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FINS1613

Business Finance
Semester 2 2009
Version 1.0.0
12th October 2009

Contents
Page 3

Basic Concepts

Page 7

Introduction to Financial Mathematics

Page 10

The Valuation of a Firms Securities

Page 14

Capital Budgeting

Page 18

Capital Budgeting Applications Part 1

Page 23

Capital Budgeting Applications Part 2

Page 26

Risk and Return

Page 29

The Capital Asset Pricing Model

Page 32

Cost of Capital and Raising Capital

Page 38

Capital Structure

Page 42

Dividend Policy

Note: This course has prerequisites and, as such, these notes are written
assuming that you have sound knowledge from those prerequisite courses.

Business Finance Semester 2 2009

Basic Concepts

Basic Concepts
Background
Before we delve into the harder components of business finance, it is imperative that we
learn the basics first.
Types of Business Forms
If you have previously studied Business Studies for the HSC, you can skip this section.
Businesses are usually formed based on a set structure. The most common of these are:

Sole Proprietorships
This is where the business is owned by a single person. It is very simple, fast to
establish and generally has very minimal government regulations. The owner gets to keep
all the profits himself so there is incentive to work harder.
The downside is that it has unlimited liability (where if the business goes bankrupt,
everything the owner owns can be taken by creditors). There is also difficulty in raising large
sums of money as you are a single person. Since the business profits are also the owners
profits, there is no distinct line between personal income and business income. The
business will only generally last as long as the owner is alive or wants to run it.
Partnerships
This is generally the same as a sole proprietorship except that there is more than
one owner. It generally has the same advantages and disadvantages as a sole proprietorship
does.
Corporations
A corporation is a legal entity. That is, it is treated like a person. In this sense,
there is limited liability for the owners as the creditors will only be able to extend as far as
the entity itself is (ie. Just the business). It differs from the two forms above in that the
owners are generally not the people who are running the business; the managers are.
It is advantageous in that it is much easier to raise funds than other forms; and
ownership can be transferred easily and, as such, has an unlimited life. Its disadvantages
are that there are many processes that must be completed to form a corporation and these
take a lot of time and money. The earnings of the corporation are also liable to corporate tax.

It is possible that some businesses may be a hybrid of a selection of the above. Generally, a
business will pick a structure that suits their needs and has the most advantages for them.
Financial Management Decisions
Decisions relating to financial management can be split into two broad categories. These are:

The Investment Decision


This is the decision is also sometimes known as capital budgeting. This is the
decision that is made on how to move effectively use raised funds to generate revenue for
the firm. This could be a decision on which project to take etc.

Business Finance Semester 2 2009

Basic Concepts

The Financing Decision


This is the decision about how to structure the firms capital (Capital Structure) such as how
much debt and equity they should be using to fund long-term investments. This also includes
working capital management which is the decision for the short-term to ensure the firm has
enough liquidity to use in daily operations.

The Goal of Financial Management


The goal of financial management is ultimately to maximise the value of the firm to
shareholders. That is: increasing shareholder value.
Shareholders of a business generally want an increase in value through:

Increases in capital gains (share price increase)


Dividend payments

Since both of these are generally related to the performance of a firms shares, the goal of
financial management is sometimes shortened to, maximising the firms share price.
A firm may have intermediate goals while they are trying to achieve shareholder value
maximisation. This may include, but is not limited to:

Employee Safety
Ethics (Corporate Governance)
Environmental Issues
Local and/or International Society

The Agency Problem


If you have previously studied ACCT2522, you can skip this section.
The Agency Problem is the problem associated with the division of ownership and
management in corporations. The corporation is meant to be maximising shareholder value but
management may run the company to maximise their own benefits instead of the owners. This
problem does not exist in business forms such as the sole proprietor or the partnership because the
owner is the manager in these forms.
This problem creates agency costs which are the costs associated with managers acting in
ways which do not maximise shareholder value. These costs can be either direct or indirect. Direct
costs are costs associated with monitoring and setting contracts with managers while indirect costs
arise when value maximising investments are rejected by managers.
The agency problem can be addressed to a certain extent with internal mechanisms such as:

Utilising a Board of Directors that consists of both executive (managers from within the
business with good knowledge of business workings) and non-executive members (people
from the outside who do not have very good knowledge of the business but bring in a third
party perspective to decisions).

Business Finance Semester 2 2009

Basic Concepts

Shareholder meetings. These can be grounds for a proxy fight where shareholders vote to
get rid of current management and replace them with new people if they do not like how
they are currently handling the corporation.
Compensating management with share options instead of bonuses. This means that
management is getting compensated based on the value of the firms shares meaning that
managers will take options to maximise shareholder value.
Setting up Corporate Governance.
Some external mechanisms are:

The threat of hostile takeover. Firms that perform poorly in terms of maximising
shareholder value are usually very attractive takeover targets. When a takeover does
happen, management is usually fired and as such, it is in the managers best interest to keep
shareholder value up to prevent this from occurring.

Corporate Governance
If you have previously studied ACCT1511, you can skip this section.
You can also read the Page 37 of ACCT1511 Course Notes for more information.
Corporate Governance is defined as the framework of rules, relationships, systems and
processes within and by which authority is exercised and controlled in corporations, by the ASX.
The objective of corporate governance is to:

Create value through innovation, development and different values for different companies.
Provide accountability and control systems so we know who is responsible for the firm, to
whom, in what ways, how and why they are there.

The Board of Directors is a part of corporate governance and acts as the mediator between
the shareholders and management, usually because management considers what is best for them,
and not what is best for the shareholders. The Board of Directors acts to protect the interests of
shareholders by exerting a controlling force inside the corporation.
More Agency Problems
From the above, we note the agency problem exists between the managers and the owners.
However, there are also agency problems between any entity that has a financial interest in the firm
such as debtholders, employees, customers, suppliers and even the government.
As such, debtholders usually place controls over loans (called loan covenants) which limit
something the things the company can do in favour of the debtholder. These can be in the form of:

Limit on total debt level allowed


Restrictions on dividends
Required level of debt-to-equity

Failure by the corporation to adhere to these covenants can trigger the debtholder to
immediately ask for full repayment.

Business Finance Semester 2 2009

Basic Concepts

Primary and Secondary Markets


If you have previously studied FINS1612, you can skip this section.
The primary market is the market for which the original sale of financial securities occurs.
You can think of this as the first hand market, such as when you buy a brand new item from a
store. These are usually either public offerings (sale to the public) or private placements (sale to few
select buyers).
The secondary market is where issued financial securities are traded again. Think of this as
the second hand market where youre simply buying again from people who have previously
bought it from a shop.

Business Finance Semester 2 2009

Introduction to Financial Mathematics

Introduction to Financial Mathematics


Background
Finance is all about the numbers. Hence, we need to know how to be able to get these
numbers to be able to provide an accurate analysis for things such as capital budgeting.
The Time Value of Money
A dollar today is worth less than a dollar tomorrow. This is the fundamental principle of
the time value of money. This holds because you can take that dollar you have today, deposit it in a
bank, gain interest on that dollar and it will be worth more tomorrow, even if it is by a few cents.
Example:
I have $100 today and invest it in a one year term deposit at 8% p.a. In one years time, I
would have $108. However, if I had not invested it, I would still have $100.
Some definitions we need to know:

Present Value (PV)


This is the value of the money you have today. ($100 in the above example)
Future Value (FV)
This is the value of the money you have at a specified future date. ($108 in the above
example)
Interest Rate (r)
This is the rate at which the money is invested in. (8% in the above example)
Thus we can see that our initial investment will grow at the rate of (1+r). Thus we can imply:
FV = PV(1+r)
Taking our last example FV = 100(1+0.08) = 108

Multi-Period Investments
Our previous example only took into account one period. If we are to take into account
multiple periods, we need to distinguish between simple interest and compound interest.
Simple interest only gives interest based on the principle. However, compound interest gives
interest based on the principle plus all interest received to date on that investment.
Example:
Following on from the previous example, simple interest would only give interest based on
the principle. That is, over 3 years, we would get: 100(1 + 0.08 x 3) = $124. However with compound
interest, in 3 years we would get: 100(1 + 0.08)3 = $125.97.
The formula for Simple Interest is: FV = PV (1 + r x t)
The formula for Compound Interest is: FV = PV (1 + r)t

Business Finance Semester 2 2009

Introduction to Financial Mathematics

From the example, we can see how compound interest will always give more return than
simple interest as it calculates interest based on principle plus previous interest. The difference
between simple interest and compound interest, holding everything else constant, will grow bigger
as periods increase.
Present and Future Value of T Multi-Period Investments
In the following, C is the cash flow, r is the interest rate and t is the time period. Also, the
following are:
1 + 1
, =

1 1 +
, =

Multi-Period investments include:

Annuities
Continual cash flows occur at the end of each time period.
= ,
= ,
Annuities Due
Continual cash flows occur at the beginning of each time period.
To find these, simply take the appropriate annuity formula and multiply by (1+r).
Deferred Annuities
A delayed annuity where the first cash flow occurs at k periods later.
,
=
1 +
Perpetuities
A annuity that is expected to last forever (i.e. No maturity date)

Where C1 is the first cash flow and g is the rate at which


Growing Perpetuities
A perpetuity that has cash flows which grow at a constant rate.

Where C1 is the first cash flow and g is the rate at which the cash flows grow at.
Uneven Cash Flow Investments
Where cash flows are not the same each period.
To calculate this, we have to individually take each cash flow and discount it back to the
present or future.

Compounding Periods
Not all investments compound yearly. They could compound semi-annually, quarterly,
monthly, weekly, daily and even continuously. To change the interest rate, we simply divide it by the
number of payments per year. i.e. We divide by 12 if it is compounded monthly. We must also
remember to multiply the time period (t) by the number of compounding periods per year.

Business Finance Semester 2 2009

Introduction to Financial Mathematics

To compare rates that have different compounding periods to each other, we can convert
them to effective annual rates. What this does is convert the said interest rate to a rate which, when
compounded yearly, gives the same figure as the other.
This is done with the following formula:

= 1 + 1

Example:
We have a rate which is 9% p.a. which is compounded monthly. To find the effective annual
rate:
= 1 +

0.09
1 = 9.38%
12

This means that we can either:

Compound monthly at 9% p.a.


Compound yearly at 9.38% p.a.
And we would get the same result in the end.

Business Finance Semester 2 2009

The Valuation of a Firms Securities

The Valuation of a Firms Securities


Background
A firm is valued by looking at both:

The present value of cash flows generated by the firms productive assets (such as plant,
equipment etc.)
The present value of the sum of cash flows generated by the firms securities.
Knowing that the assets must equal the liabilities plus equities, we can infer that:
V=D+E
Where:

V is the present value of cash flows generated by the firm.


D is the present value of cash flows generated by debt securities.
E is the present value of cash flows generated by equity securities.

Debt vs. Equity


Firms have a choice of using debt and/or equity financing. The majority of firms will use both
types but most will have different levels of both debt and equity. This is usually based on the firms
needs and wants because both debt and equity have their advantages and disadvantages.
Debt
Do not gain ownership of the firm
Do not gain voting rights in the firm
Interest is tax deductible
Must repay interest and principal amounts
First claim if the firm goes bankrupt

Equity
Gain ownership of the firm
Gain voting rights in the firm
Dividends are not tax-deductible
Dividends do not have to be paid
Residual claim if the firm goes bankrupt

Bonds
Bonds are debt instruments that are issued for periods greater than one year. Those that are
issued for periods of less than one year are known as commercial bills.
Bonds have a face value and coupon rate. The principle is generally repaid at maturity date
while coupons are paid semi-annually at the coupon rate. The coupon rate can be a:

Fixed-coupon
The coupon rate is fixed for the entire term of the bond.
Floating rate
The coupon rate is adjusted according to the market interest rate periodically.
Zero-coupon
There are no coupons paid. However, these are usually sold at discount to the face value of
the bond so that some interest is still made.

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The Valuation of a Firms Securities

The coupon payment is the par value multiplied by the coupon rate (annually). Since it is
usually paid semi-annually, the effective yearly rate is usually slightly higher than what is stated.
Extra Features of a Bond
A bond also includes a trust deed which is a contract between the issuer and holder
detailing everything about the bond such as amount of bonds, covenants (if any), call provisions and
sinking fun provisions.
Call provisions allow the issuer to repurchase bonds at any date prior to maturity. Since the
holder will generally lose out on the remaining coupon payments, issuers will generally pay an
amount higher than the face value to compensate for this. If the call option is deferred, it is not
allowed to be exercised before a certain date.
Bonds can also have a sinking fund provision. A sinking fund provision is where a certain
amount/percent of the bonds principle is also retired (i.e. repaid) each year. While this is less risky
because the principle is repaid along the way until maturity and not all at maturity, the coupon
amounts get smaller and smaller as the principle decreases.
Valuating a Bond
Looking at the structure of a bond, we can see it has two major components:

The face value


The coupon payments

The face value can be discounted back to the present to find its present value. The coupon
payments can be treated as if it were an annuity since we get paid at set periods and at set amounts.
When we discount this annuity and add it to the present value of the face value, we can determine
the bonds current value. By doing this, we can find out how much the bond is worth now.
For a zero-coupon bond, this is made easier as we can eliminate the entire coupon annuity
calculation since there are no coupons to begin with.
Bonds can be classified as:

Par bonds
Discount bonds
Premium bonds

(FV = Bond Value)


(FV > Bond Value)
(FV < Bond Value)

Interest Rate Risk


Fluctuating interest rates are a risk for investors. This risk increases as the time to maturity
increases and the value of coupons decreases. This is the cause of two effects known as:

Reinvestment Effect
The reinvestment effect is concerned with the time to maturity. If you had two identical
bonds but the only difference was that one was a 10 year bond and the other was a 1 year
bond, would it be better to invest in one single 10 year bond now (and thus lock in the

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The Valuation of a Firms Securities

interest rate) or invest in 1 year bonds each year (and thus have a different rate each year).
We must note that the interest rate may rise or decline each year so the 1 year bonds would
be better if they rose, but would not be if they declined. This is a choice and risk that the
investor has to make.
Price Effect
The price effect is concerned about the fact that a bonds value will change in terms of yield
as a result of changed in the interest rate. A rising interest rate means the value of the bond
will drop. This risk is greatly magnified the longer the term of the bond is and the lower the
coupon rate is.

The Term Structure of Interest Rates


The relationship between interest rates and time to maturity is known as the term structure
of interest rates and is graphically represented by the yield curve.
However, this general curve would only be correct if we looked at securities which had no
default risk and if inflation did not exist. To compensate for these, we have the:

Inflation Premium
This is the extra increase in interest rates as a result of future expectations of a rising
inflation. The higher the expectation for an increase, the larger the premium is.
Interest Rate Risk Premium
This is the extra increase in interest rates as a result of default risk. The higher the risk of
defaulting is, the higher the premium must be to compensate for this. Usually this increases
as time to maturity increases as the risk of default increases.
Liquidity Premium
There may also be a premium as a result of cash being locked up in an investment. Usually,
this will increase the longer the time to maturity is as cash is locked up for longer.

Shares
Shares are equity instruments that give the holder ownership rights of the firm in question.
Shares can either be:

Ordinary Shares
Ownership of these gives voting rights and residual claim in event the firm goes bankrupt.
Preference Shares
These do not give voting rights to the owner but they do have preferential rights to any
dividends. The dividend, however, can be omitted.

The market value of a share is how much the market believes that the company is worth.
Dividends are payments that are made to shareholders and can be in the form of either cash or
more shares. The dividend growth rate is the rate at which dividends are expected to increases each
year. In most cases, dividends do not grow at constant rates.
We will eventually find that the price of a share is essentially just the present value of all
expected future dividends from the firm.

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The Valuation of a Firms Securities

Dividend Valuation Models


There are different dividend models based on how dividends are expected to grow. These
are:

Constant Dividend
This is where the firm pays a consistent dividend, such as 10c each year. To calculate the
present value of this, we simply use the perpetuity formula (dividend divided by return rate)
as we see this constant dividend as one without maturity.
Constant Dividend Growth
This assumes that the firm will pay a dividend that grows at a certain amount each year,
such as 1%. To calculate this, we use the formula: PV = Dt+1 / (R - g). Where g is the rate at
which dividends grow.
Inconsistent Dividend Growth
This assumes that dividends will be inconsistent for a few years before it becomes consistent
for the remainder. To calculate this, we simply find the present value of the inconsistent
cash flows and the present value of the constant period afterwards. This means using both
the above models together.

Estimating g, the Growth Rate


Most companies will not disclose information such as dividend growth rate. As such, we
must come with ways of estimating them. One approach is to take the firms:

Earnings per share (EPS)


Dividends per share (DPS)
Return on equity (ROE)

From this, we can see from EPS, exactly how much goes into DPS. The difference between
EPS and DPS is how much the company retains in its coffers as retained profit. We assume that this is
reinvested at the companys ROE which would turn into EPS growth. Adding this EPS growth back
onto EPS and repeating the cycle, we can estimate how much the growth rate of dividends will be.
Simply in a formula:
G = (1 payout ratio) x ROE
The payout ratio is the ratio of funds that are dividends. i.e. A firm that has an EPS of 100c
and has a DPS of 50c, the payout ratio is 50/100 which is .

Business Finance Semester 2 2009

13

Capital Budgeting

Capital Budgeting
Background
Capital budgeting is also known as the investment decision. That is, finding out which
projects the company should undertake. This section introduces a range of tools to use to help
decide which project is the most ideal for a company.
The Capital Budgeting Process
Capital budgeting is important to a business because it is a large initial outlay of capital to
gain long-term benefits. This means that there is a huge potential for failure and thus, a proper
process must be used. It is as follows:
1.
2.
3.
4.
5.

Generate Project Proposals


Screen Projects
Evaluation
Implementation and Control
Post-Implementation Audit
For this course, we mostly focus on the evaluation part of the process.

Types of Projects
Projects can generally be classified into four categories, these being:

Replacement
These projects are done to replace things that are already running in the business, such as
worn out/old machinery, re-training staff etc.
Expansion
These projects are done to expand the business such as going into new markets or
expanding on existing products and markets.
Safety and Environmental
These projects are undertaken to ensure compliance with government regulation. These
projects will not always provide positive cash flows for the firm, but they still must be
undertaken to ensure compliance.
Other
These are other projects that do not fit into the above three. For these, we analyse using the
best techniques for that specific project.

Independent and Mutually Exclusive Projects


Independent projects are projects that, when accepted or rejected, will have absolutely no
impact on any other project under consideration. However, mutually exclusive projects are projects
that, when accepted or rejected, can have impacts on other projects. Most of this is due to resource
limitations and capital rationing. This is because the company does not have enough resources or
budget to do all projects respectively, so taking one project means another must be rejected. Such

Business Finance Semester 2 2009

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Capital Budgeting

as if we only have one piece of land, we cannot run two projects if each must use the entirety of that
piece of land.
Contingent projects are those that are dependent on the acceptance or rejection of another
project. They can be further classed as complementary or substitute projects.
Complementary projects are those where the acceptance of another project would further
increase cash flows in the originally accepted project. If a project is to be undertaken only if another
is accepted, this is known as a purely complementary project.
Substitute projects are the opposite of complementary projects in that accepting one
project would impair on the cash flows of another project.
Evaluation
Evaluation is done by:
1) Forecasting predicted cash flows from the project.
2) Determining the level of risk of cash flows.
3) Applying evaluation methods.
In this course, we generally look at applying evaluation methods and assume the cash flows
predicted and the risk level are appropriate.
Accounting Rate of Return
This method uses accounting book values to find out the return on invested physical capital
such as machinery. To use this method we find the average net profit of the firm (after depreciation
and tax) over the life of the project. We also need to find the average book value of capital (after
depreciation) over the life of the project. We then apply the following formula:
AAR = Average Net Income / Average Invested Capital
The decision to accept or not depends if the projects are independent or mutually exclusive.
The decision rule for independent projects is to accept projects with an AAR which is larger than the
target set by the company. For mutually exclusive projects, the rule is to select the project with the
higher ARR.
The advantage of using ARR is that data can be easily obtained by looking through the
financial statements of the company. It is also very easy to calculate once you have the data and it
also takes into account income over the entire life of the project.
The disadvantage is that accounting numbers are generally not overly reflective of real cash
flows because they are done on an accrual basis. This method also ignores the time value of money
in that it assumes cash flows later are worth the same as cash flows now. The benchmark value is
also very arbitrary as it can be set to any value.

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Capital Budgeting

Payback Rule
The payback rule simply looks at how long it takes for the investment to return the invested
capital back into the company. To use this method, we simply cumulatively add up cash flows from
the beginning until the figure equals or is greater than the initial invested amount. If it breaks even
in the middle of a year, we assume the flow of cash flows is spaced evenly throughout the year so
that we can find exactly when during that year that we will break even.
Example:
We have an initial investment in a project of $100,000. The cash flows in each year
afterwards are $50,000, $30,000, $30,000, $20,000 and $20,000.
Adding these figures slowly, we get $50,000 then $80,000 then $110,000. We can see that
we breach $100,000 somewhere between year 1 and 2. To accurately find when we can divide as
follows:
($100,000 - $80,000) / ($110,000 - $80,000) = $20,000 / $30,000 = 2/3.
This means we break-even at 2/3rds of the way through year 2, meaning the payback period
is 2.67 years.
For independent projects, we accept any project that is below a target maximum payback
period. For mutually exclusive projects, we choose the one with the shortest payback period.
The advantages of the payback method are that it is simple to use, interpret and has a clear
decision rule.
The disadvantages are an arbitrary payback period benchmark since it can be set to
anything with no real reason. It also ignores all cash flows after the payback period is done, so it is
bias towards projects that regain capital back earlier.
Discounted Payback
This method is an extension of the payback method and attempts to eliminate one of its
disadvantages; that it does not take into account the time value of money. This method is exactly
the same as the previous except that we discount all the cash flows before adding them.
It has the same advantages and disadvantages as the payback method except that it no
longer has the disadvantage that it now does take into account the time value of money.
Net Present Value
The Net Present Value (NPV) Method is a method of simply summing up all of a projects
forecasted discounted cash flows.
For independent projects, we accept the project if its NPV is positive. For mutually exclusive
projects, we choose the one with the highest NPV.

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Capital Budgeting

The advantages to NPV are that it has a simple and clear decision rule that is not arbitrary (it
is set and cannot be changed). It can also incorporate risk with a higher discount rate and with this,
takes into account the time value of money. It also takes into account all cash flows generated
throughout the life of the project and correctly ranks projects based on its ability to maximise
shareholder wealth.
The disadvantages are that cash flows are forecasted, so there is a level of risk involved
there. It is also difficult to choose an appropriate discount rate to use. Managers that have no
knowledge of finance also find it hard to grasp the concept of discounting cash flows.
Profitability Index
This method is similar to NPV except that it ranks projects in relative terms. This is so it isnt
biased towards projects with large cash flows. We simply take the NPV and divide it by the initial
outlay to find the profitability index.
For independent projects, we accept if it is higher than 1. For mutually exclusive projects, we
select the one with the highest index.
This is very similar to NPV and usually leads to the same conclusion as if we used NPV.

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Capital Budgeting Applications Part 1

Capital Budgeting Applications Part 1


Background
So far, we have looked at a few tools we can use to evaluate projects. In this section, we
introduce another two. These are the Internal Rate of Return (IRR) and the Modified Internal Rate of
Return (MIRR).
The Internal Rate of Return
The Internal Rate of Return (IRR) is closely related to the NPV in that the IRR is the discount
rate which, when used to find the NPV of a project, would cause the NPV to equal zero. That is, it is
the projects expected rate of return.
The decision rule for IRR is to accept if the IRR is larger than the hurdle rate (the required
rate of return on the project) for independent projects. This is for an investment project only. For a
financing project, we would need to reverse this decision rule so that we accept the project if the IRR
is lower than the hurdle rate. For mutually exclusive projects, we simply take the project with the
highest IRR.
The formula for calculating IRR is exactly the same as NPV. All we do is set NPV to equal zero.
The equation can only be solved by either using a financial calculator, a spreadsheet or by trial and
error.
The advantage to IRR is that it is very closely related to NPV, normally leading to identical
conclusions. The added bonus is that an interest rate is very intuitive to any manager, unlike NPV.
The disadvantage of IRR is that its hard to find by hand. However, with the advent of
computers, this disadvantage has disappeared in almost all situations. The more pressing problem is
that it assumes interest rates will stay fixed and that cash flows returned back at the beginning of
the project can be reinvested somewhere else at the same rate, which in some cases, is ridiculous to
even contemplate. Sometimes, you can also end up with two IRRs which confuse people.
Multiple Internal Rates of Return
Multiple IRRs result from projects that have both positive and negative future cash flows.
These are considered non-conventional because conventional projects have an initial negative cash
flow followed by a series of positive inflows.
The best way to go about solving this issue is to plot an IRR diagram. By plotting this diagram,
we will be able to see regions where the IRR is positive. Only in these regions should we accept the
project. In all other cases, we should reject the project.
However, in such cases with non-conventional cash flows, we should simply revert to using
NPV as it provides a more reliable result compared to IRR in such a situation.

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Capital Budgeting Applications Part 1

Comparing IRR and NPV


The NPV of a project at different discount rates can be graphed. When graphed, the value at
which the NPV curve reaches zero NPV is the point where the projects IRR is.

The Crossover rate is the discount rate at which both Project A and Project Bs NPVs are
equal. In the case of mutually exclusive projects, we would take Project B at any discount rate under
the crossover rate and we would take Project A for any discount rate above the crossover rate.
In this situation, if you computed the IRR to find the project with the highest IRR, you would
find that Project A has the higher IRR. However, if you were undertaking this project at a rate which
is lower than the crossover rate, you would be undertaking the wrong project because at rates lower
than the crossover rate, Project B prevails. Thus, it is better to calculate NPV in these situations at
your desired rate of return to confirm your IRR result.
IRR and the Scale and Time Problems
With mutually exclusive projects, the IRR can usually lead to incorrect results and is usually
skewed towards projects on a lower scale and projects that recoup most of their cash flows in early
periods.
To rectify this problem, we need to find the incremental cash flows and then, find the
incremental cash flows NPV and IRR. This means we take the cash flows of the larger project and
deduct the cash flows of the smaller project.
By doing this, if we find that the NPV and IRR are positive for the incremental cash flows, we
should accept the project if it is a scaling problem. We would find that the IRR of the incremental
cash flows is actually the crossover rate of both projects. In this case, we follow our previous rule
and accept the better project based on whether it is above or below the crossover rate.

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Capital Budgeting Applications Part 1

The Modified Internal Rate of Return


The Modified Internal Rate of Return (MIRR) is similar to the IRR except that it assumes that
cash flows are not reinvested at the IRR rate but instead, at normal discount rates. The MIRR will
also not generate more than one result.
The MIRR works by finding the discount rate at which the present value of a projects costs
equals the present value of the projects terminal value. As such, we can deduce that the formula is:


=
1

Here, TV is the terminal value which means the future value of all cash inflows of the project.
The decision rule is to accept the project if the MIRR is larger than the hurdle rate for
independent projects and to choose the project with the highest MIRR with mutually exclusive
projects.
The advantages to MIRR are that is it similar to IRR but does not generate multiple rates in
the event of non-conventional cash flows. It also assumes that the cash flows are reinvested at the
discount rate, not the IRR rate.
The disadvantage of MIRR is that the calculation is more complicated than other capital
budgeting evaluation tools. It also does not account for different project life spans. When comparing
projects, to ensure that the period is the same, the project with the smaller life span has its missing
years filled with cash flows of zero to compensate.
Forecasting Cash Flows
The majority of capital budgeting evaluation tools require cash flow forecasting. The only
one that does not require this is the AAR. This means that forecasting cash flows is a very large part
of evaluation and is also very crucial to the evaluation as it relies on these forecasted cash flows.
In reality, forecasting cash flows is not as easy as it sounds as there are many factors that
must be taken into account.
When looking at cash flows, we only consider:

Free cash flows


Incremental cash flows only
The timing of cash flows
Inflation
Tax

Free Cash Flow


Free cash flow is the actual cash flow from a project that is available for distribution to other
parties (such as shareholders, debtholders etc.) after all necessary expenses have been deducted
from it. This differs from accounting cash flows as it is not based on the accrual system.

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Capital Budgeting Applications Part 1

Free cash flow can be determined by:


EBIT + Depreciation Taxes Capital Expenditures Change in net operating working capital
In here, we:

Include the cost of fixed assets


Include non-cash expenses
These provide a tax shield and should be included.
Includes changes in net operating working capital
Found by taking current assets and deducting current liabilities from it.
Ignore financing expenses
The cost of financing is already accounted for in the cost of capital and does not need to be
counted again.

Incremental Cash Flows


Incremental cash flows are cash flows that result from undertaking a project. A relevant
cash flow is one that only results when a project is accepted. All other cash flows are irrelevant and
should be discarded. To this end, we:

Include opportunity costs


These are costs that result from undertaking the project. The assets dedicated to this project
could have otherwise been used on other projects.
Ignore sunk costs
Sunk costs are unavoidable and should be ignored. They will be incurred or have been
incurred regardless of whether the project has been accepted or rejected.
Consider side effects
We need to consider side effects of taking a project. Such as introducing a new product may
degrade the sales of an existing product the company already sells. Such side effects need to
be included.
Need to be aware of allocated overhead costs

Timing of Cash Flows


It is important to note the timing of cash flows so that they can be properly discounted. If we
do not, then we are basically ignoring the time value of money and would skew the result of
evaluation.
Inflation
Inflation is the general downward trend of the purchasing power of money. To account for
inflation, we must discount actual or nominal cash flows using the nominal rate of return. The Fisher
effect can be used to convert nominal rates to real interest rates and vice-versa. The equation is:
(1+rn) = (1+rr)(1+p)
rn is the nominal rate, rr is the real rate and p is the inflation rate.

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Capital Budgeting Applications Part 1

Tax
Tax is an outflow of cash and needs to be deducted from operating cash flows to find a
firms free cash flows. Three taxes which are relevant to us are:

Goods and Services Tax (GST) Usually 10%


Corporate Income Tax Usually 30%
Capital Gains Tax Varies

GST can generally be disregarded as firms gain GST from selling their products which they
then give to the government. The only exception is in the finance industry as GST cannot be levied
on financial products. Thus, financial firms need to include a GST component in cash payments for
external transactions.
Corporate Income Tax is paid on assessable income (income minus any deductions).
Depreciation, although it is a non-cash expense, must be taken into account as they provide a tax
shield for the company. As always, after-tax cash flows should be discounted at the required rate of
return. For consistency, we should apply the same rate of return for tax and cash flows.
Note that we also get a tax shield or a liability when we sell assets at any price other than its
carrying value.
Capital Gains Tax is paid on any changes in the real value of an asset when it is sold. A real
increase only occurs if the value of the asset rises more than inflation. We treat this as a normal cash
outflow.

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Capital Budgeting Applications Part 2

Capital Budgeting Applications Part 2


Background
The previous sections looked at different tools we can use to evaluate projects. In this
section, we look at more minute details dealing with cash flows.
Forecasting Cash Flows
The cash flows that are forecasted by a company are usually split into three broad categories.
These are:

Initial Investment Outlay


These are cash flows that occur at time zero.
Operating Cash Flows & Net Working Capital
These are cash flows that occur between time zero and the end of the project.
Terminal Cash Flows
These are cash flows that occur at the end of the project such as selling off assets the project
used etc.

By taking into account these three types of cash flows, we can work out net annual cash
flows to use in calculations such as with NPV analysis.
Evaluating a Project with Forecasted Cash Flow
When we look at forecasted cash flows, our first step is usually to sort out what costs are
what. Any assets we buy at the beginning of the project are generally initial investment outlays etc.
Our first step in the entire analysis is thus, to work out the initial outlay. Most importantly,
remember to take into account the required net working capital in year zero as well.
The next step is to work out the operating cash flows and net working capital required
throughout the life of the project. Remember to take into account depreciation and any other
requirements the business has.
The final step is to work out the terminal cash flows. These cash flows are those that result
at the very end of the project such as when we sell off assets used in the project and that we no
longer have a need for. When selling off assets, remember to also calculate the tax saving or liability
that may result when we sell the asset at a different price to its book value. It can also include any
net working capital that was unused.
We can then use these forecasted, and grouped, cash flows in evaluating projects and thus,
select the best project to undertake.
Projects with Unequal Lives
When we have two projects with unequal lives, we cannot compare them properly as the
evaluation results will be skewed. To fix this issue, we can look at two different methods.

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Capital Budgeting Applications Part 2

The two methods are:

The Equivalent Horizon Approach


With this approach, we assume that we can start the project again with the same
resources/cash flows after it has ended. As such, we can stack these projects end on end
until they both have a common life span. For example: If we had a project with a 3 year life
and a 4 year life, we would expand this out so that the lifetime is 12 years by doing the 3 year
project 4 times and the 4 year project 3 times.
The Equivalent Annuity Approach
In this method, we take the cash flows of the entire project and split them out evenly over
the lifespan of the project. In this way, we can see how much of a return the project gets in
each period (we compare each period now). In this approach, we would select the one with
the higher approach.

Qualitative Factors
One should not only look at quantitative factors that we get from our analysis. There are
qualitative factors that may cause a company to take a project with a lower return such as:

Environmental issues
Government Legislation
Social Consequences
Staff
Corporate Image

Other than this, a firm should also investigate where it gets its positive NPV. It may be
because the firm has a comparative (or competitive) advantage in the market or because the firm
made an error in forecasting cash flows. In any case, a positive NPV should always be double
checked to ensure its authenticity.
A firm should see if such comparative advantages in the market are sustainable in the future
if it impacts on the project. When does the patent run out? When will competitors react? We have
to ask such questions when considering how much cash flow our comparative advantage can give.
To avoid errors in forecasting cash flows, we should use risk analysis and real options
analysis.
Project Risk Analysis
The more risky a project is, the more uncertain the cash flows that the project generates is.
Risk can thus, be incorporated into a project by using a higher discount rate that has been adjusted
to include risk.
Another method is to apply techniques to analyse the sensitivity of the projects NPV to
changes in assumptions in the project (such as assumptions in inflation, taxes etc.) The three
techniques that can be used to do this are the sensitivity analysis, scenario analysis and the
simulation analysis.

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Capital Budgeting Applications Part 2

The sensitivity analysis measures the impact that the change of one variable has on NPV.
This is done by simply recalculating NPV after changing one variable. However, this technique is
often limited because most underlying variables in NPV analysis are interrelated with each other.
The scenario analysis is similar to the sensitivity analysis except that it alters more than one
variable at a time. We usually do three different scenarios which are the worst case, base case and
best case. This gives an idea of the overall risk of the project.
The simulation analysis is normally done by a computer. The computer selects random
variables and randomly changes them based on assumptions given. This process is repeated many
times and the NPV is calculated each time. From these calculated NPVs, we can find their statistical
means, standard deviation and also the probability of getting a negative NPV.
Note that we should not incorporate risk into the discount rate while doing these analyses.
This is because the whole point of it is to find risk, and if it is already incorporated into it, we are
effectively double counting risk.
Real Options Analysis
NPV analysis does not take into account that managers of a company can change the project
based on the fact if a project is going well or not. Managers could expand the project further if its
doing well or just scrap the entire project if it is failing. A firm could also wait to start a project
instead of starting it right away if there is any reason where waiting would be better than starting
immediately.
These real options can be put onto a tree diagram and be used to physically view different
situations. The probability of each outcome is used in the NPV calculation so that the NPV takes into
account the risk of that particular circumstance occurring. The expected NPV is simply the NPV
generated through that circumstance multiplied by the probability rate.

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25

Risk and Return

Risk and Return


Background
Risk is tied to return in that the larger the amount of risk, the higher the required return is.
In this section, we look at the relationships between risk and return.
Returns on Investment
A return on investment is the profit that is expected to be made when an investment is
made. The return on investment can be measured by:

Dollar Returns
The dollar return is simply the profit made on the investment. That is, we find the amount
received from the investment and deduct the amount invested. Usually when we use this
method, we need to also look at the scale and the length of the project.
Rate of Return
The rate of return is found by simply taking the dollar return and dividing it by the amount
invested. This expresses the dollar return as a percentage which can help us since we do not
need to worry about the scale of the project as much.

Risk and Return


As mentioned, risk and return are related in that the return on investment must be sufficient
enough that the investor is willing to take the risk associated with the investment.
Risk is defined as the probability that actual results will differ from expected results. Risk is
usually measured by using probability. This is usually done by making a payoff matrix. It allows us to
calculate the expected rate of return.
To find the expected rate of return, we simply multiply the estimated rate of return in that
scenario with its probability. We repeat this with all other scenarios and then add them up to get the
expected rate of return.
Example:
Company A wants to invest in Company B. It has done some research and reached the
following conclusion:

There is a 20% chance of a recession occurring and the rate of return would be 3%.
There is a 50% chance of the economy staying the same and the rate of return would be 12%.
There is a 30% chance of a boom occurring and the rate of return would be 20%.
The expected rate of return would thus be:
(0.2)(0.3) + (0.5)(0.12) + (0.3)(0.2) = 0.18
This means the company should expect an 18% p.a. return on investment from Company B.

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Risk and Return

Risks
Standalone risk can be measured by using the standard deviation. The standard deviation
tells us how far a distribution of values moved from its expected value (average). To find the
standard deviation, we need to know the expected value and the other values in the distribution.
The standard deviation itself is just the square root of the variance. Thus, to find variance,
we:

Take the expected value and minus from it a value, square the result and multiply it by the
associated probability if there is any.
Repeat the above step for all other values.
Sum all the values together.
To get the standard deviation, simply square root the result from the above steps.

The larger the standard deviation is, the more risky an investment is because it is a measure
of how varied the returns can be. Remember that risk is the chance that the actual differs from the
expected. Thus the larger the variation is, the larger the risk.
If, by chance, the standard variations of two projects are the same, we can calculate the
coefficient of variation to help decide between the two. The coefficient of variation is calculated by
taking the standard deviation and dividing it by the expected return of that project.
The lower the coefficient of variation, the lower the risk is.
Realised Return
The realised rate of return is how much the investment actually makes. This will always be
different from the expected rate of return unless you have invested in risk free assets.
We can use historical realised rates of return to predict future expected rates of return. We
do this by finding the standard deviation like we did before but instead, we base this on the previous
realised rates of return.
However, after summing all the values together as we do in finding the standard deviation,
we need to also divide the summed value by the number of observations minus one before we
square root it. That is, if we have 5 values, we divide the summed values by 4 instead.
Portfolio Returns
Usually, an investor holds more than one stock. This means the portfolios expected return
will be different from each stock. To find this, we must first find the weight each stock has on the
portfolio. This is found by dividing the value of the stock by the total value of the portfolio. We then
multiply this by the expected return of that stock. Repeat this step for all other stocks and sum them
together to get the portfolio return.
The portfolios standard deviation is:
+ + 2
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Risk and Return

Risk Aversion
Some investors do not like taking on a lot of risk. These investors are known as risk adverse
investors. Risk adverse investors will not take on risky investments unless there is a higher expected
return. This is known as the risk premium; the extra amount of return required because the
investment is risky.
More formally, the risk premium is known as the extra return required over the risk-free
rate of return.
Correlation between Stocks
The level of correlation between two stocks can be found by finding the covariance with the
following formula:
Covariance = 12 1 2
Where 12 is the correlation between the two stocks. Rearranging this formula, we find that
the correlation is equal to the covariance divided by the standard deviations of both stocks.
To find the correlation, we find:

The return on investment of one security during the same time interval.
Deduct the mean return on investment of that security.
Repeat the above two steps with the other security and multiply the two results.
Repeat the above three steps with all the other time intervals.
Sum all the results and divide by the number of observations minus one.

The result we get is the covariance. The covariance measures the amount of association
between the two stocks. That is, how similar they are.
The covariance result we get is always between -1 and 1. A positive result means that both
stocks will move in the same direction while a negative result means the stocks will move in opposite
directions.
In reality, most stocks are positively correlated.
Diversifiable Risk and Market Risk
Risk can be divided into two major components, these being:

Diversifiable Risk
This is risk that can be diversified away by investing in many stocks. Generally, these are risks
of each individual investment.
Market Risk
This is risk that cannot be diversified away as it affects in entire market. This can be risk such
as the state of the economy and the price of oil.

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The Capital Asset Pricing Model

The Capital Asset Pricing Model


Background
The Capital Asset Pricing Model (CAPM) is an extension to better understand risk. It
theorises the relationship between market risk and the expected return on an investment.
The Systematic Risk Principle
The systematic risk principle states that because unsystematic risk (diversifiable risk) can be
diversified away, a well diversified portfolio will have only systematic risk (market risk).
Thus, the expected return on an investment only depends on that assets market risk. This
means that an investor will only be rewarded for taking investments with diversification. The
investor will not be rewarded for taking on firm-specific risk since it can be diversified away.
Risk Premium and Risk
In general, a well diversified investor will only expect a risk premium to be available for
systematic risks. There would be no risk premium for unsystematic risk as it can be diversified away
instead.
Systematic risk is generally less than unsystematic risk and, as a result, the risk premium for
systematic risk is generally lower. The diversified investor usually has to accept a lower return.
Beta
Beta is the measure of systematic risk. It shows the correlation between movements in the
market and movements in the stock. A beta of:

1 means that the stock will move exactly the same as the market does.
Above 1 means the stock will move more than the market does.
Less than 1 means the stock will move less than the market does.

The average stock has a beta of 1. This is because the stock market indices are a formulated
using all or selected stocks in the market. Beta can be calculated by taking the standalone risk,
dividing it by the risk of the market and then multiplying by the correlation coefficient.
The beta of a portfolio is simply the weighted average of all the betas of the stocks in that
portfolio.
The Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a theory that tries to explain the relationship
between beta and the expected return on an asset. This is mostly done by using the Security Market
Line (SML) which is a graphical representation of the CAPM. This is a line on a graph that depicts the
level of risk premium for an asset can be estimated by taking the stocks beta and multiplying it by
the market risk premium.

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The Capital Asset Pricing Model

The Security Market Line


The Security Market Line (SML) as mentioned above, states that the level of risk premium
for an asset can be estimated by taking the stocks beta and multiplying it by the risk premium.
Mathematically:
k = kRF + x RPM
Where: k is the required return on the asset, kRF is the risk free asset, is the beta for the
asset and RPM is the market risk premium.
A companys position on the line is thus, vulnerable to being changed based on the above
factors such as change in the companys beta and changes in risk aversion. The companys beta can
be changed by changing their capital structure or through changes in industry and competition.
However, we must note that inflation and interest rates also play a role in shaping a companys
position on the SML.
Inflation and the Security Market Line
As mentioned above, inflation
impacts on the SML. Inflation decreases
purchasing power and therefore, causes an
increase in the risk-free rate. An increase in
the risk-free rate means that there will also
be an increase in the rate of return.
Simply, the line shifts upwards on
the SML diagram (from the green line to the
red line). The line shifts upward by the
expected level of inflation.
Risk Aversion and the Security Market Line
When the level of risk aversion
increases, the slope of the SML becomes
steeper. This is because as people become
more risk adverse, they will require a higher
rate of return the more risky the asset is.
On the SML diagram, the curve
simply becomes steeper (from the green
line to the red line). The risk free rate level
stays the same however.
Capital Asset Pricing Model Uses
The CAPM allows us to easily:

Benchmark portfolio performance

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The Capital Asset Pricing Model

Identify under or overvalued assets


Estimate the cost of capital which can then be used in other analysis (such as NPV)
However good the CAPM is though, it has its disadvantages:

Heavy reliance on estimation from historical figures for inputs.


Beta estimation issues. The beta may not always be constant and stable.
It is a model that looks into the future using past data.

The CAPM also assumes that there is a positive relationship between returns and beta and
that beta is the only thing that explains returns. In reality, there could be a variety of other factors
that could influence the expected return on an asset.

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31

Cost of Capital and Raising Capital

Cost of Capital and Raising Capital


Background
Previously, we have looked at ways of spending capital and how to most efficiently do so. In
this section, we look at the cost of capital of an asset and raising the necessary capital to fund it.
Cost of Capital
The cost of capital is the amount of capital that the entity has to spend to invest in an asset.
Contrary to popular belief, the cost of capital is dependent on how the capital is going to be used. It
does not depend on where we get the capital from.
Capital can be gained from:

Equity
Hybrids
Debt

Estimating the Cost of Capital


The cost of capital can be estimated by using the weighted average cost of capital (WACC).
This is the weighted average of the rate of returns required by investors who have invested in the
securities that the firm has issued. The WACC formula is as follows:
=

+
+

Where: RE is the cost of equity, RD is the cost of debt, E is the market value of equity
financing and D is the value of debt financing.
Example:
If a firm has $2,000 of equity which costs 10% per year and $5,000 of debt which costs 8%
per year, the firms WACC would be:
= 0.08

5,000
2,000
+ 0.1
= .
2,000 + 5,000
2,000 + 5,000

This means that the average cost of capital is 8.57% p.a.


The Cost of Debt
The cost of debt is the rate of return which is required by the firms creditors. Note that this
is not necessarily the prevailing interest rate as debt securities can be issued at a discount which
affects the rate of return. This can be found by:

Finding the Yield-to-Maturity on outstanding bonds


Finding bond yield and then adding risk premium

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Cost of Capital and Raising Capital

Looking at financial statements

The first method of finding the cost of debt is more preferable to the other two methods if it
is feasible. The financial statements are only moderately accurate because they use past data.
Estimating the Yield-to-Maturity on Outstanding Bonds
This method is found by simply utilising our bond formula that we learnt previously. Recall:
1 1 +
=
+ 1 +

The cost of debt here is actually the discount rate used (r). So by determining r, we can
estimate the yield-to-maturity on outstanding bonds. However, the value of the bond can be hard to
determine as corporate bonds are not usually frequently traded amongst investors.
Estimating Bond Yield and Adding Risk Premium
This method is very simply in that it finds the risk-free bond yield by simply looking at
government bonds with the same maturity. These are concluded to be risk-free as the government
can never default. We then add a few percentage points based on the firm to allow for a risk
premium. This level depends on how risky the firm is. It is only really useful for large corporations
who have very stable debt levels.
Estimating by looking at the Financial Statements
This method is done by finding the net interest (interest paid minus any interest received)
and dividing it by the carrying value of all debt in the financial statements minus any cash.
Note that this approach assumes that the debt we hold is at market value and that we
would be holding it forever (i.e. perpetuity). Thus it will be skewed if the debt we hold is not at the
current market value.
The Cost of Equity
The cost of equity is the minimum rate of return required by the firms owners. This can be
found by using either the dividend growth model or the CAPM.
Estimating with the Dividend Growth Model
Since we can easily find the market price of a firms shares on the share market, we can
simply use the following formula to find the discount rate.
=

Where D1 is the dividend in the first year, P0 is the current price of the shares and g is the
dividend growth rate. The dividend growth rate is estimated by using historical growth rates and/or
analytical forecasts.

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Cost of Capital and Raising Capital

This analysis is easy; however, not all companies always pay out dividends. To date,
Microsoft has not paid a single dividend in the entire entitys life. Many companies also never pay
dividends. Even if a company does pay dividends, it may not always be constant or constantly
growing which further serves to weaken this method. It is also very sensitive to the growth rate and
it does not adjust for risk.
Estimating with the CAPM
To estimate with the CAPM, we use the following formula:
= + [ ]
Where E(RE) is the required return on equity, RF is the risk-free rate, E is the equity beta and
E(RE-RF) is the required return on the market above the risk-free rate.
Its strength lies in the fact that it can adjust for risk and applies to all stocks since it does not
need to use dividends as a measurement. Its weakness is that it uses historical data and the beta
estimates may be incorrect.
Estimating the Risk Premium
While we have estimated the cost of equity or capital, we also need to estimate the risk
premium. This can be found by looking at:

Historical values for returns on the stock market. This assumes that realised returns will
equal expected returns and is thus, not very reliable in times of economic instability.
Current stock prices and forecasts. This is done by using a formula which is very similar to
the dividend growth model:

=
+

Where: r is the equity cost of capital, D1 is the forecasted dividend next year, P0 is the
current price of the stock and g is the expected growth rate of the stock.
Note that this method assumes that the forecasts are accurate. If not, they will lead to
deviations.

Issuing New Shares


Instead of digging into the firms retained earnings (its equity stash), the firm can issue new
shares. This is preferable when equity funding is required but there are not enough retained
earnings.
Issuing new shares can either be done using:

Initial Public Offerings (IPOs)


Seasoned Equity Offerings (SEOs)
Rights Issues
Private Placements

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Cost of Capital and Raising Capital

Each of these is aimed at different shareholders but all of them have the same goal, to raise
equity by issuing shares.
Issuing shares, however, is a very complicated procedure and a lot of the equity raised is
actually used to cover the costs of the complicated procedure. An investment bank is usually hired to
do the work for the company wanting to issue new shares. These costs need to be taken into
account and usually include:

Management fees
Administrative fees
Portions of management salaries
Underpricing
Underwriting fees (if applicable)

The formula used here is the same as the constant dividend growth model except that the
price per share also includes flotation costs (i.e. 1-F where F is the flotation cost in terms of a
percentage).
The Consistency Principle
Inflation and taxes should be treated consistently. This means nominal cash flows should
always equal the nominal rate while real cash flows should also equal the real rate. The same tax
bracket should be applied to every aspect to ensure that it is consistent.
Taxes
Taxes impact on almost every aspect of finance. Under the classical tax system, taxes are
paid on all aspects on income. This means the shareholder is taxed on the dividend itself and taxed
again as it is a part of personal income. Effectively, this means dividends are double taxed.
However, under an imputation tax system, any tax the firm has made on behalf of the
shareholder can be used by the shareholder as franking credits. This means the shareholder only has
to pay the difference and not the entire tax sum. It effectively eliminates double taxation.
Incorporating Tax into the Weighted Average Cost of Capital
How we incorporate tax into the WACC is entirely dependent on whether we are using a
classical system or an imputation system.
Under a classical system the appropriate before-tax WACC is:
=

[ + ]
[1 ]
[ + ]

Where: TC is the corporate tax rate of the firm.


If we want to find the after-tax WACC, we simply multiply through by 1-TC. You can simply
memorise the above formula and multiply it through by 1-TC to save memorising the following:

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Cost of Capital and Raising Capital

= [1 ]
+

[ + ]
[ + ]
Under an imputation system, the appropriate before-tax WACC is:
=


[ + ]
1 [1 ]
[ + ]

Where: is the franking credits the shareholders use.

The after-tax WACC is the same except that we multiply through by (1-T*C). This is the
effective tax rate after interest to yield corporate tax is paid.
Capital Budgeting with the Weighted Average Cost of Capital
The WACC itself is a measure of the average cost of capital for the firm as a whole. Therefore,
when we use the WACC in new investments, we assume that this new investment is similar to what
the firm has and is currently undertaking; most importantly, in terms of risk. The WACC can only be
used for projects that have the same typical beta that other projects in the firm have, otherwise it is
unusable.
Thus, instead of using the WACC, we use the Project Cost of Capital instead. This is first
done by looking at project risk.
Project Risk
Project risk can be defined in three ways:

Standalone Risk
This is the risk of the project in isolation. It is not affected in anyway by any of the firms
other undertakings. This risk will usually not alter the firms beta coefficient.
Corporate Risk
This is the risk that the project has to the firm itself. It is possible that this investment
actually lowers risk due to diversification.
Market Risk
This is the risk to a well diversified investor in the market. This is measured by seeing how
much of an impact the project will have on the firms beta coefficient. It is, however, the
most difficult to estimate.
After we have evaluated the projects risk level, we can use one of two methods.

Subjective Approach
This is where risk is split into levels (such as high, medium, low etc.) and an appropriate predetermined discount rate is applied to it. While this method may not be very accurate, it is very
quick to determine.

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Cost of Capital and Raising Capital

Security Market Line Approach


This method takes the SML equation and states that the required rate of return on the
project is equal to:
+ +
Where Rf is the risk free rate, RM is the market return and A is the projects beta. The
problem here lies in how to find the projects beta. We can find it by either using the Pure Play
Method or the Accounting Beta Method.
The Pure Play Method
This method is done by simply looking at other companies that are very similar to the firm in
question. We then estimate the equity betas of those companies and find the average beta. We can
then use this beta in the above formula to find the projects cost of capital.
This method is very useful if the project is not similar to other projects the firm is
undertaking but is only really useful for large projects. Suitable firms to compare to may also be hard
to find.
The Accounting Beta Method
In this method, the beta is estimated by regressing the firms accounting return against a
large number of other firms.

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Capital Structure

Capital Structure
Background
The capital structure of a company is the proportion of debt, equity and hybrids used to
comprise the firms financing on investments. Every firm has their own optimal capital structure
and a targeted capital structure by management. Note that the targeted capital structure does not
necessarily have to be the optimal one.
Questions
When looking at a firms optimal capital structure, we have to ask ourselves many questions
including:

How much should the firm borrow?


How much should it raise through shares?
How much equity should be raised internally or externally?
Should the firm seek loans directly from investors or through intermediaries?
Should the firm underwrite a share issue?
These questions can be answered by looking at some capital structure theories.

The Financial Leverage Effect


The financial leverage effect basically states that as companies increasingly finance assets
with debt, shareholders face greater levels of financial risk. Financial risk is the risk associated with
financing and financing with debt carries higher risk than financing with equity. We will discuss this
in the theories to follow.
The Modigliani and Miller Theory (M&M Theory)
The Modigliani and Miller Theory is split into two. One is where there is a perfect capital
market and the other is where there is an imperfect capital market. It assumes that:

There are no taxes or transaction costs


Information is freely available
There are no bankruptcy costs
Firms all have the same business risk but different gearing ratios
Fixed investment policies
All cash flows and projects are perpetual.
There are no capital constraints (unlimited borrowing/lending at same rate for everyone)
No agency conflicts
No asymmetric information (i.e. no signals)

The theory proposes that, the firm is valued based on its expected earnings applied at a risk
level of an all equity firm. The use of homemade leverage proves this idea because an investor can
always change their leverage on a personal level to lower risk.

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Capital Structure

Another proposition the theory makes is that the WACC is independent of the firms capital
structure. This means no matter how much or little debt the company has, WACC will not change.
Thus our formula is very simple. The value of a leveraged (VL) and unleveraged (VU) firm is
the same.
=
M&M Theory with Taxes
We now relax the assumption that there is no tax. The M&M theory thus proposes that firm
value increases as debt increases because debt provides a tax shield. Interest is tax deductible and as
such, reduces the amount of tax the firm pays compared with equity financing. The present value of
the tax shield is the amount of debt multiplied by the corporate tax rate. This is true because we
assume that all cash flows are perpetual (as stated above).
With tax, the expected return on equity will increase as more debt is added to the firm.
However, the rate of increase is lowered due to the presence of tax.
In this theory, the optimal capital structure is one that has 100% debt. This is because the
more debt there is, the larger the tax shield is. Note that this theory uses a classical tax system. If the
imputation system is applied, the advantage is lessened.
Thus our formula now incorporates the tax shield from debt denoted by TCD.
= +
Static (Trade-Off) Theory
The Static (Trade-Off) Theory follows on from M&M Theory with taxes except that it now
relaxes another assumption, that there are no bankruptcy costs. The reason why a 100% debt firm
was the most optimal before was because there were no bankruptcy costs.
As the firms level of debt rises, bankruptcy costs increase as risk increases. Bankruptcy costs
are costs that arise from financial distress within the firm. There could be loan covenants placed on
the firm which will not allow anymore debt as lenders could see the firm as highly risky. As such,
managers will tend to not have too much debt as it could detrimentally affect the business.
The optimal structure here is one that balances the tax shield benefit from debt and
bankruptcy costs. This means the firm should try to keep debt at a level where for each extra dollar
of debt, tax shield savings equals bankruptcy costs. It should not increase debt to a point where for
each extra dollar of debt, bankruptcy costs are greater than tax shield savings it generates.
Thus our formula now incorporates the present value of bankruptcy costs as denoted by
PVBC.
= +

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Capital Structure

Free Cash Flow Theory


The Free Cash Flow Theory, yet again, relaxes another assumption. This time, we assume
there are agency costs. Agency costs exist because managers and shareholders have a conflict of
interest. A well diversified investor usually only has a very small part of their portfolio in the firm
while managers have their entire portfolios at stake on the firm. As such, managers may be too riskaverse or, on the contrast, may over invest.
Debt financing reduces the agency costs associated with equity. This is because shareholders
like debt more than equity. However, debt financing increases the agency costs associated with debt
holders. This is because the cost of acquiring and maintaining debt increases.
Thus our formula now becomes:
= + +
Signalling Theory
The Signalling Theory drops another assumption. Different people know different things and
thus, there is information asymmetry; unlike M&M theory where information is freely available.
In reality, management obviously knows more information than any investor on the market.
There is information that they would also not tell anyone else such as possible new plans and trade
secrets. Anyone that does trade on this knowledge is an insider trader and is subject to prosecution.
As such, investors in the market look for signals when management acquires new debt or
equity. When debt is acquired, it gives a positive signal that the firm is confident about its future
prospects. This is because to acquire debt, a firm knows it can finance that debt and repay it within
that period of time.
If a firm issues equity, it signals that the firm is taking advantage of overpriced equity to
benefit existing shareholders. This is because equity is more sensitive to mispricing than debt is. It
also signals to investors that the firm is not confident enough to raise debt finance and thus, possibly
has bad prospects.
With such possible signals, management always need to consider what signal they would be
sending to the market by raising either debt or equity. It has been shown that this is a great
influence on the type of finance that managers raise.
Pecking Order Theory
Pecking Order Theory notes that managers are far more inclined to use internal financing
before looking at external financing. This is because internal financing does not send out any bad
signals to investors. As such, the theory establishes an implied order of most preferred to least
preferred methods of financing.
1. Internal Funds (Retained Earnings, cash and marketable securities)
2. Issue Debt
3. Issue Hybrids

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Capital Structure

4. Issue Equity
Capital Structure Theories and Reality
In reality, there is no one theory that can specify what the optimal capital structure for a
firm should be. Looking at real data, we see that different firms in different countries and industries
can have completely no debt at all to almost completely debt financed.
Thus, each firm should look at its own business risk levels, asset characteristics, industry, tax
position, financial performance etc. to find its optimal capital structure. This being said, surveys
indicate that most firms have either no capital structure target or have a very flexible one indicating
that most firms simply take what is appropriate when required.
Most firms also take less debt on so that they have financial flexibility. This means that when
they really require debt, they have the capacity to take on that debt instead of increasing financial
risk to a point where bankruptcy is more probable.

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Dividend Policy

Dividend Policy
Background
Dividends are the payments a firm makes to its investors from retained earnings. A firm has
choices into how much and what type of dividends they should deliver or if they should even deliver
dividends at all.
Cash Dividends
Cash dividends are pretty self explanatory; the company gives out cash to shareholders.
There are four different types of cash dividends; these being:

Regular
Payments the firm regularly makes at set intervals.
Extra
Additional payments that may be repeated.
Special
Additional payments that will not be repeated.
Liquidating
Payments as a result of the firm liquidating.

Dividends are first declared by the company and from that day, shares trade with the
dividend entitlement (cum-dividend) until four days before the record date. This is because share
trades are settled 3 days after the trade on the ASX so four days is the required time. Four days
before the record date, shares sell ex-dividend (with no dividend entitlement). The ex-dividend price
of the share is expected to be the cum-dividend price minus the dividend per share.
Dividend Irrelevance Theory
The Dividend Irrelevance Theory was developed by Modigliani and Miller (the same people
who proposed the M&M theory in Capital Structure). It states that dividends are irrelevant because
firm value is defined by its earning power and business risk, not its dividends.
As with before, this theory comes loaded with assumptions:

Perfect capital markets


No tax
No transaction costs
Information is widely and freely available
Investors are price takers and rational
Investors all have the same wants and needs
Investment decisions are not affected by dividend decisions
No agency costs

This theory also states that shareholders are indifferent to dividend policy because they can
use a homemade dividend policy by reinvesting dividends that have been paid out or selling shares

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Dividend Policy

off. Thus, an investor will not want to pay more for a share with high dividends than one with low
dividends.
The Tax Preference Theory
Generally, the assumptions made in the dividend irrelevancy theory are wild in that there is
no way it is possible to assume in reality. The real world has taxes, uncertainties, asymmetrical
information, transaction costs and agency costs just to name a few.
The tax preference theory states that investors are more inclined towards capital growth
instead of dividends. This is because dividends are taxed twice under a classical tax system while
taxes associated with capital gains can be deferred until the shareholder sells their shares. Under an
imputation tax system, this also holds but it applies less because there is less tax on dividends.
The Bird-in-the-Hand Theory
The Bird-in-the-Hand Theory drops the assumption that all investors want the same things.
Some investors are risk averse and would rather want certain dividend payments now than
uncertain capital gains in the future. Thus, investors value firms that have high dividend payouts
compared to one with low dividend payouts. Shareholders would thus, require a higher capital
return on shares with little or no dividends.
Information Content Effect
The information content effect is the observed change in share price as a result of news of
changes in dividend policies. Share prices usually rise when an announcement is made regarding an
increase in dividends while share prices usually fall when an announcement is made regarding a
decrease in dividends.
Asymmetric information between managers and investors allows managers to use this as a
signal to investors. An increase in dividends means confidence in the firms future while a decrease
means little confidence.
The Clientele Effect
The Clientele Effect results from people who have different wants. Some investors prefer
high dividend stocks while some prefer low dividend stocks. Different firms attract different types of
clientele (investors) with their dividend policies.
As such, a firm should not change its dividend policy too greatly; otherwise it will cause
investors in the firm to be unhappy that its changed too much. There is a general knowledge
amongst managers that you should not change something that has settled on for a while too much,
otherwise, it will cause backlash, no matter if it is a good change or a bad change.
Factors affected choice of Dividend Policy
As we can see, dividend policy choice is affected by many factors. On the next page is a list
of factors that affect either a low or high dividend policy.

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Dividend Policy

Low Dividend Policy


Taxes under Classical System
Flotation Costs
Dividend Restrictions
Liquidity Issues
Ownership Dilution
Desire for capital gains over dividends

High Dividend Policy


Taxes under Imputation System
Good for tax-exempt investors
Cost of trading shares
Desire for certain and current income

So with all this information, how much do we pay in dividends then? We have four different
types of policies we can use to determine how much to pay.
Residual Dividend Approach
This approach is self explanatory in that we give out all our residual earnings as dividends.
The firm needs to have a target capital structure for this approach however. We take however much
net income the firm got from the last investment and deduct from that the required equity in the
next project. Any remaining equity here is known as the residual and distributed out as dividends.
A strict residual dividend approach is bad for a variety of reasons because it is not a stable
approach. The residual amount is most certainly to be different each time leading to an unstable
dividend which can give out wrong signals to shareholders about the profitability of the firm.
Constant Payout Approach
This approach is where the firm pays a constant percentage of earnings at each defined
payment date (usually annually or bi-annually). They may also choose to pay it out over an earning
cycle instead which can be a different period of time.
Constant Dividend Growth
This approach was discussed previously and it is where dividends increase at a set
percentage each year.
Low Regular and Extra
This method is where the firm pays a regular low dividend and only pays an extra dividend
when earnings are high enough to warrant one. This can be bad in the long run though because
investors will come to expect an extra dividend and when there isnt one, investors will believe the
firm is not doing well (bad signal).
Constant Nominal Payout
This is simply paying out the same fixed amount of dividends every period. The dividend is
only increased when management is fully confident that the firm can support a higher dividend for
perpetuity.
In doing this, firms should not cut back on projects just to pay dividends, avoid cutting
dividends, avoid selling equity and maintain targeted debt to equity and dividend payout ratios.

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Dividend Policy

Dividend Reinvestment Plans


Alternatives to cash dividends exist and one of them is a dividend reinvestment plan. This is
where shareholders are option to automatically reinvest all or part of their cash dividends in new
shares. This is partially irrelevant to the investor because they can use a homemade dividend policy
to do this by themselves. The only bonus to this is that there are less transaction costs. These are still
considered dividends for tax purposes.
Some firms may also allow open enrolment where shareholders can, if they wish, to buy
even more shares by paying more when a dividend reinvestment plan is available. This allows
shareholders to buy even more shares while avoiding brokerage fees.
The amount of shares a shareholder is entitled to, is found by multiplying the cash dividend
by the number of shares, then dividing it by the difference between share price and the discount.
Dividend reinvestment plans can be advantageous for a firm because they can issue new
equity without having to go through the normal long and costly procedures of a normal sale. It also
allows the firm to re-evaluate its dividend policy. If the majority of investors are opting for the plan,
then the firm would be better off paying less dividends and concentrating on capital growth. The
reverse is also true.
Bonus Issues
Bonus issues are where a firm issues additional new shares on a pro-rata basis for free to
investors. What this does is increase the amount of shares on the market but it also decreases the
per share price, EPS and DPS. This is an intended effect so that share prices do not get too high.
Share Splits
Share splits are where each share is split up into more shares. These have the same similar
effect as bonus issues do.
Both bonus issues and share splits are typically interpreted by investors and shareholders as
a good signal that management is confident about its future because it is concerned that share
prices will get too high. It is also good for investors because the more shares that are traded at once,
the cheaper transaction costs get.
Reverse Splits
This is a complete reverse of a share split. Shares are grouped and replace with one new
share instead. This has the opposite effect of share splits and bonus issues in that they increase
share price, EPS and DPS.
This sends a negative signal to investors as aggregate dividends will usually decrease. Firms
may choose to do this to reduce transaction costs and improve liquidity (very low price shares have
high costs in percentage terms).

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Dividend Policy

Share Repurchase/Buyback
A share repurchase/buyback is where a firm uses cash to buy back their own shares. This is
done by firms to reduce the amount of shares in the market, increase share price and EPS. Firms can
either purchase directly from the share market or make an offer to shareholders to purchase shares.
If we assume perfect capital markets, shareholders will be indifferent between buybacks and
dividends.
Managers use share buybacks because it is a way of distributing cash without it technically
being a dividend. Thus, it provides financial flexibility for the manager who does not want to
increase dividends temporarily as this would cause a wrong signal to be sent when they are brought
down again.
It can also be useful for managers to alter the capital structure of the firm. They can issue
debt and use that money to buy back shares. This increases the debt of the firm and decreases
equity, thus, changing the firms capital structure. However, this is only really useful for large
changes in the capital structure.
Share buybacks give positive signals to the market that management believes that equity is
undervalued. Firms that do so tend to outperform the market for months after a buyback has
occurred.
Shareholders themselves also like share buybacks because, unlike dividends, they have a
choice whether to sell those shares or not for cash. This also gives them tax flexibility. No buyback
means no tax, and buying back means tax. Having a choice is valuable for a shareholder who may not
want more tax liability.
However, share buybacks are disadvantageous in that some shareholders may prefer cash
dividends over anything else. They may view it as a negative signal because the firm may have to
buyback at a very high price compared to the market. In the long-run, this causes share price to fall
and thus, disadvantages all shareholders who did not sell their shares.

This document ends here.


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