers, staff, debtholders and
anyone else with a legitimate claim to paid their due. If any of these groups go unpaid, the
owners get nothing. Because the goal of financial management is to maximize the value of
the stock, we need to learn how to recognize those investments and financial planning that
positively impact the value of the company. We can say that corporate finance is the study of
the relationship between business decisions and the value of the shares.
2.1.1 Principal-Agent Problem
The relationship between managers and owners is called principal-agent problem (or
agency relationship). Such a connection exists whenever someone (the principal) employs
another (the agent) to represent his interests. Shareholders are the principals and the manag-
ers are their agents. Shareholders want the management to raise the value of the company,
but managers may have their own aims. Agency costs are incurred when (1) managers do
not attempt to maximize company’s value and (2) shareholders incur expenses to monitor
the managers and influence their actions. Usually, the expression agency costs refers to the
costs of the conflict of interest between owners and management. Naturally, there are no costs
when the owners are also the managers.
11
Agency costs can be indirect or direct. An indirect agency cost is an opportunity cost.
Direct ones come in two types. The first type is corporate spending that benefits management
but constitute excessive costs for the owners (i.e. luxurious and unnecessary corporate cars
or even jets). The second type of direct agency cost is an expense that arises from the need to
control management actions. Hiring external auditors to assess the correctness of financial
statement information is a typical example.
2.1.2 The Objectives of Financial Management
Under the neoclassical profit maximization assumption, we expect the financial manage-
ment to make profits or add value for the owners. This aim is however a little unclear, so
we observe somewhat different ways of formulating it while trying to come up with a more
precise definition. Such a description is important because it provides an objective basis for
making and evaluating financial decisions.
If we consider possible financial goals, we may list some ideas such as the following:
• Survive,
• Avoid financial distress and bankruptcy,
• Beat the competition,
• Maximize sales or market share,
• Minimize costs,
• Maximize profits,
• Maintain steady earnings growth.
There are economic theories which assume that management may tend to overemphasize or-
ganizational survival to protect their job security. Management may have an aversion to outside
interference, so independence and corporate self-sufficiency may be the important goals for them.
Baumol presented a managerial theory of the firm based on the sales maximization.
According to the managerial theory, if the management have no control at all it seeks prestige
and higher salaries by expanding the company’s sales even at the expense of its profits.
It is the idea which comes from the outside mainstream economy that, with the separation
of ownership and control in modern companies, managers prefer the company to be rather
bigger than more profitable. Therefore, managers left on their own would tend to maximize
the amount of resources over which they have control or, more generally, corporate power or
wealth. This goal could lead to an overemphasis on corporate size or growth.
2.1.3 Managers and Stockholders in Practice
Agency problems would be easier to solve if owners and managers have the complete in-
formation. That is however rarely the case in finance. Managers, shareholders, and debtholders
may all have different information about the value of a financial asset, and it may be many years
before all the information is revealed. Financial managers have to recognize these information
asymmetries and find ways to convince investors that there are costly surprises on the way ahead.
12 2. THE AGENCY PROBLEM IN CORPORATIONS
Two basic aspects decide if managers act in the best interest of owners: how closely are the
goals of management aligned with those of stockholder and, if management can be replaced
when they do not follow owners’ goals. The first aspect relates to the way managers are com-
pensated. The second aspect relates to control of the company. Usually, there are some reasons
to believe that, even in the corporations with complex structures, management has a signifi-
cant incentive to perform in the interests of owners.
2.1.3.1 Managerial Compensation

Managerial compensation is usually analyzed by means of four categories:
• Wage Level
• Base Pay
• Variable Pay
• Benefits
Management will normally have a significant economic incentive to increase share value
for two reasons. First, managerial compensation, particularly at the top, usually depends on
the financial performance in general and to share value in particular. Managers are regularly
given the option to buy shares at an individual price. The more the shares are worth, the more
valuable this option is. Actually, options are increasingly being used to motivate managers of
all types, not only the top management.
The second incentive for managers refers to their career prospects. Better performers
within the company will tend to be promoted. More generally, those managers who are suc-
cessful in pursuing stockholder’s goals will be in greater demand on the labor market and
thus they will command higher salaries. In fact, managers who are successful in pursuing
stockholder’s goals can reap enormous rewards.
2.1.3.2 Control of the Company

The control of the company depends ultimately on stockholders. They vote for the board
of directors which employ management. A key mechanism that allows dissatisfied stockhold-
ers to change the current management is called a proxy fight. A proxy is the authority to vote
someone else’s stock. A proxy fight occurs when a group solicit proxies in order to replace the
elected board, and thus replace the incumbent management.
Another way that management can be replaced is by takeover. Those companies that are
badly managed are more attractive as acquisition targets than well-managed companies be-
cause a greater possible gain exists. Therefore, avoiding a hostile takeover by another com-
pany provides the management another incentive to take action in the owners’ interest.
Management and owners are not the only players that may have an interest in the compa-
ny’s decisions. Customers, employees, suppliers, and even the state authority all have a finan-
cial interest in the company. These different groups are called stakeholders in the company.
Normally, a stakeholder is someone other than a stockholder or creditor who potentially has
a claim on the cash flows of the company. Such groups will also try to exert control over the
company, possibly to the loss of the owners.
3. Time Value of Money
Time value of money refers to the fact that the cash today is worth more than the cash prom-
ised at some time in the future. One explanation for this is that one could receive interest while
waited, so the money today would grow over the time. The trade-off between cash now and cash
later thus depends on, among other things, the rate of return we can receive from investing.
3.1 Future Value
Future value (FV) is the amount of money that an investment will grow to over some
period of time at some given interest rate. Put differently, future value is the cash value of an
investment at some time in the future. Let us consider now a single-period investment first.
3.1.1 Investing for a Single Period
Suppose we invest $1 in a savings account that pays 100% interest per year. How much will
we get after one year? We will get $2. This $2 is equal to our original principal of $1 plus $1
in interest that we earn. We say that $2 is the future value of $1 invested for one year at 100%,
and we simply mean that $1 today is worth $2 in one year, given that 100% is the interest rate.
Generally, if we invest funds for one period at an interest rate of r, our investment will grow to
(1 + r) per dollar invested. In our example, r is 100%, so our investment grows to 1 + 1 = 2 dollars
per dollar invested. We invested $1 in this case, so we end with $1*(1+1)= $2.
3.1.2 Investing for More Than One Period
Going back to our $1 investment example, what will we get after two years, assuming the
interest rate doesn’t change? If we deposit the entire sum of $2 in the bank, we will earn $2*
1 = 2 in interest during the second year, so we will have a total of $2* (1+1)=$4. This $4 is the
future value of $1 in two years at 100%. Another way of looking at it is that one year from now
we are effectively investing $2 at 100% for a year. This is a single-period problem, so we will
end up with $2 for every dollar invested, or $2 (1+1) = $4 total.
This $4 contains four elements. The first element is the $1 original principal. The second
element is the $1 in interest we earned in the first year, and the third element is another $1 we
earn in the second year, for a total of $3. The last $1 we end up with (the fourth part) is interest
we earn in the second year on the interest paid in the first year.
This method of putting our money and any accumulated interest in an investment for more
than one period, thereby reinvesting the interest, is called compounding. Compounding the inter-
est means receiving interest on interest, so we call the result compound interest. With simple inter-
est, the interest is not reinvested, so interest is earned each period only on the original principal.
14 3. TIME VALUE OF MONEY
Now we discuss how we calculated the $4 future value. We multiplied $2 by 2 to get $4.
The $2, however, was $1 also multiplied by 2. In other words:
$4 = $2*2= ($1*2)*2= $1*(2*2)= $1 * 22
Now let’s ask: How much would our $1 grow to after three years? Once again, in two years,
we will be investing $4 for one period at 100%. We will end up with $2 for every dollar we
invest, or $4 *2 = $8 total. This $8 is thus:
$8 = $4*2= ($2*2)*2= [($1*2)*2] *2= $1*(2*2 *2)= $1 * 23
After becoming aware of a pattern to these calculations, we can go ahead now and state the
general result. As our examples suggest, the future value of $1 invested for t periods at a rate
of r per period is:
Future value = $1 * (1 + r)t
The expression (1 + r)t is called the future value interest factor (or just future value factor)
for $1 invested at r% for t periods and can be abbreviated as FVIF(r, t). Let us consider what
would your 1$ be worth after five years with interest rate 10%? We can first calculate the rel-
evant future value factor as:
(1 + r)t = (1 + 0.10)5 = 1,15 = 1,6105
Your $1 will thus grow to:
$1 * 1.6105 = $1.6105
3.2 Present Value and Discounting
After we discuss future value, now we have a similar issue that is even more present in financial
management and is clearly related to future value. Assume we need to have $10000 in 5 years, and
we can earn 10% on our money. How much do we have to invest today to reach our objective?
3.2.1 The Single-Period Case
Consequently, now we want to find out how much do we have to invest today at 10% to get
$1 in one year? To make things simpler, we have to calculate the present value (PV) if we know
that the future value is $1. The solution is not too complicated to find. The amount we invest
today will be 1,1 times bigger at the end of the year. Since we need $1 at the end of the year:
Present value * 1,1 = $1
15
Or, solving for the present value:
Present value = $1/1,1 = $0,909
In this example, we must find the amount (the present value), invested today, that will
grow to $1 after one year if the interest rate is 10%. Present value is therefore just the opposite
of future value. Instead of compounding the money forward into the future, we discount it
back to the present.
From our examples, the present value of $1 to be obtained in one period is basically given as:
3.2.2 Present Values for Multiple Periods
Assume we want to have $100 in two years and if we can earn 10% per year. How much do
we have to invest now to make sure that we have the $100 when we want it. So now the issue
is, what is the present value of $100 in two years if the relevant rate is 10%?
Based on our understanding of future values, we know the amount invested must grow to
$100 over the two years. In other words, it must be the situation that:
$100 = PV * 1,1 * 1,1 = PV * 1,12 = PV * 1,21
Given this, we can easily find the solution for the present value:
Consequently, $82,65 is the amount we must invest in order to achieve our goal. As we
have known by now, calculating present values is quite similar to calculating future values,
and the general result looks much the same. The present value of $1 to be collected t periods
into the future at a discount rate of r is:
1
Because the measure is used to discount a future cash flow, it is called a discount
(1 + r) t
factor and the rate r used in the calculation is named the discount rate. We will tend to call it
1
in talking about present values. The measure is also called the present value interest
(1 + r) t
factor (or just present value factor) for $1 at r% for t periods and is sometimes abbreviated as
PVIF(r, t). Calculating the present value of a future cash flow to determine its value today is
usually called discounted cash flow (DCF) valuation.
16 3. TIME VALUE OF MONEY
3.3 Present versus Future Value
If we look back at the formulas we provided for present and future values, we will see
there is an straightforward connection between the two. We investigate this relationship and
some related issues. What we called the present value factor is just the reciprocal of (that is,
1 divided by) the future value factor:
Future value factor = (1 + r)t

1
Present value factor =
(1 + r) t
Certainly, the simple way to calculate a present value factor on many calculators is to cal-
culate the future value factor first and then press the “1/x” key to flip it over. If we let FVt stand
for the future value after t periods, then the relationship between future value and present
value can be formulated very simply as one of the following:
PV (1 + r)t = FVt
This last formula we will name the central present value equation. We will use it through-
out the text. There are a number of differences that will occur, but this simple equation lies
beneath many of the most important ideas in corporate finance.
4. Capital Budgeting
Today, the professional allocation of capital resources is a most essential function of the
financial management. This purpose involves organization’s decision to invest its resources in
long-term assets such as a new production facility or investing in machinery and equipment,
land, vehicles, etc. All these assets are very important to the company because, usually all the
profits are obtained from the use of its capital in investment in assets which correspond to
a very large commitment of financial resources, and these funds typically remain invested
over a long period of time. The future expansion of a company is contingent on the capital
investment projects, the replacement of existing capital assets, and the decision to abandon
previously accepted activities which appear as less attractive to the company than was origi-
nally assumed, and redeploying the resources, new concepts and planning. In an ideal world,
companies should reject all projects and opportunities that harm shareholder’s value.
The process during which a company determines whether particular endeavor such as
building a new factory or investing in a long-term project is worth investing is called capital
budgeting (or investment appraisal). Generally, a prospective project’s lifetime cash outflows
and inflows are evaluated in order to determine whether the returns generated meet a target
baseline.
In real economy the total available capital at every given time for new businesses is strictly
limited, executives need to use capital budgeting methods to determine which businesses will
yield the highest return over an applicable period of time.
Consequently, capital budgeting can be defined as long-term planning for proposed capi-
tal outlays and their financing. Therefore, it includes both raising long-term funds and their
use. To be more specific, capital budgeting decision may be defined as long-term investments
in which the assets involved have useful lifes of multiple years. Capital budgeting is a method
of estimating the financial viability of a capital investment over the life of the investment.
The capital budgeting question is probably the most important issue in corporate finance.
How a company chooses to finance its operations (the capital structure question) and how
a company manages its short-term operating activities (the working capital question) are cer-
tainly issues of concern, but it is the fixed assets that define the business of the company.
Capital budgeting, unlike other types of investment analysis, concentrates on cash flows
rather than profits. It involves identifying the cash inflows and cash outflows rather than ac-
counting revenues and expenses ﬂowing from the investment, such non-expense items as debt
principal payments are included in capital budgeting because they are cash flow transactions.
Over the long run, capital budgeting and traditional performance analysis will yield analo-
gous net values. However, capital budgeting methods include the time value modifications.
18 4. CAPITAL BUDGETING
There is a huge number of viable investment available for each company. Each viable invest-
ment is an option available to the company. Some alternatives are valuable, others are not. The
essence of successful financial management, of course, is learning to recognize which are which.
Capital investments create cash flows that are often spread over several years into the future.
To accurately assess the value of a capital investment, the timing of the future cash flows is taken
into account and converted to the current time period (present value). There are two approaches
to making capital budgeting decisions using Discounted Cash Flow model (DCF). One is the
net present value method (NPV), and other is the internal rate of return method (also called the
time adjusted rate of return method). Another popular method of capital budgeting is payback
period.
4.1 Cash Flows
In capital budgeting issues, the most important are cash flows (not accounting net income).
The idea is that accounting net income is based on results that ignore the time value of cash
flows into and out of a company. From a capital budgeting perspective, the timing of cash flows
is essential, because money received today is more valuable than money received in the future.
Consequently, even though accounting net income is useful for many things, it is not generally
used in discounted cash flow analysis. Instead of determining accounting net income, the man-
ager concentrates on recognizing the specific cash flows of the investment project.
4.2 Typical Cash Outflows and Inflows
Typical businesses will have an immediate cash outflows in the form of an initial outlay or
other assets. Any estimated resale value of an asset at the end of its useful life (salvage value)
can be recognized as a cash inflow or as a reduction in the required investment. Some projects
require that a company increase its working capital as well. When a company decides to do
a new project, the balances in the current assets will often raise. Opening a new Orlen gasoline
station would require additional cash, increased accounts receivable for new customers, and
more inventory. These additional working capital requirements should be treated as a part of
the initial investment in a business. These all should be treated as cash outflows for capital
budgeting purposes.
On the cash inflow side, a project will usually either increase incomes or reduce expendi-
tures. Either way, the amount involved should be treated as a cash inflow for capital budget-
ing purposes. We can observe that so far as cash flows are concerned, a reduction in costs is
equivalent to an increase in revenues. Cash inflows are also regularly realized from salvage of
equipment when a project ends, although the company may actually have to pay to dispose of
some low - value or hazardous items. Furthermore, any working capital that was used in the
project can be available for use somewhere else at the end of the project and should be treated
as a cash inflow at that time. Working capital is released, for example, when a company sells
off its stock or collects its receivables.
19
4.3 Net Present Value (NPV)
A project is worth undertaking if it generates value for its owners. In the common sense,
we create value by recognizing a project worth more in the marketplace than it costs us to
obtain. It is a case of the whole being worth more than the cost of the parts. The real challenge
is to somehow recognize ahead of time whether or not a particular investment is a good idea
in the first place. This is what capital budgeting is all about, specifically, trying to determine
whether a proposed investment or project will be worth more, once it is in place, than it costs.
The difference between an investment’s market value and its cost is called the net present
value of the investment (NPV). Thus, the net present value is a measure of how much value
is added or created today by undertaking a project. Given our aim of creating value for the
owners, the capital budgeting procedure can be viewed as a search for investments with posi-
tive net present values.
We can imagine how we can get on with making the capital budgeting decision of new
technology. First we look at what price a similar technology is selling for in the market. Then
we must estimate the cost of creating a new technology and bringing it to market. Therefore,
we have an estimated total cost and an estimated market value. If the difference is positive,
then this investment is worth undertaking because it has a positive estimated net present
value. Naturally, there is uncertainty, because there is no guarantee that our estimates will
turn out to be correct.
Investment decisions are significantly simplified when there is a market for assets compa-
rable to the investment we are taking into consideration. Capital budgeting becomes much
more complicated when we cannot monitor the market price for almost comparable invest-
ments since we are then faced with the problem of estimating the value of an investment using
only indirect market information.
4.3.1 Estimating Net Present Value
We can assume that we are considering starting a new project. First, we can estimate the
initial costs with reasonable accuracy because we know what we will need to buy to begin
business. We will try to estimate the future cash flows we expect the new project to produce.
Then we will apply our basic discounted cash flow procedure to estimate the present value of
those cash flows. Once we had this estimate, we will then estimate NPV as the difference be-
tween the present value of the future cash flows and the initial cost of the project. This method
is often called a discounted cash flow (DCF) valuation.
In order to see how we might estimate NPV, suppose we believe the cash revenues from
our project will be $30 per year, assuming everything goes as expected. Financial costs will
be $10 per year. We will end the project in 6 years. The property and equipment will be worth
$50 as salvage at that time. The project costs $100 to launch. We use a 10% discount rate on
new projects such as this one.
Table 1
Discount rate= 10%
Year 0 1 2 3 4 5 6
Initial cost -100
Salvage value 50
Cash infow 30 30 30 30 30 30 30
Cash outflow -10 -10 -10 -10 -10 -10 -10
Net cash flow 20 20 20 20 20 20 20

Present value factor 1,00000 0,90909 0,82645 0,75131 0,68301 0,62092 0,56447
Present value cash flow 20,00 18,18 16,53 15,03 13,66 12,42 11,29
Total PV of cash flow 107,11
+PV of salvage value 28,22 28,2237
135,33
-Initial cost - 100,00
Net present value 35,33
From a simply mechanical perspective, we need to calculate the present value of the future
cash flows at 10%. The net cash inflow will be $30 cash income less $10 in costs per year for
six years. These cash flows are illustrated in Table 1. As Table 1 suggests, we effectively have a
six-year annuity of
$30 - $10 = $20
per year, along with a single lump-sum inflow of $50 in six years. The total present value is:
Present value =
When we compare this to the $100 estimated cost, we see that the NPV is:
NPV = 135,33 – 100 = 35,33
Consequently, this is a good investment. Based on our estimates, undertaking it would

increase the total value of the company by $35,33.
21
Our example illustrates how NPV estimates can be used to determine whether or not
a particular project is desirable. Thus we can observe that if the NPV is negative, the effect on
company’s value will be unfavorable. If the NPV were positive, the effect would be favorable.
As a result, all we need to know about a particular proposal for the purpose of making an
accept-reject decision is whether the NPV is positive or negative.
There are some advantages and disadvantages of the net present value method. On one
hand, NPV accounts for time value of money. Thus it is more reliable than other investment
appraisal methods such as the payback period or the internal rate of return. NPV is quite
straightforward to calculate, as well. On the other hand, NPV is based on estimated future
cash flows of the project and estimates may be far from real results.
4.4 Internal Rate of Return (IRR)
This method seeks to identify the rate of return that an investment project yields based on
the amount of the original project remaining exceptional during any period, compounding
interest annually.
4.4.1 Estimating Internal Rate of Return
The Internal Rate Of Return (sometimes referred to as an economic rate of return ERR) is
closely connected to the Net Present Value discount rate. To calculate IRR using the formula,
we must set NPV equal to zero. Thus IRR of a project is the discount rate which if applied to
the project yields a zero NPV, so it is the solution, for i, to the following simple equation:
which could be solved using the standard solution to a quadratic equation. The answer
incidentally is i = 0,099 or 9,9%.)
We can now look at a little bit more complicated example of the equation from which we
must solve for i:
− 1000 300 300 300 300 300
0
+ 1
+ 2
+ 3
+ 4
+ =0
(1 + i ) (1 + i ) (1 + i ) (1 + i ) (1 + i ) (1 + i ) 5
Solving for i here is not that simple and because of the nature of the formula, IRR cannot
be calculated analytically, and must instead be calculated either through trial-and-error or
using software program. In practice, we usually solve for i by trying various values of i until
we find one which satisfies or almost satisfies the equation.
In Table 2 we can calculate that the NPV is $137 when discounted at 10%.
Table 2
i= 10,00%
CF PV
0 - 1 000,00 - 1 000
1 300,00 273
2 300,00 248
3 300,00 225
4 300,00 205
5 300,00 186
NPV= 137
Now we know that we must have an IRR of above 10%, because the higher the discount
rate, the lower the present value of each cash flow. How much above 10% is the IRR we actu-
ally do not know, so some higher discount rate needs to be tried, say 15 and 16%.
In Table 3 referring to the 15 and 16% we can calculate NPV.
Table 3
i= 15,00% i= 16,00%
CF PV CF PV
0 - 1 000,00 - 1 000 0 - 1 000,00 - 1 000
1 300,00 261 1 300,00 259
2 300,00 227 2 300,00 223
3 300,00 197 3 300,00 192
4 300,00 172 4 300,00 166
5 300,00 149 5 300,00 143
NPV= 6 NPV= -18
Since the NPV when the cash flows are discounted at 16% is negative and at 15% is posi-
tive, we know that the discount rate which gives this project a zero NPV lies below 16% and
apparently close to the midpoint between 15 and 16%. We can prove this in Table 4 by dis-
counting at 15,5%.
As the NPV when the cash flows are discounted at 15,5% is negative and at 15% is positive,
we know that the discount rate which gives this project a zero NPV lies between 15,0% and
15,5%. In Table 4 we also can try discounting at 15,25%.
23
Table 4
i= 15,50% i= 15,25%
CF PV CF PV
0 - 1 000,00 - 1 000 0 - 1 000,00 - 1 000
1 300,00 260 1 300,00 260
2 300,00 225 2 300,00 226
3 300,00 195 3 300,00 196
4 300,00 169 4 300,00 170
5 300,00 146 5 300,00 148
NPV= -6 NPV= 0
As NPV is now zero, we know that the IRR is about 15,25%.

Generally, the higher a project’s Internal Rate of Return, the more likely it is to be under-
taken. IRR is standardized for investments of varying types and, as such, IRR can be used
to sort out multiple prospective projects a company is considering on a quite even basis.
Assuming projects are competing and the costs of investment are equal among the various
ones, the project with the highest IRR would probably be considered the best one and under-
taken first.
4.4.2 Net Present Value and Internal Rate of Return
As we can see, Internal Rate of Return calculations rely on the same formula as net present
value. The NPV method is a direct measure of the cashflow contribution to the owners. The IRR
method shows the return on the original money invested. NPV method has several important
advantages over the IRR method. The net present value method is often easier to use. The in-
ternal rate of return method may require looking for the discount rate that results in a net pre-
sent value of zero. This can be a very laborious trial-and-error process, although it can be pro-
grammed to some degree using a computer software. The key assumption made by the internal
rate of return method is sometimes doubtful. Both methods assume that cash flows generated
by a project during its useful life are immediately reinvested in another project.
In short, when the net present value method and the internal rate of return method are not
coherent in terms of the attractiveness of a project, it is best to go with the net present value
method. Of the two methods, it makes the more realistic assumption about the rate of return
that can be earned on cash flows from the project.
The NPV method does not measure the project size. The IRR method can, at times, give
us inconsistent results when compared to NPV for mutually exclusive projects (multiple IRR
problem). A multiple IRR problem occurs when cash flows during the project lifetime are
negative (i.e. the project operates at a loss or the company needs to contribute more capital).
This is known as a “non-normal cash flow,” and such cash flows will give multiple IRRs.
When a project is an independent project, meaning the decision to invest in a project is

independent of any other projects, both the NPV and IRR will always give the same result,
either rejecting or accepting a project.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that
is, when the decision must be one project or another - these metrics do not always point the
same direction. This is a result of the timing of cash flows for each project. In addition, con-
flicting results may simply occur because of the project sizes.
4.5 Payback Period
Payback period in capital budgeting refers to the period of time required for the return
on an investment to “repay” the sum of the original investment. This period is sometimes
referred to as “the time that it takes for an investment to pay for itself.” The basic premise of
the payback method is that the more quickly the cost of an investment can be recovered, the
more desirable the investment is. The payback period is expressed in years. When the net
annual cash inflow is the same every year, the following formula can be used to calculate the
payback period.
4.5.1 Evaluation of the Payback Period Method
The formula or equation for the calculation of payback period is as follows:
Payback period = Investment required / Net annual cash inflow
To illustrate the payback method, we can consider the following example. The company
needs a new device. The company is considering two devices. Device A and device B. Device
A costs $15,000 and will reduce operating cost by $5,000 per year. Device B costs only $12,000
but will also reduce operating costs by $5,000 per year.
Device A payback period = $15,000 / $5,000 = 3.0 years

Device B payback period = $12,000 / $5,000 = 2.4 years
According to payback estimations, the company should acquire device B, since it has
a shorter payback period than device A.
Payback period, as a tool of analysis, is often used because it is easy to apply and easy to
interpret for most individuals, but it is not a true measure of the profitability of an invest-
ment. When used carefully or in order to compare similar investments however, it can be
quite useful. All else being equal, shorter payback periods are preferable to the longer ones.
As a stand-alone tool to compare an investment to “doing nothing,” payback period has no
explicit criteria for decision-making (except, perhaps, that the payback period should be less
than infinity).
25
Payback period simply tells the manager how many years it will take to recover the origi-
nal investment. Unfortunately, a shorter payback period does not always mean that one in-
vestment is more desirable than another.
4.5.2 Criticism of Payback Method
The payback period is an effective measure of investment risk. The project with a shorter
payback period has less risk than those with a longer payback period. The payback period is
often used when liquidity is an important criteria to choose a project.
Payback period method is suitable for projects of small investments. It is not worth spend-
ing much time and effort on sophisticated economic analysis in such projects.
Criticism of payback method is that it does not consider the time value of money. A cash
inflow to be received several years in the future is weighed equally with a cash inflow to be
received right now. On the other hand, under certain conditions the payback method can be
very useful.
In addition, the payback period is often of great importance to new companies with cash
shortage. In such companies, a project with a short payback period but with a low rate of
return might be preferred to another project with a high rate of return but a long payback
period. The reason is that the company may simply need a faster return of its cash investment.
And finally, the payback method is sometimes used in industries where products become
obsolete very rapidly (i.e. laptops or mobile phones). As products may last only a year or two,
the payback period on investments must be very short.
5. Risk and Portfolio
The first and basic thing we should know: an economic risk is the risk that happens then
and only then when we expect something in the future. The risk is the possibility of difference
between agent’s expectations and reality. If one is not concerned about future, (s)he has no
risk (i.e. each state of future has identical utility). Risk is everywhere and affects every con-
sumer and company, because every agent expects something, even if one is not aware of this.
We remember the discount rate for safe projects, and an estimate of the rate for average-
risk projects. However we do not know so far how to find discount rates for assets that do not
fit these simple cases. Therefore, we have to learn (1) how to measure risk and (2) the relation-
ship between risks borne and required risk premiums.
5.1 Rates of Return
To make things less complicated, we assume no inflation in economy thus all rates are
nominal. If investor buys an asset of any kind, one’s gain (or loss) from that investment is
named the return on investment. This return typically has two components. First, receive
some cash directly while one’s own the investment. This is called the income component of
the return. Second, the change in value of the purchased asset and it’s named capital gain
(or loss) on investment. On the other hand, the term is also used in reference to percentage
return, which is e.g. stock’s total return - dividend and change in value - divided by the invest-
ment amount (Figure 2).
Figure 2 Components of the return on investment.
Suppose investor bought the stock at the beginning of 2010 when its price was $10.00
a share. By the end of the year the value of that investment rose to $15.00 yielding a capital
gain of $5:
$15- $10 = $5.
27
Additionally, in 2010 the company paid a dividend of $1 a share. The return on investment
is therefore:
Nominal return = capital gain + dividend = (15-10) + 1 = 6
Percentage rate of return is income on an investment expressed as a percentage of the invest-

ment’s purchase price. With a common stock, the rate of return is dividend yield, or annual divi-
dend divided by the price paid for the stock, thus the percentage return on investment was:
The percentage return can also be formulated as the sum of the dividend yield and per-
centage capital gain. The dividend yield is the dividend formulated as a percentage of the
stock price at the beginning of the year:
In the same way, the percentage capital gain is

capital gain (15 10 ) 5
Percentage=capital gain = = = = 50 %
initial share pnce 10 10
Thus the total return is the sum of 10% + 50% = 60%.
5.2 Variance and Standard Deviation
Even if there can be different definitions of risk, the standard statistical measures of risk
are variance and standard deviation. Variance measures the variability of realized returns
around an average level. The larger the variance, the higher the risk in the portfolio.
The variance of the market return is the expected average value of squared deviations from
mean squared deviation from the expected return. In other words:
where r is the actual return and E(r) is the expected return.
The standard deviation is typically used by investors to measure the risk of a stock or
a stock portfolio. The fundamental idea is that the standard deviation is a measure of spread:
the more stock’s returns vary from the stock’s average return, the more volatile is the stock.
The standard deviation is simply the square root of the variance:
28 5. RISK AND PORTFOLIO
Think of the following two stock portfolios and their individual returns over the last six
months. Both portfolios end up increasing in value from $1,000 to $1,058 but they clearly
differ in volatility. Portfolio A’s monthly returns range from -1.5% to 3% whereas Portfolio B’s
range from -9% to 12%. The standard deviation of the returns is a better measure of volatility
than the range because it takes all the values into account. The standard deviation of the six
returns for Portfolio A is 1,52 while for Portfolio B it is 7,24.
Another uncomplicated example demonstrates how variance and standard deviation are
calculated. Suppose that you have the chance to play the following financial game. You start
by investing $1000 and return on this investment depends on combination of two different
states of economy:
• Changing interest rates by FED
• Changing interest rates by EBC
For each interest decreasing that occurs you get back your initial capital plus 10%, and
for each interest increase you get back your starting capital less 5%. There are obviously four
equally expected outcomes determined by possible states of economy:
• FED-decreasing, EBC-decreasing: profit 10+10=20%.
• FED-decreasing, EBC-increasing: profit 10-5=5%.
• FED-increasing, EBC-decreasing: profit -5+10=5%.
• FED-increasing, EBC-increasing: profit -5+-5 =-10%.
There is 25% probability (1 in 4) that you will make 20%; 50% probability (2 in 4) that
you will make 5%; and 25% probability (1 in 4) that you will lose 10%. The gamble’s expected
return is, as a result, a weighted average of the possible profits:
Table 5 illustrates that the variance of the percentage returns is 0,0113. Standard deviation
is the square root of variance. This figure is in the same units as the rate of return, so we can
say that the game’s variability is 10,61%.
One way of defining uncertainty is to say that more things can occur than will occur. The
risk of an asset can be thoroughly expressed by writing all possible result and the probability
of each. In practice this is awkward and often impossible. Thus we use variance or standard
deviation to summarize the spread of possible profits. These measures are natural indexes of
risk. If the outcome of the game had been certain, the standard deviation would have been
zero. The actual standard deviation is positive because we do not know what is going to hap-
pen.
29
Table 5.
return probability
FED EBC ri*p E(rp)- ri [E(rp)- ri]2 p [E(rp)- ri]2
ri p
Decreasing decreasing 20% 25% 5,00% -15% 0,0225 0,0056
Decreasing increasing 5% 25% 1,25% 0% 0,0000 0,0000
Increasing decreasing 5% 25% 1,25% 0% 0,0000 0,0000
Increasing increasing -10% 25% -2,50% 15% 0,0225 0,0056
E(rp)= 5% σ2= 0,0113
σ= 10,61%
Table 6 shows a second game, again, there are four equally likely profits:
Table 6
return probability
FED EBC ri*p E(rp)- ri [E(rp)- ri]2 p [E(rp)- ri]2
ri p
decreasing decreasing 40% 25% 10% -35% 0,1225 0,0306
decreasing increasing 5% 25% 1% 0% 0,0000 0,0000
increasing decreasing 5% 25% 1% 0% 0,0000 0,0000
increasing increasing -30% 25% -8% 35% 0,1225 0,0306
E(rp)= 5% σ2= 0,0613
σ= 24,75%
In this game the expected return is 5%, the same as that of the first game. However its
standard deviation is more than double that of the first game: 24,75% versus 10,61%. By this
measure the second game is more than twice as risky as the first one.
5.3 Diversification and Risk Reducing
By now we have concentrated on single assets considered separately, but most investors
hold a portfolio of assets. Investors usually own more than just a single bond, stock, or other
asset. Therefore, portfolio return and portfolio risk are of obvious significance. Consequently,
we now explain portfolio expected returns and variances.
5.3.1 Portfolio Weights
Portfolio can be described in many equivalent ways. The most popular approach is to list
the percentage of the total portfolio’s value that is invested in each portfolio asset. We call
these percentage the portfolio weights.
Table 7
USD portfolio weights portfolio weights
(Asset A)/
Asset A $ 200,00 20%
(Asset A+Asset B+Asset C)
(Asset B)/
Asset B $ 300,00 30%
(Asset C)/
Asset C $ 500,00 50%
Total $1 000,00 100%
Table 7 shows simple illustration of a porfolio. An investor has $200 in asset A, $300 in as-
set B and $500 in asset C, then the portfolio is worth $1000. The percentage of the portfolio is
summarized in the last column: the asset A is $200/$1000, or 20%, the asset B is $300/$1000,
or 30%, the asset C is $500/$1000, or 50%. The weights of the portfolio are thus 0,20; 0,30 and
0,50. It’s easy to see that the weights have to add up to 100% because the entire amount that
investor holds is somewhere invested.
5.3.2 Portfolio Expected Returns
Let’s now consider the portfolio of the same three assets, but the portfolio weights are
different: Asset A 40%, Asset B 30% and Asset C 30%. The rate of return depends on two dif-
ferent states of economy (decreasing or increasing interest rates by FED), each with the same
probability 50%. First in Table 8 we calculate expected returns, variance and standard devia-
tions for each asset.
31
Table 8
Return Probability
FED Asset A Asset B Asset C
decreasing 20% 30% 10% 50%
increasing -10% 0% -10% 50%
Expected return 5,00% 15,00% 0,00%

σ=2
0,0450 0,0450 0,0200
σ= 21,21% 21,21% 14,14%
portfolio weights 40% 30% 30%
Now we calculate the rates of expected return on this portfolio. To answer these questions,
suppose the FED increased interest rates and economy actually declines. In this case, 40% of
invested money loses 10%, 30% of invested money does not change its value and the other
30% also loses 10%. The portfolio return, rP, in a depression is thus:
rP = 0,40 * (-10%) + 0,30 * 0 + 0,30 * (-10%) = -7%
Table 9 summarizes the remaining calculations. When FED decreases interests, during
boom the portfolio will return 20%:
rP = 0,40 * 20% + 0,30 * 30% + 0,30 * 10% = 20%
Table 9
Return Probability
FED rp rp*p
Asset A Asset B Asset C p
decreasing 20% 30% 10% 50% 20,00% 10,0%
increasing -10% 0% -10% 50% -7,00% -3,5%
E(rP) = 6,50%
portfolio
40% 30% 30%
weights
As specified in Table 9, the expected return on portfolio, E(rP), is 6,5%. We can also cal-
culate the expected return more directly. Having these portfolio weights, we could have rea-
soned that we expect 40% of our money to earn 5%, 30% to earn 15% and 30% to earn 0%.
Our portfolio expected return is as a result:
E(rP) = 0,40 * rA + 0,30 * rB + 0,30 * rC =
0,40 * 5% + 0,30 * 15% + 0,30 * 0% = 6,5%
This is exactly the same portfolio expected return as we calculated previously. This method
of calculating the expected return on a portfolio is successful, regardless of how many assets
there are in the portfolio. Assume we had n assets in our portfolio, where n is any number. If
we let wi stand for the percentage of our money in Asset i, then the expected return would be:
where:
wi – weight of i-th asset,
ri – return of i-th asset.
This implies that the expected return on a portfolio is a simple combination of the expect-
ed returns on the assets in that portfolio. This seems rather obvious, but, as we will examine it
next, the obvious approach is not always the correct one.
5.3.3 Portfolio Variance
To understand the effect of diversification, we must find out to what extent the risk of a port-
folio depends on the risk of the individual shares. We must calculate the risk of portfolio know-
ing the expected return on a portfolio that contains investment in Assets A, B and C is 6,5%.
At the beginning we may tend to wrongly assume that the standard deviation of the portfolio is
a weighted average of the standard deviations of the two stocks. Simple intuition suggests that by
analogy the risk of portfolio, measured by standard deviation is (Table 10):
Unfortunately this method is completely wrong as a rule (sic!). That would be correct only
in an extremely exceptional case if the prices of the two stocks were moving in ideal lockstep,
with which we will deal later on.
Table 10
Return
Asset A Asset B Asset C Portfolio
Expected return 5,00% 15,00% 0,00% 6,50%
Variance 0,0450 0,0450 0,0200 0,04
Standard deviation 21,21% 21,21% 14,14% 19,09%
Wrong!
Portfolio weights 40% 30% 30%
Table 11 illustrates what the portfolio’s standard deviation really is. After summarizing the
relevant calculations, we can see that the portfolio’s variance is about 0,018 and its standard
33
deviation is much less than we tried to predict - it’s only 13,5%. It implies that the variance of
a portfolio is basically not a direct combination of the variances of the assets in the portfolio.
Table 11
Probability
FED Return pj rj pj rj [E(rp)- rj]2 pj [E(rp)- rj]2
Asset Asset Asset

A B C
decresing 20% 30% 10% 50% 20,00% 10,0% 0,018225 0,009113
incressing -10% 0% -10% 50% -7,00% -3,5% 0,018225 0,009113
σ 2
P = 0,01823
Portfolio
weights
40% 30% 30% E(rp)= 6,50% σP = 13,50%
First basic formula for variance is:
where:
pj – probability of j-th state of economy,
rj – return of portfolio in j-th state of economy
E(rp) – expected return of portfolio
5.3.4 Portfolio Risk and Correlation
As we noticed, calculating the expected portfolio return is straightforward. The more

challenging part is to find the risk of the portfolio. Let us assume that in the past the standard
deviation of returns was σA for Asset A and σB for Asset B. We assume that these figures are
a good estimate of the spread of possible future outcomes. At the moment we must ask the
most important question: how strong and in what way these two assets are “linked”?
The portfolio variance is dependent on the way in which individual securities are cor-
related with each other. In order to calculate the portfolio variance of a two-stock we can use
the following formula:
where:
ρ12 – correlation coefficient
σAB – covariance
The portfolio standard deviation is, of course, the square root of the variance.
σ P = σ P2
Let us examine this formula more thoroughly. At first, we must weigh the variance of the
returns on Asset A by the square of the proportion invested in it. In the same way, we weigh
the variance of the returns on Asset B by the square of the proportion invested in Asset B. The
first two parts of this formula depend on the variances of Asset A and B whereas the last part
of this formula depend on their covariance. Just as we weighted the variances by the square of
the proportion invested, so we must weigh the covariance by the product of the two propor-
tionate holdings wA and wB.
The covariance essentially tells us whether or not two securities returns are correlated. The
covariance can be expressed as the product of the correlation coefficient and the two standard
deviations:
Covariance measures themselves do not provide any measurement of the degree of cor-
relation between two securities. Thus, correlation is standardized by dividing covariance by
the product of the standard deviation of two individual securities. The correlation coefficient
is therefore a standardized measure of correlation:
The correlation coefficient is a pure measure of the co-movements between the two se-
curities and it ranges from –1 to +1. For the most part stocks are likely to move together. In
this case the correlation coefficient is positive, and therefore the covariance is also positive.
Portfolio risk can be effectively reduced (diversified) by combining securities with returns
that do not move in the same direction.
A correlation of +1 means that the returns of the two securities always move in the exactly
same direction; they are perfectly positively correlated.
ρ12=1
generally:
Therefore, we get an analogical result as the return on portfolio E(rP ).

In any other case, diversification reduces the risk below this level.
35
A correlation in interval 0 < ρ12 < 1 means that the returns on the two securities always
move in the same direction. Positive correlation coefficient is typical in real economy and it
means that we have limited possibility of risk reduction.
A correlation of –1 means the returns are negatively correlated and always move in the
exactly opposite direction.
ρ12= -1
If the stocks just tend to move in opposite directions, the correlation coefficient and the
covariance would be negative.
-1 < ρ12 < 0
The last interesting example is when the correlation coefficient is zero, which means that
the two securities are independent and unrelated to each other.
If the prospects of the stocks were totally unrelated, both the correlation coefficient and
the covariance would be zero;
Therefore, assume that assets are independent, ρ12=0, but additionally they are equally
weighted
and equally risky
σ1= σ2 = σn
but with different rates of return the portfolio variance is:
Consequently, standard deviation is:
We can see that in this case we can significantly reduce the risk by adding very large
amount of assets to our portfolio.
In Table 12 and Table 13 we have two examples of a portfolio comprised of two Assets.
Table 12
Probability
Asset A Asset B
decresing 24% 3,0% 50% 13,50% 6,8% 0,000506 0,000253
incressing 12% 6,0% 50% 9,00% 4,5% 0,000506 0,000253
E(rp)= 12,25% σ =2
P 0,00051
σP = 2,25%
Expected return 18,00% 4,50%
σ 2 = 0,0072 0,0005
σ = 8,49% 2,12%
ρ= - 1,00
portfolio weights 50% 50%
Table 13
Probability
Asset A Asset B
decreasing 24% 3,0% 50% 7,20% 3,6% 0,000000 0,000000
increasing 12% 6,0% 50% 7,20% 3,6% 0,000000 0,000000
E(rp)= 7,2% σ 2
P
= 0,000000
σP = 0,00%
Expected return 18,00% 4,50%
σ2 = 0,0072 0,0005
σ = 8,49% 2,12%
ρ= - 1,00
portfolio weights 20% 80%
5.3.5 Diversification, Systematic and Unsystematic Risk.
We can observe a significant differences among various sources of risk. Some fraction
of risk is specifically attached to particular assets, and some part of risk is more universal.
Specific risk stems from the fact that many of the threats that surround a specific company are
peculiar to that company and perhaps its direct competitors.
37
Diversifiable risk (unsystematic, specific or residual risk) represents the fraction of an

asset’s risk and risk aspects affecting only that particular company. It’s typical for compa-
ny-specific events, such a lawsuit, strikes, regulatory actions, and the loss of a key account.
Unsystematic risk is due to factors specific to a company or an industry such as product cat-
egory, labor unions, research and development, marketing strategy, pricing etc.
The market risk (un-diversifiable or systematic risk) refers to economy-wide (macroeco-
nomic) factors which affect all companies. This is the relevant fraction of an asset’s risk typical
for market factors that affect all companies such as inflation, war, international incidents, and
political events. So systematic risk is inherent to the entire market or entire market segment
and stems from the fact that there are other economy wide perils that threaten all businesses.
Figure 3 Systematic and Unsystematic Risk
Unsystematic risk can be reduced through diversification because it is associated with ran-
dom causes. Company or industry specific risk is inherent in each investment. The fraction
of unsystematic risk can be reduced through appropriate diversification. On the other hand,
systematic risk comes from economy-wide sources of risk that generally affect the entire capi-
tal market. Sources of systematic risk affect the entire market and cannot be avoided through
diversification. Systematic risk can be mitigated only by being hedged. The combination of
a security’s non-diversifiable risk and diversifiable risk is called the total risk.
Total Risk = Systematic Risk + Non-Systematic Risk.
Systematic risk is due to risk factors that affect the entire market such as investment policy
modifications, a change in socio-economic or in taxation clauses, foreign investment policy,
international security threats and measures etc. Systematic risk underlies all other investment
risks is beyond the control of investors and cannot be mitigated to a large extent. In contrast
to this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that
can be avoided and the market does not compensate for taking such risks.
Specific risk disappears in the portfolio construction process when you diversify among
assets that are not correlated. Diversification is succesful because prices of different assets do
not move exactly together. If we randomly choose a certain number of marketable assets and
form them into portfolios of varying sizes, measure the expected returns and standard devia-
tions of returns from each of our various-sized portfolios and then plot standard deviation
against the size of portfolios, we should obtain a picture similar to that in Figure 4.
The market portfolio is a combination of individual stocks, but its variability does not re-
flect the average variability of its components. It means that diversification decreases the over-
all variability. Even a small diversification can provide an important reduction in variability.
Market risk is the risk that remains after creating the market portfolio, which apparent-
ly contains all risky assets. These are the risks that cannot be diversified away. The various-
sized portfolios are constructed randomly. Various portfolios of each size are created, and the
standard deviation of returns shown in Figure 4 is the average of the standard deviations of all
of the portfolios for each size. As the standard deviation of returns around the mean is a rea-
sonable measure of risk, Figure 4 suggests that large reduction in risk can be achieved simply
by randomly combining assets in portfolios.
Figure 4 Market risk and the portfolio size
These two characteristics might be a surprise:
• Very limited diversification yields significant reductions in the level of risk. Even split-
ting the investment funds available into a couple of different assets effectively eliminates
a large portion of risk. Each additional and different asset added to the portfolio produces
less marginal risk reduction.
• If the portfolio contains about 15 to 20 assets there is little benefit to be gained by way of
risk reduction from additional increases in its size. Part of the risk seems to be immune
to attempts to reduce it through diversification.
39
There are two basic implications of the phenomenon depicted in Figure 4. First, the inves-
tors should hold assets in portfolios as, by doing so, risk can be reduced at little cost and second,
that there are limits in diversifying into many more than 15 to 20 different assets as nearly all the
benefits of diversification have been exhausted at that size of portfolio. Additional diversification
implies that the investor will have to pay higher transaction costs (e.g. dealing commissions) to
establish the portfolio and then will have more expenses and more work in managing it.
Market risk must be taken into consideration by investors because it is caused by market-
wide factors so it seems possible that some securities are more vulnerable to these factors than
others. We will now examine if the level of risk attached to the returns from all securities is the
same, even though no one is forced to bear any specific risk.
In Figure 4 we have split the risk into its two parts – specific risk and systematic risk. If we
have only a single asset, specific risk is very important; but once we have a portfolio of 20 or
more assets, diversification has done its job. For a rationally well-diversified portfolio, only mar-
ket risk is important. Consequently, the major source of uncertainty for a diversified investor is
that the market will expand or contract, moving the investor’s portfolio value with itself.
5.3.6 Limits of Diversification
A level of risk can possibly be reduced by diversification, but there is also some risk that
we cannot avoid, regardless of how much we diversify. Normally market risk affects each asset
and that is why assets have a propensity to move together. So that is why investors are exposed
to market risk, no matter how many assets they hold.
If the expected returns on the assets were completely unrelated, both the correlation coef-
ficient and the covariance would_ be zero. We assume that all _ assets in portfolio are equally
weighted, so w1= w2 = wn =1/n, σ is average variance and σ ij is average covariance.
To begin with, we start our discussion with a portfolio of two assets:
In case of an n-asset portfolio:
Consequently, with n goes to infinity we have:
We can observe that the portfolio variance goes to average covariance with number of
assets goes to infinity.
5.3.7 Beta
Beta is a measure of the systematic risk, or volatility, of assets or a portfolio in comparison

to the entire market. Therefore, beta gives a sense of a stock’s market risk compared to the
greater market. Beta is also used to compare a stock’s market risk to that of other stocks.
In compare to standard deviation, beta measures volatility relative to a relevant baseline
rather than to the mean of the asset that is being evaluated. Beta is the appropriate measure of
an asset’s input to our portfolio’s risk, as it measures only the market risk.
Beta is estimated using a regression analysis, and you can think of beta as the tendency of
a security’s returns to respond to swings in the market. We should recall that Y = a + bX is the
standard form of the equation of the regression line. When we regress one asset on another
asset or a benchmark index, the slope of the regression line, b, is referred to as the dependent
variable’s beta and it describes the movement of the asset (the dependent variable) relative to
its benchmark (the independent variable).
For example, if we assume, based on the daily data, that the pension fund beta is 1,5 it
informs us that for every 1% move in the market the pension fund can be expected to move
around 1,5% in the same direction. The market’s beta is by definition 1,0 and it is the baseline
market risk. The risk-free asset’s beta is obviously 0. In our example, there is very little disper-
sion of the data points with respect to the regression line. This is predictable, as the dependent
variable, being a “large market capitalization” pension fund is supposed to be extremely corre-
lated with the market and it is a well-diversified portfolio. If we have the same exercise with an
individual “large market capitalization” asset, the data points would probably be much more
dispersed. In addition, the “large market capitalization” asset’s market risk, beta, could be sig-
nificantly higher or lower than 1,0, considerably depending on the character of the company.
Beta is a frequently published value that we know how to use to estimate the market risk
of assets that we are considering adding to our portfolio. On the other hand, betas are usually
obtained by using the WIG 20 as an initial value that can be used to compare past, current
and projected future values (called benchmark). It is fine if we are evaluating “large market
capitalization” domestic stocks or if we want to see how any specific asset moves relative to
the WIG 20. We must remember that betas thus obtained are relative to the WIG 20 and that
they simply correspond to the residual volatility.
Portfolio betas are estimated as the weighted average of the betas of the assets that com-
pose the portfolios. If we enlarges economy well beyond the market, to get a really relevant
portfolio beta, the individual asset’s betas would have to be obtained using a benchmark that
is model of the assets in the portfolio. The market risk of our economy is still 1.0 by assump-
tion but it may be more or less volatile than the market. For a largely diversified portfolio, this
would involve developing a weighted average index of the appropriate indexes. We do not say
that investors have to do this, we only state an item of importance. The portfolio standard
deviation is all we need to estimate portfolio’s possible variability.
Since beta determines the risk, it can be associated with the standard deviation. Certainly,
an asset’s beta is equal to the product of its correlation coefficient and its standard devia-
41
tion divided by the market’s standard deviation. Mathematically, the correlation coefficient
divided by the market’s standard deviation factor the specific risk out of the asset’s standard
deviation leaving only the systematic risk, which is the market risk of the asset.
We can recapitulate that:
if β = 0
asset is risk free,
if β = 1
asset return is equal to market return,
if β > 1
asset is riskier than market risk,
if β < 1
asset is less risky than market risk.
An asset’s market risk, relative to the average, can be measured by its beta coefficient. The risk
premium on an asset is then given by its beta coefficient multiplied by the market risk premium,
[E(rM) - rf] *β
The expected return on an asset, E(ri), is equal to the risk-free rate, rf, plus the risk premium:
E(ri) = rf + [E(rM) - rf] *β
As a result risk free rate is a type of reference point adjusted by the risk which has qualita-
tive and quantitative part. This is the equation of the Security Market Line (SML), and it is
often called the capital asset pricing model (CAPM). We tried to complete our arguments of
risk and return as we have a better understanding of what decides of a company’s cost of capi-
tal for an investment. Now we can move on to examine more closely how companies analyze
the cost of capital in practice.
6. Cost of Capital
The required return (or an appropriate discount rate) is essential in making a capital budg-
eting of new businesses or projects (such as building a new plant), worthwhile is often called
the cost of capital associated with the investment. The cost of capital decides how a company
can raise money (through equity, debt, or a mix of the two). This is the rate of return that
a company would receive if it invested in a different projects with similar risk.
It is referred to as the required return is what the company must earn on its capital invest-
ment in a project just to break even. From an economic point of view it can be interpreted
as the opportunity cost linked with the company’s capital investment. Observe that when it
is said that an investment is lucrative if its expected return exceeds what is offered in capital
markets for investments of the identical risk, we are effectively using the internal rate of return
(IRR). The only difference is that now we have a much better concept of what determines the
required return on an investment. This will be crucial when we discuss the capital structure
and the cost of capital.
As we identify the relation of risk and return, we must observe that the correct discount rate
depends on the riskiness of the project. The new business will have a positive NPV only if its
return exceeds what the financial markets offer on investments of similar risk. Consequently,
this minimum required return is the cost of capital linked with the business.
One of the most important idea we develop is that of the weighted average cost of capital
(WACC)1. WACC is an estimate of a company’s cost of capital, or the minimum that a com-
pany must earn to gratify all debts and support all assets. The calculation includes the com-
pany’s debt and equity ratios, as well as all long-term debt. Companies usually do an internal
WACC estimation to assess overall company. The more complex and larger a company is, the
more complicated it is to estimate WACC. Tax treatments are an important reflection in de-
termining the required return on an investment, because we are always interested in valuing
the after tax cash flows from a business. Unfortunately, only some of the information needed
to calculate WACC can be found in a statement of financial positions.
The weighted average cost of capital shows how much it costs a company to raise money
for a business. WACC is important when a company needs to raise money to expand. Beta is
the systematic risk – risk that is intrinsic with the market – that a company has comparing to
the market.
The security market line (SML) can be used to explore the relationship between the ex-
pected return on a security and its systematic risk. We concentrated on how the risky re-
turns from buying securities looked from the viewpoint of a shareholder in the company.
This helped us understand more about the alternatives available to an investor in the capital
1
Sometimes also called the marginal cost of capital
43
markets. Now, we look more closely at the other side of the issue, which is how these returns
and securities look from the point of view of the companies that issue them. The important
fact to observe is that the return on a security an investor receives is the cost of that security
to the company that issued it.
6.1 Required Return, Cost of Capital and Financial Policy
Required return is the minimum annual percentage earned by an investment that will
encourage companies or individuals to put money into a particular project or security. The
required rate of return is used in both corporate finance and in equity valuation.
Stockholders use the required rate of return to decide where to put their funds. They
evaluate the return of an investment to all other available alternatives, taking the risk-free rate
of return, liquidity and inflation into consideration in their estimations. For stockholders us-
ing the dividend discount method to choose stocks, the required rate of return influences the
maximum price they are willing to pay for a stock. The required rate of return is also used in
calculations of net present value in discounted cash flow study.
Companies use the required rate of return to choose if they should start a new business or
a project . In corporate finance, the required rate of return is equal to the weighted average cost
of capital (WACC). When we state that the required return on an investment is 10%, we gener-
ally mean that the investment will have a positive NPV simply if its return exceeds 10%. A dif-
ferent way of understanding the required return is to observe that the company must earn 10%
on the investment just to compensate its investors for the use of the capital needed to finance the
business. Thus we could also say that 10% is the cost of capital associated with the investment.
Assuming that the other information is unchanged, required return is obviously higher
if a project is risky. In other words, if the project is risky the appropriate discount rate would
exceed the risk-free rate and the cost of capital for this project is greater than the risk-free rate.
From now on we will use the terms cost of capital, required return and appropriate discount
rate more or less interchangeably because they all mean basically the same thing. The key fact
to grasp is that the cost of capital associated with an investment depends on the risk of that
investment.
The cost of capital depends primarily on the use of the funds, not the source. It is a com-
mon mistake to forget this critical point and fall into the trap of thinking that the cost of capi-
tal for an investment depends primarily on how and where the capital is increased.
The particular mixture of debt and equity a company chooses to employ its capital struc-
ture is a managerial variable. We presume the company’s financial policy as given. In particu-
lar it means that the company has a given debt-equity ratio that it maintains. This ratio reflects
the company’s target capital structure. We know that a company’s overall cost of capital will
reflect the required return on the company’s assets as a whole. If a company uses both equity
and debt so overall cost of capital will be a combination of the returns needed to compensate
its debtholders and those needed to compensate its stockholders. In other words, a company’s
cost of capital includes the cost of debt and the cost of equity.
44 6. COST OF CAPITAL
6.2 The Cost of Equity
A company’s cost of equity represents the compensation that the market requires in ex-
change for possessing the asset and bearing the risk of ownership. Put it in different words:
this is the return that stockholders demand from a company. The capital asset pricing model
(CAPM) or security market line (SML) is the method used to find the cost of equity.
6.2.1 The Security Market Line and Cost of Capital
Company’s cost of capital is based on the average beta of the assets. The average beta of the
assets is based on the proportion of funds in each asset. From security market line we know
that the expected or required return on a risky asset depends on three things:
1. The expected risk-free return in that market (e.g. treasury bond yield), rf
2. The risk premium of market assets over risk free assets, E(rM) - rf
3. The sensitivity to market risk for the security, beta coefficient βE,
With the SML, we can reformulate the expected return on the company’s equity, E(rE), as:
E(rE) = rf +βE [E(rM)- rf ]
or just:
rE = rf +βE(rM- rf )
rf 3%
rM 9%
rM-rf 6%
Beta rE
Equity value 1,2 10,20%
To apply Security Market Line approach, we must have a risk-free rate, rf, an estimate
of the market risk premium, rM - rf, and an estimate of the appropriate beta, βE. We assume
estimated market risk premium (based on large common stocks) is 9%. Treasury bills yield
around 3,0%, so we will use this as our risk-free rate. Beta coefficients for publicly traded
companies are usually available. We could thus estimate the cost of equity as:
rE = rf + βE *(rM - rf)= 3,0% + 1,2*(9-3)% = 10,2%
As a result, using the SML approach, we estimate that cost of equity is about 10.2%.
6.2.2 Advantages and Disadvantages of the Approach
The Security Market Line approach has two most important advantages. First, it explic-
itly adjusts for systematic risk. Second, it is applicable to all companies. As long as we com-
45
pute beta it is applicable to companies others than just those with steady dividend growth.
Therefore, it may be useful in a wider variety of situations.
There are however some disadvantages as well. The SML approach requires two things
to be estimated: the market risk premium and the beta coefficient. We have to estimate the
expected market risk premium, which differs over time: to some degree that the estimates are
poor, the resulting cost of equity will be imprecise. Using different stocks or different time
periods could result in very different estimates. In SML approach we have to estimate beta,
which also fluctuates over time.
We trust the past statistics in order to predict the future, which is not always reliable.
Economic circumstances can change very quickly, thus, the past may not be a good guide to
the future. If the dividend growth model and the SML happen yield similar answers, we might
have some confidence in our estimates.
6.3 The Cost of Debt
Calculating the cost of capital associated with debt is much easier than calculating the cost
of equity. The cost of debt is calculated by taking the rate on a risk free bond whose duration
matches the term structure of the corporate debt, then adding a default premium. This default
premium will rise as the amount of debt increases (as all other things being equal, the risk
goes up as the amount of debt increases).
Because in most cases the cost of debt is a deductible expense, the cost of debt is calculated
as an after-tax cost to make it comparable with the cost of equity (incomes are after-tax as
well). Consequently, for profitable companies, debt is discounted by the tax rate. For the sake
of consistency with our other notation, we will use the symbol rD for the cost of debt and the
formula can be written as:
rD=(rf + default premium)(1-T),
where T is the corporate tax rate and rf is the risk free rate. The yield to maturity can be used as an esti-
mation of the cost of debt.
The cost of debt is the return that the company’s debtholders require for new debt. A com-
pany will use various loans, bonds and other forms of debt, so this measure is useful for giving
a concept as to the overall rate being paid by the company to use debt financing. In general,
we could determine the beta for the company’s debt and then use the SML to estimate the
required return on debt just as we estimated the required return on equity. This is in fact not
necessary. The measure can also give investors an idea as to the riskiness of the company com-
pared to others, because riskier companies generally have a higher cost of debt.
Company’s cost of debt, unlike its cost of equity, can usually be observed either directly or indi-
rectly, because the cost of debt is basically the interest rate the company must pay on new debt, and
we can monitor interest rates in the financial markets. Thus company’s cost of debt is the effective
rate that a company pays on its current debt. If the company already has bonds outstanding, then the
yield to maturity on those bonds is the market-required rate on the company’s debt. On the other
hand, if we know that the company’s bonds are rated A, then we can simply find out what the interest
rate on newly issued A-rated bonds is. Consequently, there is no need to estimate beta for the debt
because we can directly observe the rate we want to know. However, there is one thing to be accurate
about. The coupon rate on the company’s outstanding debt is irrelevant here. That rate simply tells us
approximately what the company’s cost of debt was back when the bonds were issued, not what the
cost of debt is today. This is why we have to monitor the yield on the debt in the present day’s market.
6.4 The Weighted Average Cost of Capital
When we have the costs linked with the main sources of capital the company employs, we will
take this mix, which is the company’s capital structure, as given for now. We will focus mostly on
debt and ordinary equity. As we mentioned earlier investors frequently focus on a company’s total
capitalization, which is the total of its long-term equity and debt. This is mostly true in determin-
ing cost of capital; short-term liabilities are often ignored in the process. The general approach
of explicitly not distinguishing between total value and total capitalization is basically applicable.
6.4.1 The Capital Structure Weights
We calculate market value of the company’s equity by taking the number of shares cur-
rently held by all its shareholders and multiplying it by the price per share. We will use the
symbol E (for equity). In the same way, we will use the symbol D (for debt) to stand for the
market value of the company’s debt. For long-term debt, we calculate this by multiplying the
current price of a single bond by the number of bonds currently held by all its debtholders.
If there are multiple bond issues (as there normally would be), we repeat this calculation
of D for each and then add together the results. If there is debt that is not currently traded we
must monitor the yield on similar, currently traded debt and then estimate the current market
value of the privately held debt using this yield as the discount rate. For short-term debt, the
book (accounting) values and market values should be to some extent comparable, thus we
can use the book values as approximation of the market values.
Figure 5 Capital structure.

47
As a final point, we will use the symbol V (for Value) to stand for the combined market
value of the equity and debt:
V=D+E
We can calculate the fractions of the total capital represented by the debt and equity if we
divide both sides by V:
These fractions can be interpreted identically to portfolio weights, and they are often
called the capital structure weights. For example, if the total market value of a company’s stock
was calculated at $50 million and the total market value of the company’s debt were calculated
at $50 million, then the combined asset value would be $100 million:
so 50% of the company’s financing would be equity and the remaining 50% would be debt.
We highlight here that the proper way to proceed is to use the market values of the debt
and equity. Under certain circumstances, such as when calculating figures for a privately held
company, it may not be possible to get reliable estimates of these quantities.
USD Weights
Debt value (D) 50 50%
Equity value (E) 50 50%
Asset value (V) 100 100%
6.4.2 Taxes and the Weighted Average Cost of Capital
Since we are always interested in after-tax cash flows, there is one final problem we need to
discuss. If we estimate the discount rate appropriate to after-tax cash flows, then the discount
rate needs to be expressed on an after-tax basis as well. The interest paid by a company is deduct-
ible for tax purposes, but cash flows to equityholders, such as dividends, are not. In effect, the
government pays some of the interest. Consequently, in determining an after tax discount rate,
we need to distinguish between the pretax and the after tax cost of debt.
In Table 14 we presume a company borrows 50 at 4,8% interest. The corporate tax rate is
35%. The total interest payments are tax deductible, thus the interest reduces the company’s
tax bill by:
0,35 * 0,048 * 50 = 0,84
The after-tax interest bill is thus

2,4 - 0,84 = 1,56
The after-tax interest rate is thus
1,56/50 = 3,12%
The after-tax interest rate is basically equal to the pretax rate multiplied by 1 minus the corpo-
rate tax rate. For example, using the previous numbers, we notice that the after-tax interest rate is:
4,8%*(1-0,35) = 3,12%.
Table 14
rf 3%
rM 9%
rM-rf 6%
T 35%
no tax
beta r WACC
Debt value 50 0,3 4,80% 0,024
Equity value 50 1,2 10,20% 0,051
Asset value 100 0,075
tax
beta r WACC
Debt value 50 0,3 4,80% 0,0156
Equity value 50 1,2 10,20% 0,051
Asset value 100 0,067
We have the capital structure weights along with the cost of equity and the after-tax cost of
debt. To find the company’s total cost of capital, we multiply the capital structure weights by
the associated costs and add them up. The total is the weighted average cost of capital (WACC).
WACC = (E/V) * rE + (D/V) * rD * (1 - T)
This WACC has a very simple explanation. It is the total return the company must earn on
its existing assets to keep the value of its stock. Moreover, the required return on any invest-
ment in the company has essentially the same risks as existing operations. Thus, if we were
estimating the cash flows from a recommended expansion of our existing operations, this is
the discount rate we would use.
If a company uses preferred stock in its capital structure, then our expression for the
WACC needs a small extension. If we define P/V as the fraction of the company’s financing
that comes from preferred stock, then the weighted average cost of capital is:
49
WACC = (E/V) * rE + (P/V) * rP + (D/V) * rD * (1 - T)

where rP is the cost of preferred stock.
6.4.3 The Security Market Line and the Weighted Average Cost of Capital
When we consider investments with risks that are significantly different from those of the
company taken as a whole, the use of the weighted average cost of capital will possibly lead to
ineffective decisions.
In Figure 6, we have plotted a Security Market Line corresponding to a risk-free rate of
x% and a market risk premium of y%. To keep the discussion simple, we assume an all-equity
company with a beta of 1. As we have indicated, the weighted average cost of capital and the
cost of equity exactly equal (x+y)% for this company because there is no debt.
Figure 6 Security Market Line (SML) and Weighted Average Cost of Capital WACC
We can assume that our company uses its weighted average cost of capital to evaluate all
investments. This means that any investment with a return of greater than (x+y)% will be ac-
cepted and any investment with a return of less than (x+y)% will be rejected. From risk and
return discussion we know, however, that an attractive investment is the one that plots above
the Security Market Line. As Figure 6 illustrates, using the weighted average cost of capital for
all types of projects can prompt the company to incorrectly accept relatively risky projects and
incorrectly reject relatively safe ones.
7. Capital Structure
and Financial Leverage
Capital structure refers to the way a company finances its assets through some combina-
tion of debt and equity. A company’s capital structure is then the composition (structure) of
its liabilities. To this point, we assumed the company’s capital structure as fixed. In real world
debt-equity ratios are the result of some kind of a dynamic optimization. We want to find out
where the real capital structure comes from. Decisions about a company’s debt-equity ratio
are referred to as capital structure decisions.
Company can select any capital structure that it wants and such activities that change the
company’s existing capital structure are recognized as capital restructurings. Company could
either issue some bonds and use the proceeds to buy back some stock (increasing the debt-
equity ratio) or issue stock and use the money to pay off some debt (reducing the debt-equity
ratio). Restructurings take place when the company substitutes one capital structure with
another leaving the company’s total assets unchanged.
Capital restructuring does not directly influence assets of a company, thus we can look
at the capital structure changing separately from its business activities. Thus, capital budget-
ing decisions are not dependent on capital structure and therefore restructuring decisions.
Consequently, we can assume investment decisions as given and focus on capital structure
matters (long-term financing).
Subject to several assumptions, financing by debt rather than equity does not seem to
make any difference to shareholders’ value. Let us now review the traditional view, that the
capital structure does have an effect on the wealth of the shareholders.
7.1 Capital Structure
Weighted average cost of capital demonstrates the company’s overall cost of capital and
should reflect the mixed returns expected by the different suppliers of capital. A company’s
WACC accounts for both the company’s cost of equity and its cost of debt, weighted according
to the proportions of equity and debt in the company’s capital structure.
When we defined the WACC, we assumed the company’s capital structure as fixed. Now
we need to find what happens to the cost of capital if a company increases the amount of debt
financing, or the debt-equity ratio. Most important reason for studying WACC is that WACC
is the rate investors use to discount cash flows.
A company’s WACC is in general a required return on the company as a whole and, as
such, it is often used internally by company directors to determine the economic feasibility
of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash
flows with risk that is similar to that of the overall company.
51
Hence, the value of the company is altering when the WACC is changing. Values and dis-
count rates alter in opposite directions, so minimizing the WACC will maximize the value of
the company’s cash flows. This optimal capital structure is also called the long-term targeted
capital structure.
7.2 The Effect of Financial Leverage
We know why the capital structure that produces the highest company value (or the lowest
cost of capital) is the most beneficial to stockholders. Now, we examine the impact of financial
leverage (gearing, solvency) on the cash flows to stockholders. Financial leverage can be ap-
propriately described as the extent to which a business or investor uses debt.
A lot of companies meet part of their long-term financing requirements through debt,
often by means of the loan stocks issuance. This gives debtholders contractual rights to receive
interest, typically at a predetermined rate and on specified dates. Debt finance could also be
provided by a bank or a similar institution, which would acquire similar contractual rights.
The important thing about debt finance lies in the fact that neither interest nor redemp-
tion payments are matters of the borrowing company’s discretion. Interest on such loans
amounts to an annual charge on profits. This must be satisfied before the equity shareholders
(owners), who in the typical company provide the larger part of the finance, may participate.
As we observed, under several assumptions, financing through debt rather than equity
does not make any change in a company’s value. We can now review the traditional point of
view, that capital leverage does have an effect on a company’s value. Then we can try to make
some conclusions on the matter.
Any additional debt financing in a company’s capital structure raises its financial lever-
age. As we explained, financial leverage can significantly modify the payoffs to shareholders
in the company. On the other hand, financial leverage may not affect the total cost of capital.
Consequently, a company’s capital structure is irrelevant because changes in capital structure
will not have an effect on the value of the company.
7.2.1 Financial Leverage and ROE
Let us begin by demonstrating how financial leverage works. For the moment, we take
no notice of the impact of taxes. Moreover, for ease of presentation, we explain the impact
of leverage in terms of its effect on earnings per share (EPS) and return on equity (ROE).
We use cash flows instead of accounting numbers, which would lead us to exactly the same
conclusions, but a little more work would be needed. We show the impact on market values
in a following part.
52 7. CAPITAL STRUCTURE AND FINANCIAL LEVERAGE
Table 15
Capital structure A Capital structure B rD=10%
Shares 1000 500
Price per share 10 10
Equity value 10000 5000
Debt value 0 5000
Asset value 10000 10000
Table 15 shows two capital structures. As predented, the company’s assets have a market val-
ue of $10 000, and there are 1000 shares outstanding. Since it is an all-equity company the price
per share is $10. The planned debt issue would raise to $5000; the interest rate would be 10%.
As the stock sells for $10 per share, the $5000 in new debt would be used to purchase
$5000/10=500 shares, leaving 500. After the restructuring, this company would have a capital
structure that was 50% debt, thus the debt-equity ratio would be 1. Observe that, for now, we
assume that the stock price will stay at $10.
Table 16 compares the company’s capital structure A and capital structure B under three
scenarios. The scenarios mirror different assumptions about the company’s EBIT. Under the
expected scenario (unchanged i), the EBIT is $1500.
Table 16
Capital structure A Capital structure B rD=10%
Shares 1000 500
Debt value 0 5000

scenario scenario
Operating results: Increase i Unchanged i Decrease i Increase i Unchanged i Decrease i
Net income before
500 1500 2000 500 1500 2000
interest (EBIT)
Interest expense 0 0 0 500 500 500
Net income 500 1500 2000 0 1000 1500
Earnings per share 0,5 1,5 2 0 2 3
Return on equity 5% 15% 20% 0% 20% 30%
In the recession scenario, EBIT falls to $500. In the expansion scenario, it rises to $2000.
In order to demonstrate some of the calculations behind the figures in Table 16, consider
the expansion case. EBIT is $2000. With no debt (capital structure A) and no taxes, net in-
53
come is also $2000. In this case, there are 1000 shares worth $10 000 total. EPS is therefore
$2000/1000=2. Also, because accounting return on equity, ROE, is net income divided by
total equity, ROE is $2000/10000=20%.
With $5000 in debt (capital structure B), things are fairly different. Since the interest rate is
10%, the interest bill is $500. With EBIT of $2000, interest of $500, and no taxes, net income is
$1500. Now there are only 500 shares worth $5000 total. EPS is therefore $1500/500 =3, versus
the $2 that we calculated in the previous scenario. Additionally, ROE is $1500/5000=30%.
This is well above the 20% we calculated for the current capital structure.
7.2.2 Financial Leverage and EBIT
The impact of leverage is clear when the effect of the restructuring on EPS and ROE is ex-
amined. Particularly, the variability in both EPS and ROE is much bigger under the proposed
capital structure. This demonstrates how financial leverage works to amplify profits and losses
to shareholders.
The key thing to observe in Figure 7 is that the slope of the line in this second case is steep-
er. Actually, for every increase in EBIT, EPS rises faster, so the line is twice as steep. This shows
us that EPS is twice as sensitive to changes in EBIT because of the financial leverage employed.
Let us take a look at the effect of the capital restructuring. This figure plots earnings per share
(EPS) against earnings before interest and taxes (EBIT) for both capital structures. The first line,
labeled “No debt,” represents the case of no leverage. This line begins at the origin, indicating
that EPS would be zero if EBIT were zero. From there, every increase in EBIT increases EPS.
The second line represents the capital structure B. At this point, EPS is negative if EBIT is zero.
It happens so because interest must be paid apart from the company’s profits, the EPS is negative
as illustrated. In the same way, if EBIT were $500, EPS would be exactly zero.
Figure 7 The impact of leverage. EPS versus EBIT
7.2.3 Homemade Leverage
At that time we can formulate a few conclusions:

• The effect of financial leverage depends on the company’s EBIT. When EBIT is relatively
high, leverage is favorable.
55
• Under the expected scenario, leverage increases the returns to shareholders, as meas-
ured by both ROE and EPS.
• Stakeholders are exposed to more risk under the proposed capital structure because the
EPS and ROE are much more sensitive to changes in EBIT in this case.
• Since the impact that financial leverage has on both the expected return to stockholders
and the riskiness of the stock, capital structure is an important consideration.
The first three of these conclusions are undoubtedly correct. However the last conclu-
sion does not follow. As we discuss next, the explanation is that shareholders can adjust the
amount of financial leverage by borrowing and lending on their own. This use of personal
borrowing to modify the degree of financial leverage is called homemade leverage.
Given that the ordinary shares are contain priced when assumed returns are expected we
may presume that investors regard 10% as the proper return for such an investment. If the ex-
pected returns increase as debt increases, this seems likely to push up the price of an ordinary
share. This means that, were the assets to be financed by an issue of equity, the value of each
ordinary share would be higher, but if the assets were to be financed by debt, the company’s
ordinary shares would be worth more. In short, the shareholders’ wealth would be increased
by debt instead of issuing equity.
Finally, let us look at the situation from the point of view of the suppliers of debt. If there
are higher returns to be made from direct investing in assets, they are prepared to do so for
less return from debt. They just should buy ordinary shares in this company. The difference
between direct investment in a company by buying the shares, and lending money on a fixed
rate of interest is the different risk level. From expected profits from the new projects, only
a specific part would be paid to debtholders (providers of the new finance). The other part
goes to the stockholders, but with it goes all of the risk.
As with all real businesses, returns are uncertain. Assume that there were to be a reces-
sion in the industry, so that the profits would fell from new businesses. This would mean that
stockholders can get nothing. From this it seems clear that debt provide an apparently cheap
source of finance, but it has an unseen cost to stockholders.
7.2.4 Business Risk and Financial Risk
The inclusion of debt enhances returns on equity over those which could be earned in the
all-equity company. Where profit falls below the breakeven point, however, the existence of
debt finance weakens the ordinary shareholder’s position. In effect, below certain profit there
would be insufficient profit to cover debt interest payments.
At almost all levels of profit, the debtholders could view the situation philosophically.
Finally, not only do they have the legal right to enforce payment of their interest and repay-
ment of their capital, they even have the company’s assets as collateral. Only if major losses to
the market value were to occur, would the debtholders’ position seriously be in danger.
Wherever leverage occurs, the risk to which stockholders are exposed is clearly higher
then the risk they would bear in the all-equity company. To business risk, the normal risk at-
tached to investing in the real world, is added financial risk, the risk caused by being burdened
with the obligation to meet fixed charges.
Figure 8 illustrates the relationship between business and financial risk where operating
returns fluctuate. The amount of business risk depends on the area of activity in which the
company is involved; financial risk depends on how the company is financed.
Modern portfolio theory, as well as intuition, tells us that risk and return are correlated. If
investors recognize high risk they immediately require high returns. Consequently, while lev-
erage will lift expected dividends to ordinary shareholders, this will not necessarily increase
the share price and as a result the wealth of the shareholder. Accompanying the increased
expected dividend is a wider range of possible outcomes.
Figure 8 ROE for levered company with fluctuations
The new opportunities which the leverage brings to stockholders are not always bad. For
any profit over certain expected earnings, share dividends would be enhanced. The majority of
investors are risk-averse, which means that the possibility that profit could be below expected
earnings tends to be more important to them than the possibility that earnings could be greater
than expected.
Ordinary shareholders will only be wealthier through the introduction of leverage if the
capital market (after it reassesses the situation following the debt issue) values the ordinary
shares less than their expected yield. Prior to the company’s expansion these ordinary shares
had a certain expected yield, but as a result of the higher risk level, which occured after the
57
expansion, the market expects a higher rate of return and therefore the price per share would
increase. If alternatively capital market requirements for the level of risk are lower, the price
per share would become lower.
We must ask if the introduction of leverage lowers the weighted average cost of capi-
tal (WACC) and therefore makes more valuable the investments in which the company is
involved. Given the company’s general objective of maximization shareholder’s wealth, the
capital market responds, in terms of required returns, to the introduction of leverage are very
important issue. Leverage is presumably only undertaken with the purpose of increasing
stockholders’ wealth.
7.3 Capital Structure and the Cost of Capital
There is nothing special about corporate borrowing because investors can borrow or lend
on their own. As a consequence, whichever capital structure company chooses, the stock
price will be the same. Capital structure is thus irrelevant.
7.3.1 Traditional View
The traditional view seems to be that the expected rate of return from equity investment
will not be significantly affected by the introduction of capital leverage, not at any rate up to
reasonable levels. This view of the effect of leverage on capital market expectations of returns
from equities, debt and WACC is shown in Figure 9 and illustrates that as leverage increases,
both shareholders and debtholders recognize additional risk and require higher returns. At
lower levels of leverage neither group wants significantly increased returns to compensate
for this risk, and WACC reduces. When leverage reaches higher levels, the risk problem be-
comes increasingly important to both groups, so required returns start to increase radically
and WACC starts to rise sharply. According to traditionalists even if the point at which each
group’s required return starts going up sharply is not necessarily the same, there is a point (or
a range of points) where WACC is at a minimum. This is the optimal level of leverage. At this
point the shareholders’ wealth is maximized, i.e. the price per share would reach a peak.
The underlying principle for the traditional view is that debtholders would recognize that
at high levels of leverage their security is significantly lost and would start to demand succes-
sively higher levels of interest as compensation. Moreover, there is a common belief that, up to
a certain level of leverage, equity shareholders would not see the increased risk to their returns
as a particularly important issue.
Figure 9 Cost of capital for different levels of leverage (gearing) - traditional view
Figure 9 Cost of capital for different levels of leverage (gearing) - traditional view
Cost of capital
(%)
Cost of Equity
WACC
Cost of Debt
Debt (D)
Optimal debt (D*)
After that point, however, they would start to demand substantial increases in returns for
further increases in leverage. A traditionalist would disagree that a company 50% loan financing
still has significant security in the value of the assets for the interest and the capital repayment,
After
even that point,dropped
if market however,significantly.
they wouldNevertheless,
start to demand main
if the increases
level of loan in returns increased
financing for furtherto
90%, a fallinof leverage.
increases more thanA 10% in the marketwould
traditionalist value would erode
disagree thewith
that, security of debtholders.
company at 50% Equity
loan
holders would not consider their situation as badly threatened by the existence of moderate
financing there is still plenty of security in the value of the assets for the interest and the
levels of loan finance and would not require returns great enough to negate the advantage of
capital repayment,
the appraise even if
entry cheap market
loan dropped
finance. significantly.
Generally, Nevertheless,
the traditional conclusionif was
the that
levelleverage
of loanis
a good thing, in terms of shareholder’s wealth maximization, at least up to
financing increased to 90%, a fall of more than 10% in the market value would erode the a certain level past
which it would start to have an adverse effect on WACC and therefore on shareholders’ wealth.
security of debtholders. Equity holders would not notice their situation too badly
threatened by the&existence
7.3.2 The Miller of Proposition
Modigliani moderate levels
I of loan finance and would not require
returns great enough to negate the advantage of the appraise entry cheap loan finance.
We know from previous arguments on weighted average cost of capital (WACC) that the
Generally, the structure
optimal capital traditional
forconclusion was
a corporation that the
is when leverage
WACCisis aminimized.
good thing,
Thisinis basically
terms ofin
line with thewealth
shareholder Miller maximization,
& Modigliani Propositions I and
at least up to II aboutlevel
a certain Capital
pastStructure
which itof Corporations,
would start to
proposed by Franco Modigliani and Merton Miller, two famous
have an adverse effect on WACC and therefore on shareholder wealth. Nobel prize winners.
The simplest way to show Miller & Modigliani Proposition I is to imagine two companies
that have exactly the same assets and that they have exactly the same business operations.
Consequently, the left side of their balance sheet is exactly the same. The only difference be-
tween the two companies is the right-hand side of the balance sheet (liabilities), that is to say
how they finance their business performance.
59
In the first company (Figure 10 right), stocks (equity) make up 70% of the capital structure
while bonds (debt) account for 30%. In the second diagram (Figure 10 left), it is the exact op-
posite, stocks (equity) make up 30% of the capital structure while bonds (debt) make up 70%.
It happens so because the assets of both capital structures are exactly the same. Any financial
assets are valued by reference only to their expected return and risk. Both structures offer
equal risk/return expectations.
Figure 10 Capital structure
Miller & Modigliani Proposition I states that the value of a company is NOT dependent
on its capital structure. A change from the current to the alternative debt/equity ratio would
result in an identical expected return with identical risk.
It would NOT seem logical for corporations to be able to increase the wealth of their
shareholders simply by showing the corporation’s income in a particular way. This is made
particularly unreasonable by the fact that single shareholders can alter the packaging to their
own convenience, only by borrowing and/or lending homemade leverage. Profits of similar
expected return and risk should be adequately priced in an effective market with rational
investors, irrespective of the packaging.
The most simple balance sheet, with all entries expressed as current market value:
Table 17
Assets Liabilities
Market value of debt
Value of cash flow from the company’s real assets and operations
Market value of equity
Value of company Value of company
The right- and left-hand sides of the balance sheet are always equal. Consequently, if one
add up the market values of all the corporation’s debt and equity security, one can estimate the
value of the future cash flows from the real assets and operations.
For that reason Miller & Modigliani Proposition 1 argues that it is irrelevant how the debt
and equity is structured in a corporation. Hence, the real assets (NOT the capital structure)
determine the value of the corporation. If the value of the corporation is not affected by the fi-
nancing techniques, the cost of capital is not decreased (or affected at all) by the introduction
of leverage. The only matters on which the value of the corporation and its WACC depend are:
(a) the cash flows which the corporation’s investments are expected to generate, and
(b) their risk (i.e. their economic risk).
This is another fact following the same model as Fisher separation model2. Miller
& Modigliani were finally saying that management should concentrate all its attempts on find-
ing and managing real investment opportunities, leaving the financing engineering for single
shareholders to decide for themselves.
7.3.3 Cost of Equity and Financial Leverage: M&M Proposition II
Although changing the capital structure of the company does not change the company’s
total value, it does cause important changes in the company’s debt and equity. Let’s have a look
at what happens to a company financed with debt and equity when the debt/equity ratio is
changed. For the sake of simplicity of our examination, we will continue to ignore taxes.
Miller & Modigliani Proposition II assumes that the value of the company depends on
three things:
1) Required rate of return on the company’s assets (rA)
2) Cost of debt of the company (rD)
3) Debt/equity ratio of the company (D/E)
As we know, the method for calculating weighted average cost of capital (WACC) can be
expressed in the following formula (if we ignore taxes):
We recall that one way of interpreting the weighted average cost of capital is the required
return on the company’s overall assets. We will use the symbol rA to stand for the WACC and
write the WACC formula in another form:
The above formula can also be rewritten as:
2
Fisher’s separation theorem sates that in a perfect capital market, it is possible to separate the company’s
investment decisions from the owners’ consumption decisions.
D
rE  rA  (rA  rD )
E
This formula shows the basic idea of Miller & Modigliani Proposition II. This is the
famous Miller & Modigliani Proposition II, which shows that the cost of equity depends 61
on three things: the required rate of return on the company’s assets, r A, the company’s
This forofmula
cost debt, Rshows thecompany’s
D, and the basic ideadebt-equity
of Millerratio,
& Modigliani
D/E. Proposition II. This is the fa-
mous proposition,
Figure 11 shows our arguments so far by plotting the cost of equityon
which argues that the cost of equity depends threerEthings:
capital, , againstthe
therequired
rate of return on the company’s assets, rA, the company’s cost of debt, rD, and the company’s
debt-equity ratio. Miller & Modigliani Proposition II illustrates that the cost of equity, r E ,
debt-equity ratio, D/E.
is represented by a straight line with a slope of (rA - rD). The y-intercept corresponds to a
Figure 11 demonstrates our arguments so far by plotting the cost of equity capital, rE , against
company with a debt-equity ratio of zero. Figure 11 shows that, as the company increases
the debt-equity ratio. Miller & Modigliani Proposition II illustrates that the cost of equity, rE , is
its debt-equity
represented ratio, line
by a straight the increase in leverage
with a slope of (rAraises
- rD).the
Therisk of the equity
y-intercept and therefore
corresponds tothe
a company
with a required
debt/equity
returnratio of of
or cost zero. Figure
equity (rE). 11 shows that, as the company increases its debt-equity
ratio, the increase in leverage boosts the risk of the equity and therefore the required return or cost
of equity (rE).11 M&M Preposition II
Figure
Figure 11 M&M Proposition II

Cost of capital
(%)
Cost of Equity
WACC
Cost of Debt
Debt (D)
Summary of Miller & Modigliani Proposition II:

• required rate of return on the company (rE) is a straight line with a slope of (rA – rD),
• rSummary
E
ofcurved
is linear Miller &and
Modigliani
upwards Proposition II:
sloping because as a company borrows more debt (and
increases its debt/equity ratio), the risk of bankruptcy is even higher. As adding more
debt is risky, the shareholders demand a higher rate of return (rE) from real economic
operations in company (rE is upwards sloping),
• as debt/equity ratio increases, rE will increase (upwards sloping),
• weighted average cost of capital (WACC) - 81 - is a straight line with no slope. Thus WACC
does not have any relationship with the debt/equity ratio. This is the basic formula of
Miller & Modigliani Proposition I and II, that the capital structure of the company does
not affect its total value,
• for that reason WACC remains unchanged even if the company borrows more debt
(and increases its debt/equity ratio, table 18).
Table 18
Capital structure A Capital structure B rD= 10%
Shares 1000 500
Debt value 0 5000
Operating results scenarios scenarios

Net income before interest 500 1500 2000 500 1500 2000
Interest expense 0 0 0 500 500 500
Net income 500 1500 2000 0 1000 1500
Earnings per share 0,5 1,5 2 0,0 2,0 3,0
Return on equity 5% 15% 20% 0% 20% 30%
rA 15% 15%
rD 10% 10%
rE 15% 20%
WACC 15% 15%
Miller & Modigliani’s disagreement with the traditionalists was that Miller & Modigliani
noticed the capital market’s return expectations increase when leverage is introduced, and
that they increase in proportion to the amount of leverage. The traditionalists believed that
this would not take place at lower levels of leverage.
7.4 Taxation, Financial Distress and Bankruptcy Cost
Debt has two distinguishing features that we have not taken proper account of. First, as
we have emphasized many times, interest paid on debt is tax deductible. This is good for the
company, and it may be an added benefit of debt financing. Second, the failure to meet debt
obligations can result in bankruptcy. This is not good for the company, and it may be an added
cost of debt financing, called the cost of financial distress. Since we have not explicitly consid-
ered either of these two features of debt, we realize that we may arrive at different conclusions
about capital structure once we do.
We can start by considering what happens to Miller & Modigliani’s Propositions I and II
when we consider the effect of corporate taxes. In order to do this, we will examine two
companies, Company U (Unlevered) and Company L (Levered). These two companies are
identical on the left-hand side of the balance sheet, so their assets and operations are the same.
63
7.4.1 The Interest Tax Shield
To make things simpler we assume that (1) capital expenditure is zero, (2) there are no
changes in Net Working Capital and (3) depreciation is zero. Cash flows from Capital struc-
ture A (Unlevered) and Capital structure B (Levered) are not the same even if the two com-
panies have identical assets.
Total cash flow to Levered company is 175 more. This occurs because tax bill levered (which
is a cash outflow) is 175 less. Due to the fact that interest is deductible for tax purposes it gen-
erates a tax saving equal to the interest payment 500 multiplied by the corporate tax rate 35%:
$500*35%=$175.
We call this tax saving the interest tax shield.
Table 19
Capital Capital
rD= 10%
structure A structure B
Shares 1000 500
Debt value 0 5000
Operating results
Net income before interest 1500 1500
Interest expense 0 500 flow
Taxable income 1500 1000
Income tax 525 350 -175 tax bill less
Net income 975 flow 650 flow
Value of Tax Shield

rD 10,0%
t 35%
D 5000
TS 175
PV(TS) 1750
64 shield is generated by paying
Tax 7. CAPITAL
interest, itSTRUCTURE ANDasFINANCIAL
has the same risk LEVERAGE
the debt, so10% (the
cost of debt) is thus the appropriate discount rate. The value of the tax shield is:
7.4.2 Taxes and M&M Proposition I
the(5000
debt*is0,1perpetual,
* 0,35)
n
For the reason that 
PV(TS)= n
= the same 175 shield =1750
(5000*0,1*0,35)/0,1 will be generated every
i 1 (1  0 ,1)
year onwards. The after tax cash flow to Levered company will thus be the same 975 that
UnLevered Company earns plus the 175 tax shield. Because Levered company’s cash flow is
always
The $175 greater,
another famous Levered
result ofCompany
Miller &is Modigliani’s
worth more than UnLevered
Proposition Company,
I (after-tax the differ-
version)
ence being the value of this 175 perpetuity.
states
Taxthat market
shield forces must
is generated by cause:
paying interest and it has the same risk as the debt, so 10% (the
cost of debt) is thus the appropriate discount rate. The value of the tax shield is:
Vlevered = Vunlevered + t D
where D is the value of the company’s debt and t is the relevant Corporation Tax rate, at
Another famous result of Miller & Modigliani’s Proposition I (after-tax version) states that
which
marketdebt interest
forces mustwill be relieved.
cause:
The effect of borrowing in this caseVis illustrated + TD 12. We have plotted the value
= V in Figure
levered unlevered
of the levered company, VL, against the amount of debt, D. Miller & Modigliani
where D is the value of the company’s debt and T is the relevant Corporation Tax rate, at
Proposition I with corporate
which debt interest taxes implies that the relationship is given by a straight line
will be relieved.
with a slope of TC and a y-intercept of VU. We have also drawn a horizontal line
The effectVof
representing borrowing in this case is illustrated in Figure 12. We have plotted the value
U. As pointed out, the distance between the two lines is TC * D, the present
of the levered company, VL, against the amount of debt, D. Miller & Modigliani Proposition
value of the tax shield.
I with corporate taxes implies that the relationship is given by a straight line with a slope of TC
and a y-intercept of VU. We have also drawn a horizontal line representing VU. As pointed out,
the distance
Figure between
12 Miller the two lines
& Modigliani is TC * D,I with
Proposition the present value
corporate of the tax shield.
taxes
Figure 12 Miller & Modigliani Proposition I with corporate taxes
Company value (VL)

Value of levered company
VL = VL + TC D
Tax shield VL
TC D
Value of unlevered company (VU)
VL
Debt (D)
- 85 -
65
7.4.3 Taxes and the WACC
The Miller & Modigliani after-tax proposition implies that the value of the levered com-
pany is greater than the value of the unlevered one. Consequently the higher the level of lev-
erage, the higher the value of the company. The inevitable conclusion is that the value of the
company is the highest and WACC the lowest, when leverage is at 100% (all-debt company),
i.e. all finance is provided by debtholders.
If we consider the effect of taxes, the WACC is:
To calculate this WACC, we need to know the cost of equity. Miller & Modigliani
Proposition II with corporate taxes states that the cost of equity is:
Table 20 shows some examples of WACC with taxes. Let us assume that we have $60 debt,
so that levered company is worth $124 total. Because the debt is worth $60, the equity must
be worth $124–$60=$64. For this company, the cost of equity is thus:
rE = 0,16 + (0,16 - 0,10) *(60/64) * (1 - 0,40)= 19,4%
The weighted average cost of capital is:
WACC = (60/124) * 19,4% + (64/124) * 10% * (1 - 0,40)= 12,9%
The WACC without debt is over 16%, and, with debt, it is 12,9%. Consequently, the com-
pany is better off with debt.
Table 20
Assumptions Beta 1,50
Risk-free rate 10,0%
Equity risk premium 4,0%
Cost of unlevered 16,0%
Long Term Borrowing Rate 10,0%
Tax rate 40%
Assets=Equity+TaxShield 100 108 116 124 132 140

Equity 100 88 76 64 52 40
Debt 0 20 40 60 80 100
Debt-to-Equity ratio 0% 23% 53% 94% 154% 250%

Debt-to-Assets ratio 0% 19% 34% 48% 61% 71%
rE 16,0% 16,8% 17,9% 19,4% 21,5% 25,0%
WACC no tax 16,0% 16,0% 16,0% 16,0% 16,0% 16,0%

WACC 16,0% 14,8% 13,8% 12,9% 12,1% 11,4%
Figure 13 shows the Miller & Modigliani after-tax view of capital leverage. There is a difference
with the pre-tax proposition. In the after-tax example the cost of debt is low enough (due to higher
tax relief on loan interest) for increasing amounts of loan finance to reduce WACC at a greater rate
than the increasing demand of stockholders are raising it. Thus the WACC line slopes downward.
Nevertheless, it is unclear if this 100% debt finance conclusion is rational in practical
terms. At extremely high levels of leverage the debtholders would recognize that their safety
had been substantially eroded and that, while they theoretically might be debtholders, as risk
takers they are stockholders in reality. They would therefore demand a level of return which
would compensate them for this risk, a level of return similar to the one the stockholders
demand. This shows that at very high levels of leverage, both in the pre-tax and in the more
upwards
important at somepropositions,
post-tax high level of leverage, thedebt
the cost of WACC linerise
would can significantly.
only continue its downward
If path
Miller & Modigliani
if the cost of equityconclusions
line becomeshold, this as
less steep requires
WACCthat thetherate
line is of increase
average in the cost
of the other
of equity
two. starts to fall. In Figure 13, if the cost of debt line is going to start turning upwards at
some high level of leverage, the WACC line can only continue its downward path if the cost of
equity line becomes less steep as WACC line is the average of the other two.
Figure 13. Miller & Modigliani after-tax view of capital leverage ( gearing)
Figure 13. Miller & Modigliani after-tax view of capital leverage (gearing)
Cost of capital
(%)
Cost of Equity
WACC
Cost of Debt
Debt (D)
7.5 Financial Distress and Bankruptcy Cost
The concept of the rate of increase in the cost of equity, as leverage is increased, rapidly
7.5 Financial
decelerating distress
at high leverage and
levels, bankruptcy
seems cost Why should stockholders start
not to be sensible.
to behave differently to all the concepts and evidence of investor feedback to growing risk?
This would undermine in the M&M theorem, which possibly means that their deduction in
The concept of the rate of increase in the cost of equity, as leverage is increased, rapidly
the after-tax situation is not reasonable.
starting to reduce at high leverage levels seems not to be sensible. Why should
Cost of debt increases fixed costs and when a company has higher fixed costs then the
stockholders
probability start todistress
of financial behaveincreases.
different to all theinconcepts
It arises and evidence
the situation where aofcompany
investor cannot
feedback
meet its to growing
financial risk?toThis
obligations proposes the weakness in the M&M theorem which
its debtholders.
possibly means that their deduction in the after-tax situation is not reasonable.
Cost of debt increases fixed costs and when a company has higher fixed costs then the
probability of financial distress increases. It rises the situation where a company cannot
67
7.5.1 Cost of Capital in Practice
When financial distress cannot be handled, it can lead to bankruptcy. Financial distress is
typically associated with certain costs to the company (financial distress costs). A typical case
of a cost of financial distress are bankruptcy costs. Such financial direct costs include manage-
ment fees, legal fees, auditors’ fees and other expenditures. Cost of financial distress can occur
even if bankruptcy is avoided (financial indirect costs). If a situation of financial distress arises
indirect costs of financial distress makes higher costs of capital (banks generally increase the
interest rates).
High levels of debt expose the company to the risk. Financial distress in companies in-
volves management attention and might lead to less attention to the processes of the com-
pany. If the company is not able to meet its payment obligations to creditors, or at least not
using its operating cash flows, the company should experience a particularly adverse period
of trading. While it is equally true that the 100% equity company might have difficulty paying
dividends in analogous economic conditions, there is a key difference.
Creditors have a contractual right to collect interest payments and capital repayment on the
payable dates. If debtholders do not collect these payments, they have the right and power to
legally enforce payment. The implementation of such right and power can in practice lead to the
process of selling the company’s assets, paying off creditors, distributing any remaining assets
to the principals and then dissolving the company. This will typically be a disadvantage to the
ordinary shareholder to a significant extent, but neither in a levered, nor in an unlevered com-
pany do ordinary shareholders have any rights to enforce the declaration and dividend payment.
The risk of bankruptcy is perhaps unimportant at low levels of leverage, because any lack
of cash for interest expenses could be covered from some other source – an option probably
not so readily available to highly levered companies in distress. At very small levels of finan-
cial leverage the position of debtholders is one of great security, with the value of their bonds
probably covered many times by the value of the company’s assets. Since the level of leverage
rises, this situation erodes until at very high levels creditors, because they deliver most of the
finance, bear most of the risk.
Assume that the undeveloped company were financed 90% by equity and 10% by debt.
The value of company’s assets would have to decrease by 90% before the security of the debt-
holders would be vulnerable. Though the equity/debt ratio changed to 80:20, the debtholders’
security, while in theory somewhat weakened, is not less in practical terms than had they
only supplied 10% of the finance. If still the ratio changed to 10:90, only a small fall (10%) in
the value would leave the debtholders bearing all the risk. Unsurprisingly, debtholders would
request high returns to encourage them to buy bonds in such a highly levered company, ap-
parently something like the returns expected by equityholders.
Understandably, the debtholders would not see risk (and required return) increasing sig-
nificantly with increases in leverage at the lower end. Finally, unless the asset on which securi-
ty rests is extremely volatile in its value, an assets/debt ratio of 5:1 is probably as good as 10:1;
the debtholders only need to be paid once. If this ratio increases to nearer 1:1, debtholders
would no doubt start to see things in different way. It is remarkable that neither of these two
‘weak’ assumptions of Miller & Modigliani theorem drastically affect the situation at lower
levels of leverage, but they start to appear very large at higher levels.
Let us make a provisional conclusion: in acceptable, sensible levels of leverage the tax
compensation of debt finance will make the WACC decrease as more leverage is introduced.
Away from reasonable levels, bankruptcy risk (to equity shareholders) and the introduction
of real risk to debtholders will move up the returns required by each group, making WACC
a very high figure at high leverage levels.
It is more likely that, in real economy, reasonable is not a permanent point for any particu-
lar company; it is rather a range below which Miller & Modigliani proposition is valid, but
above which it obviously is not. The problem is that it is difficult to define a ‘reasonable level’
and, per se, it is a matter of opinion of financial management. It has to be the point at which
the tax gain on the one hand unbalance bankruptcy cost and increase cost of debt on the
other. It is different in different business and will to some degree depend upon the industry
Figure 14 shows this conclusion with D*, WACC, and Cost of Debt all following the same
risk of the investments in which the particular company is involved.
pattern as Miller & Modiguani post-tax up to a *reasonable level of leverage and then all
Figure 14 shows this conclusion with D , WACC, and cost of debt all following the same
startingastoMiller
pattern increase&toModigliani
very high levels as additional
post-tax leverage
proposition upistomade.
a reasonable level of leverage and
then all starting to increase to very high levels as additional leverage is made.
Figure 14 Cost of capital in practice
Figure 14 Cost of capital in practice
Cost of capital
(%)
Cost of Equity
WACC
Cost of Debt
Sensible level of debt
Debt (D)
*
Optimal debt (D )
The connection between the value of the levered and unlevered companies can be ex-
pressed as:
Formally the connection between the value of the levered and unlevered companies can
Vlevered
= Vunlevered + TD – Present value of the expected cost of bankruptcy
be expressed as:
Since leverage increases, the value of the tax shield (TD) increases but also does the prob-
able cost of bankruptcy.
Vlevered = Vunlevered + t D – Present value of the expected cost of bankruptcy
Since leverage increases, the value of the tax shield (TL) increases but also does the
probable cost of bankruptcy.
69
7.5.2 The Static Theory of Capital Structure

from an additional debt is precisely equal to the cost that comes from the increased
The idea ofofcapital
possibility structure
financial distress. that
We we havethat
assume presented is known
the company as intheterms
is fixed static
of theory
its of capital
structure. According
operations and assetstoandthis theory
we only companies
considers borrowratio
the debt-equity upchanges.
to the point where the tax gains
fromFigure
an additional
15 illustrates the static theory of capital structure and plotsfrom
debt is precisely equal to the cost that comes the increased
the value of the possibility
of financial distress. We assume that the company is fixed in terms of its
company, VL, against the total debt, D. In Figure 15, we have drawn lines matching to operations and assets
and we only consider the debt-equity ratio changes.
three different scenarios. The first scenario represents Miller & Modiguani Proposition I
Figure 15 illustrates the static theory of capital structure and plots the value of the compa-
with no taxes. This is the horizontal line extending from VU, and it shows that the value
ny, VL, against the total debt, D. In Figure 15, we have drawn lines matching to three different
of the company is not affected by its capital structure. The second scenario, Miller &
scenarios. The first scenario represents Miller & Modigliani Proposition I with no taxes. This
is theModiguani
horizontal Proposition I with corporate taxes, is represented by the upward-sloping
line extending from VU, and it shows that the value of the company is not
straight line.
affected by its capital structure. The second scenario, Miller & Modigliani Proposition II with
corporate taxes, is represented by the upward-sloping straight line.
Figure 15 Optimal Capital Structure
Figure 15 Optimal Capital Structure
Company value (VL)
Value of levered company (VL)
Financial distress cost

Maximum
company value
(VL*)
Present value of
tax shield on debt Current company value
Value of unlevered company (VU)
Debt (D)
Optimal debt (D*)
In third scenario in Figure 15 the value of the company rises to a maximum and then de-
In third scenario in Figure 15 the value of the company rises to a maximum and then
clines outside that point. This is the situation that we get from a static theory of capital struc-
declines outside that point. This is the situation that we get from static theory of capital
ture. The maximum value of the company, VL*, is reached at D* and this point represents the
structure. The maximum value of the company, VL*, is reached at D* and this point
optimal amount of debt in company. Put differently, that company’s optimal capital structure
is composed oftheD*/V
represents optimal
L
* inamount
debt of debt
and (1 – in company.
D*)/V L
* in We can say differently, that the
equity.
company’s
The optimal capital
final obserwation instructure
Figure is15composed
is that the D*/VL* in debt
of difference and (1 the
between – D*/V L*) of
value in the company
equity.
in static theory and the Miller & Modigliani (value of the company) with taxes is the loss in
value as financial distress is rising. Moreover, the difference between the static theory value of
the company and the Miller & Modigliani value with no taxes is the gain from leverage, net
- 92 -
of distress costs.
70
List of Figures
Figure 1 Organization chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Figure 2 Components of the return on investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Figure 3 Systematic and Unsystematic Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Figure 4 Market risk and size of portfolio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Figure 5 Capital structure.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Figure 6 Security Market Line (SML) and Weighted Average Cost of Capital WACC. . . . . . 49
Figure 7 The impact of leverage. EPS versus EBIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Figure 8 ROE for levered company with fluctuations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Figure 9 Cost of capital for different levels of leverage (gearing) - traditional view. . . . . . . . 58
Figure 10 Capital structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Figure 11 M&M Preposition II. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Figure 12 Miller & Modigliani Proposition I with corporate taxes. . . . . . . . . . . . . . . . . . . . . . 64
Figure 13. Miller & Modigliani after-tax view of capital leverage (gearing) . . . . . . . . . . . . . . 66
Figure 14 Cost of capital in practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Figure 15 Optimal Capital Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
71
List of Tables
Table 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Table 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Table 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Table 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Table 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Table 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Table 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Table 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Table 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Table 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Table 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Table 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Table 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Table 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Table 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Table 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Table 17. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Table 18. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Table 19. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Table 20. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
72 REFERENCES
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The publication co-financed by the European Union from the European Social Fund

Warsaw School of Economics

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2. The Agency Problem in Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

3. Time Value of Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

5. Risk and Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

5.3.2 Portfolio Expected Returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

7. Capital Structure and Financial Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

1.1 Corporate Finance and The Financial Manager

Figure 1 Organization chart

1.2 Long-term Financial Decisions

1.2.1 Capital Budgeting

1.2.2 Capital Structure

In traditional (neoclassical) approach a corporation is treated as a single entity, it is often

2.1.1 Principal-Agent Problem

2.1.2 The Objectives of Financial Management

2.1.3 Managers and Stockholders in Practice

2.1.3.1 Managerial Compensation

2.1.3.2 Control of the Company

3.1 Future Value

3.1.1 Investing for a Single Period

3.1.2 Investing for More Than One Period

$4 = $2*2= ($1*2)*2= $1*(2*2)= $1 * 22

$8 = $4*2= ($2*2)*2= [($1*2)*2] *2= $1*(2*2 *2)= $1 * 23

Future value = $1 * (1 + r)t

(1 + r)t = (1 + 0.10)5 = 1,15 = 1,6105

Your $1 will thus grow to:

3.2 Present Value and Discounting

3.2.1 The Single-Period Case

Or, solving for the present value:

Present value = $1/1,1 = $0,909

3.2.2 Present Values for Multiple Periods

$100 = PV * 1,1 * 1,1 = PV * 1,12 = PV * 1,21

3.3 Present versus Future Value

Future value factor = (1 + r)t

4.1 Cash Flows

4.2 Typical Cash Outflows and Inflows

4.3 Net Present Value (NPV)

4.3.1 Estimating Net Present Value

Net cash flow 20 20 20 20 20 20 20

$30 - $10 = $20

NPV = 135,33 – 100 = 35,33

Consequently, this is a good investment. Based on our estimates, undertaking it would

4.4 Internal Rate of Return (IRR)

4.4.1 Estimating Internal Rate of Return

NPV= 6 NPV= -18

As NPV is now zero, we know that the IRR is about 15,25%.

4.4.2 Net Present Value and Internal Rate of Return

When a project is an independent project, meaning the decision to invest in a project is

4.5 Payback Period

4.5.1 Evaluation of the Payback Period Method

The formula or equation for the calculation of payback period is as follows:

Payback period = Investment required / Net annual cash inflow

Device A payback period = $15,000 / $5,000 = 3.0 years

4.5.2 Criticism of Payback Method

5.1 Rates of Return

Figure 2 Components of the return on investment.

$4 = $22= ($12)2= $1(22)= $1 22

$8 = $42= ($22)2= [($12)2] 2= $1(22 2)= $1 23