Note: Equations in RED are not given on aid sheet, Equations in

ORANGE given

Ch. 9 Risk Analysis, Real Options, and Capital Budgeting

Decision Trees identify the sequential decisions in NPV project & analysis
o Graphically represent alternatives available and the likely consequences
o Calculate NPV of successful & unsuccessful outcomes (NPV @ t = 1)
o Expected Payoff = (Prob Success x Payoff success) + (Prob fail x Payoff
fail)
o Then calculate NPV at t = 0
Initial investment + (Expected payoff/1+discount rate)
If positive, accept if negative, reject
o Note: Projected cash flows may be unmet realistically
Ratios to look behind NPV and analyze effect of various assumptions used
o Sensitivity analysis NPV is very sensitive to change in revenues?
o Every __% drop in revenues leads to a __% drop in NPV
o Breakeven analysis
o Breakeven Incremental After-Tax Cash Flow
NPV = 0 = -Investment + IATCF/(1+r)t
o Accounting B/E = Sales volume where NI = 0
o Cash B/E = Sales volume where OCF = 0
o Financial B/E = Sales volume where NPV = 0
o Scenario Analysis
Calculate NPVs for good, normal, and bad scenarios
Monte Carlo Simulation
o Models real-world uncertainty, used to analyze gambling strategies
o Step beyond sensitivity or scenario analysis
o Interactions between variables explicitly specified (more complete
analysis)
Real Options
o Business options provide value when a project is faced with uncertainty
o The Option to Expand Maybe expand project to get larger NPV
This option has value if demand is higher than expected
o The Option to Delay
Has value if underlying variables are changing w/ favourable trend
o The Option to Abandon or Option to Contract
Has value if demand turns out to be lower than expected
Or contracting if you don't want to fully abandon
E.g. Have drilling project, and if unsuccessful can sell or hold
Discounted Cash Flows and Options
o Market Value (M) = NPV (without option) + Option
If 2 machines cost the same, last the same, but one machine is
more versatile, then that one is more valuable b/c it has options

Ch. 10 Risk & Return: Lessons from Market History

Returns Dollar returns = Dividend + Change in Market Value
Percentage returns = Dollar Return/Beginning Market Value = Div. Yield +
Yield
Holding Period Returns (HPR) Return earned when holding an investment ov
period
o HPR = (1+r1) x (1+r2) x (1+rn) 1
o Geometric Avg. Return (Annual Return) = rg = t (# periods)HPR
So the investor earned GAV% on his money for four years, realizi
HPR of %
Return Statistics Summarize history of capital market returns
o Average Return (given), St. Dev. of those returns (given), Frequency Dist.
the returns
Risk Premium Additional return above risk-free rate resulting from bearing risk
o Difference between return on shares and return on T-bills
Risk-Return Tradeoff Common stocks most can earn highest return but are mor
volatile, Long bonds have higher return than T-bills but lower return than commo
stocks
Statistics:
o Mean = Sum of values/# of values
o Median = Equal number of values on either side of median
o Mode = Most frequently occurring number in group of values
Measures of Dispersion:
o Range = Difference between highest value and lowest value in the series
o Standard Deviation (SD) = shows dispersion of data within distribution
SD = x mean of series
o Variance = SD2 (both measure variability & both involve normal distribution
Variance = (x mean of series)2
Central Limit Theorem
o Group of sample averages tends to be normally distributed
Larger the sample size, higher tendency towards normality
o Allows conclusions to be drawn from sample data & applied to a population

 Value at Risk (VaR)

o Popular risk measurement tool used by banks, insurance co., fin. instit.
o Represents maximum possible loss in $$$ for given confidence level
Value at risk = (Total exposure x 22.85)
Note: -22.85 = 2 SD, 95.44% will lie within this range
Normal Distribution Formula
o Find area under normal curve Z = (Xi X)/s
Z = (X value of interest X average)/s.d.
o Example 1: Proportion of subs w/ calories < 230? (mean = 251, s.d. =
50.06)
1. Calculate Z value Z = (230 251)/50.06 = - 0.42
2. Use Z-table to find area to left of -0.42 P = 0.3372
Note: Z table values all the way to right, so for Q asking for >
__, must subtract (1 P) = Correct P
o Example 2: Proportion of subs w/ calories between 270 and 340?
1. Draw distribution and show range there to visualize
2. Re-write formula P (X < 340) P (X<270)
3. Solve for P for each boundary
a. Z = (340 251)/50.06 = 1.78 (to left of) P = 0.9625
b. Z = (270 -251)/50.06 = 0.38 (to right of) P = 0.6480
4. Find difference between P values 0.9625 0.6480 = 0.3145
o Example 3: Want to buy sub from low 10th percentile calories, whats
most calories in the low 10th percentile?
Must reverse-engineer calculations:
1. Must find Xi in Z = (Xi X)/ s Find Z score of the low region
(10%)
a. Find Z value where P = 0.1 (Closest = 0.1003 @ -1.28)
b. Calculate -1.28 = (X 251)/50..06 Xi =186.92
Note: Calculate multiple ways by going either directions + subtracting or add
Average Returns:
o Arithmetic Average = return earned in a typical year
o Geometric Average = average compound return per p. over multiple p.s
(1+rg)t = t(1+r1) + (1+r2) + + (1+rt)
Note: Geometric avg. < Arithmetic avg. unless all returns equal
o Which is better?
Arithmetic Overly optimistic
Geometric Overly
pessimistic

 COMBINE two averages with Blumes Formula

Blumes Formula
o R(T) = (T-1/N-1) x Geometric Avg. + (N-T/N-1) x Arithmetic Avg.
T = forecast horizon, N = # years of historical data used (T must
be <N)

Ch. 11 Risk & Return: The CAPM

Characteristics of Individual Securities:
Expected Return What an investor expects to earn over p. of time
o E(R) = n Pi x Ri
o Equation = Sum of all (probability x return)
Variance & Standard Deviation
Measure volatility of a securitys return
o Formula Given for Standard Dev!
o Var(R) = Expected value of (R R)2 (Calculate for each scenario x Prob.)
Variance = Deviation2 = [E(R) - Ri]2
Covariance & Correlation (to another security)
Measures returns on 2 securities relative to one another
o Covariance Measures degree to which random variables move
together
o Correlation Measures dependence of two random variables

Risk & Return for Portolios:

Rate of Return on Portfolio
o Rp = w1r1 + w2r2 (Weight of security x Rate of return on security)
Expected Rate of Return on Portfolio
o E(rp) = w1E(r1) + w2E(r2) (Weight of sec. x Expected return on sec.)
Note: Remember expected return is sum of all probabilities x
returns (sum of all scenarios)
Variance of a 2-security Portfolio
o NOT GIVEN (but s.d. is just square it)
Standard Deviation of a 2-security Portfolio
o GIVEN (square this to get variance of a 2 security portfolio)

Correlation Coefficient between 2 securities

o GIVEN
The Efficient Set for 2 Assets:
Plot of the different combination of
weights of 2 assets showing
Risk (X) and Return (Y)

 Note: Some portfolios better than

others Higher returns w/ same risk
o Efficient Frontier on graph
Two-Security Portfolios with Various Correlations:
Smaller correlation, greater
the risk reduction potential
o p = -1.0, complete risk
reduction possible b/c
negatively correlated
o p = +1.0, no risk reduction
is possible b/c positively
correlated

The Efficient Set for Many Securities:

1. Identify opportunity set of risk-return combinations of various
portfolios
2. Find minimum variance portfolio (Equation below given!)

Example: Find the proportion of A & B that

results in
the minimum variance portfolio (GIVEN)
1.
a) WB = 100 - WA
2.
3. So get ERP, then substitute w to get
Var(ERP)=0
Note: Investors only consider the efficient frontier (on line from min. v.pt to top
right pt.)
Diversification:
Can substantially reduce variability of the returns w/o an equivalent
reduction in ER!
o Eliminates some but not all risk!

 Systematic (Market) Risk Risk that cannot be diversified away

o Economy-wide random events that affect almost all assets to a
certain degree
Unsystematic Risk Diversifiable
Random events that affect single securities
or small groups of securities
Significantly diminishes in large
portfolios
Risk & the Sensible Investor:]
Risk & the Sensible Investor:
Investors are risk-averse and want to avoid unnecessary risk (aka
unsystematic risk)
Increasing investment in mutual funds/exchange-trade funds indicate
investors want diversified portfolios
Riskless Borrowing & Lending:
Investors can allocate money across T-bills + balanced mutual fund!
*Choose Capital Allocation Line w/ steepest
slope!
- All investors now would choose a
point
along the line
(risk free asset + market
portfolio)
- In a world w/ homogenous
expectations for
lending/borrowing, M is same
for all
investors
Note: M point is where CML meets the
efficient frontier! (balanced fund)
Separation Principle
Market portfolio (M) is same for all investors they can separate their
risk aversion from their choice of the market portfolio
Investors level of risk aversion revealed in where they stay along the
CML
o NOT their choice in line
ALL INVESTORS HAVE SAME CML because they all have
same optimal risky portfolio given the risk-free rate

Separation principle implies choice separated into 2

tasks:
a) Determine optimal risky portfolio
b) Select point on CML

Market Equilibrium Portfolio:

Homogenous expectations all investors have access to same info
o Everyone would have same efficient set of risky assets
Reality Everyone has different risk-free rates b/c of different
investment horizons
Optimal risky portfolio depends on risk-free
rate + risky assets
o CML shifts as risk-free rate changes!
NOTE: STEEPEST CML SLOPE = OPTIMAL
ONE
Beta

():
Best measure of the risk of a security in a large portfolio
Measures responsiveness of a security to movements in market portfolio
Estimate with slope on regression line (/)
o Estimate of depends on choice of proxy for the
market portfolio
Average across all securities when weighted by
proportion of each securities market value to the
market portfolio = 1
< 1 Less volatile compared to the market
= 1 Move with the market
> 1 More volatile compared to the market
Essentially, markets volatility = 1 so compare
to that
(GIVEN)
Capital Asset Pricing Model (CAPM):
States the expected return on a security is
positively related to the securitys beta
If i = 0, then Expected return = Rf
If i = 0, then Expected return =
Market risk
Expected Return on the Market

o RM = RF + Market Risk Premium

Expected Return on an Individual
Security
o THIS LEFT FORMULA
o Applies to individual securities
held within well-diversified
portfolios

QUESTIONS FOR FINAL:

Formula for standard deviation has probabilities Forward looking
o Make sure to divide by (n-1) when it's a probability MC QUESTION
o

Ch. 12 Risk & Return: Arbitrage Pricing Theory

Arbitrage Arises if an investor can construct a zero-investment portfolio w/
sure profit
o Because no investment is required, investors can create large positions
to secure large levels of profit
o In efficient markets, profitable arbitrage opportunities quickly
disappear!
2 Parts of Return:
1. Expected/Normal Return Return that S/H in market predict/expect
when depending on all available info
2. Unexpected/Risky Return Comes from info that will be revealed in
the month

Return on a Stock in the Coming Month:

NOT GIVEN
R Actual total return in the month
R Expected part of the return
U Unexpected part of the return
Announcements = Expected part + Surprise/Innovation
o Expected Info market uses to form the expected return on the stock
o Surprise News that influences unanticipated returns on the stock
Risk: Systematic + Unsystematic
o Unexpected part of return = true risk
o Systematic Risk (all) General economic conditions, GNP, interest
rates, inflation
o Unsystematic Risk (1/s) Company announcements
Note: Variance terms can be diversified away, but Covariance terms
cannot
Three-Factor Model: (Bottom Given!)
o Risk = Expected return + systematic risk + unsystematic
risk
Systematic sources of risk, F = factors
F = surprise = actual - expected
I = inflation, S = spot exchange
rate (%)
= unsystematic risk
1-Factor Model/Market Model:
o Actually used by researchers on returns on the S&P/TSX 60 index
=
(given!)
Return on any portfolio determined by:
1. Weighted average of expected returns
No uncertainty here as its expected return
2. Weighted average of (betas x factor F)
In large portfolio, only uncertainty is portfolios sensitivity to F
3. Weighted average of unsystematic risks

 In a large portfolio, #3 disappears as unsystematic risk is

diversified away
Return on diversified portfolio = Sum (Expected Return + Sensitivity of
p.) given!

Relationship between Beta & Expected Return:

o Relevant risk in large, well-diversified portfolios = systematic
Because all unsystematic risk diversified away
Assuming no security
has disproportionate
market share, then this
market portfolio has no
unsystematic risk and is
perfectly correlated with
1-factor
o The market portfolio, like
every security/portfolio, lies on
SML
When market portfolio is
the factor, the beta of
market portfolio is 1
If market portfolio is
factor, equation is
RM = expected
return on market
(GIVEN)
Shows expected return
on any asset is linearly
related to securitys beta

CAPM + APT (Arbitrage Pricing Theory):

o APT
Applies to well-diversified portfolio, not necessarily to individual
stocks
Demonstrates unsystematic risk falls (eventually none) as #
securities in the portfolio increases but systematic risk
doesnt increase
Possible for some individual stocks to be mispriced
(Not lie on Security Market Line, SML)
Can be extended to multifactor models

Multifactor APT

Empirical Approaches to Asset Pricing:

o Both CAPM + APT are risk-based models, have alternatives
o Empirical methods based less on theory, more on looking for
regularities in the historical record
Classification of portfolio by style Value portfolio, growth
portfolio
Note: Correlation doesnt mean causation

QUESTIONS FOR FINAL:

Security + market move inversely If market rate is increasing and beta
is negative, then security will decrease

Ch. 13 Risk, Return, and Capital Budgeting:

Discussing the appropriate discount rate when cash flows are risky
Importance of the Cost of Capital:
o Return earned on asset depends on the risk of the asset
o Return to investor = Cost to the company
o Cost of capital indicates how the market views the risk of companys
assets
o Knowing cost of capital helps determine required return for capital
budgeting projects
Required Return:
Required return = discount rate, based on risk of cash flows
Need to know required return for investment before computing NPV and
deciding
Must earn at least the required return to compensate investors for
financing
Cost of Equity:
o The return required by equity investors
given the risk of the cash flows from firm
Because S/H can reinvest the
dividend in risky financial assets,
the
expected return on capitalbudgeting projects should be at least
as great as the expected return on
financial assets of comparable risk
o 2 Methods for Determining Cost of Equity:
1. Dividend Growth Model (DGM):
Start with dividend growth model formula, rearrange to solve
for RE
Note: Remember D1 = Dividend in
1 year
FORMULA NOT GIVEN
Note: Can also estimate g by finding historical average of growth OR
if ROE + Div. policy is stable and company not looking to raise
new external capital, can use:
g = Retention ratio x ROE
o Advantages: Easy to use
o Disadvantages: Company has to be currently paying dividends,
dividends must
grow at a reasonably constant rate, very
sensitive to estimated growth rate,
does not explicitly consider risk
2. The SML/CAPM Approach:
From firms perspective, cost of equity = expected return
not given
To estimate firms cost of equity, must know:
Risk-free rate, RF
1.

2. Market risk premium

3. Beta
o Advantages: Adjusts for systematic risk, applicable to all
companies as long as we can compute beta
o Disadvantages: Must estimate expected market risk premium
(varies in time), must estimate beta (varies over time), relying on
past to predict future
Note: Question can ask for appropriate discount rate
Using SML to Estimate the Risk-Adjusted Discount Rate for Projects:
o All-equity firm should accept a project whose IRR > cost of equity capital
Reject projects whose IRR < cost of capital
o SML = shows equilibrium relationship
between systematic risk &
expected rates of return for individual
securities
Excess of return on
a risky asset = excess
return on a risky asset
= excess return on
market portfolio x beta
(GIVEN)
Estimating Beta:
o Market Portfolio Portfolio of all assets in economy
Broad Stock Market Index (e.g. S&P Composite) represents the
market
o Beta Sensitivity of a stocks return to the return on the market
portfolio
Generally stable for firms remaining in the same industry
BUT beta could change due to changes in product line,
technology, deregulation, financial leverage
Industry vs. Firm Beta:
If operations similar to operations of industry Use
Industry Beta
If operations fundamentally different to rest of industry
Own Beta
Dont forget adjustments for financial leverage
Determinants of Beta:
Business Risk
Cyclicality of Revenues High cyclicality = high
beta
E.g. Mining, retail, high-tech Food/utilities
low
Operating leverage How much of a companys
costs are fixed rather than variable (Sensitivity to
FC of production)

Firm with high op. costs has larger changes

in EBIT with respect to changes in sales
revenue
Degree of Operating Leverage (DOL)
measures how sensitive a firm/project is to
its fixed costs
o Increases as FC rise + VC fall (GIVEN)
o Magnifies effect of cyclicality on beta

Financial Risk
Financial Leverage Sensitivity to firms FC of
financing
Relationship b/w s of firms debt, equity, and
assets (GIVEN)
Fin. Leverage always increases equity relative to
asset

The Firm vs. The Project:

o Any projects cost of capital depends on what the capital is used for, NOT
the source
Depends on the risk of the project, NOT the risk of the company
A firm using one discount rate for all
projects may over time increase the
risk of the firm
while decreasing its value

Multiple Investment Projects:

o Firms beta = 1.3, betas of investments
o Calculate expected return for all 3
Expected returns = cost of capital
on each of these investments
Cost of Debt:
o Return demanded by firms long-term creditors
o Required return on companys debt

o Determines YTM on firms current debt + Credit ratings used to set rate
for new bonds
Cost of debt coupon rate Coupon rate is cost of debt when
bond issued
Want to know rate we have to pay on newly issued debt
o Cost of Debt with a Bond:
Cost of debt for a bond = YTM
Financial Calculator Enter N, PMT, FV, PV (-ive, currently selling
@)
CPT I/Y YTM + (I/Y x 2, semi-annual)
o Cost of Preferred Stock:
Preferred generally pays constant dividend every period (paid every
p. forever)
Annuity ReturnPreferred = D/Po
Weighted Average Cost of Capital (WACC):
o Use individual costs of capital to compute average cost of capital for firm
o Average = required return on assets b/c markets perception of risk of
those assets
Weights determined by how much of each type of financing used
S = Equity (Stocks)
(GIVEN)
B = Debt (Bonds)
(1-Tc) B/c interest expense is tax
deductible
rs, rb market values of equity + debt
Alternative Notation V (Market Value of Firm) = D + E
o After-tax Cash Flows:
After-tax cost of debt = RD (1-TC) interest expense reduces tax
liability, reduced tax liability reduces cost of debt!
Note: Dividends not tax-deductible, so no impact on cost of equity
NOT GIVEN
Determining Value of Entire Firm:
o Use same principle as capital budgeting
Discount all future expected CF generated by firms WACC
Flotation Costs + Weighted Average Cost of Capital
o Flotation Costs arise from issuance of equity or debt (legal,
underwriting, fees)
When projects funded by stocks/bonds, flotation costs incurred!
So when evaluating NPV of project, flotation costs should be
considered
Calculating f = (equity % x fEquity) + (debt % x fDebt)
Tells us that for every $1 needed, firm must raise $1/(1-f)
Flotation Costs + NPV:
o When assessing NPV and considering flotation costs, steps:

1. Estimate WACC
2. Estimate PV of project
3. Estimate Weighted Average Flotation Costs and true cost of
investment 1/(1-f)
4. Estimate NPV using true cost of investment
Note: If internal equity used, flotation costs = $0
Reducing Cost of Capital Liquidity
o Liquidity Expected Return on stock and Firms cost of capital ively
related to liquidity of firms shares
Liquidity of a share relates its cost of buying + selling:
Brokerage fees, bid-ask spread, market impact costs
Stocks that are expensive to trade = less liquid than those cheaper
to trade
o Higher the cost of trading Less liquid are the shares
Cost of trading illiquid stock reduces total return investor receives
Investors demand high expected return when investing in stocks
with
high trading costs/low liquidity
o High expected return = high cost of capital to firm
o Increase in liquidity = reduction in trading costs = lower cost
of capital
o Adverse Selection determines liquidity of stock
Says traders with better info can take advantage over specialists
and traders who have less information
o Greater differences in info wider the bid-ask spread
higher required return on equity
What can the firm do?
Incentive to lower trading costs b/c it lowers cost of capital!
Stock split increases liquidity, reduces adverse selection,
lowers bid-ask spreads
Facilitate stock purchases allows small investors to buy
securities cheaply online
Disclose more info, especially to security analysts to narrow
gap between informed/uninformed traders reduces bid-ask
spread

Ch. 16 Capital Structure: Basic Concepts

Value of a Firm V = B + S = Debt + Equity
o Management to make firm as valuable as possible Pick appropriate
D/E ratio
Capital Structure Question:
1. Why should S/H care about maximizing firm value? Maybe should just
be interested in strategies that maximize S/H value.
2. What is the ratio of D/E that maximizes S/H value?
Changes in capital structure benefit S/H ONLY IF value of firm increases!
o Generally, changes in capital structure benefit S/H if firm value
increases, hurts S/H if firm value decreases
Managers should choose capital structure that maximizes
firm value
S/H should care about maximizing firm value, not just
equity value
1. Line for proposed structure has steeper slope,
implying
higher debt increases sensitivity/risk of EPS to
EBIT
2. EPS + ROE are higher when EBIT is high and
lower when EBIT is low
3. At the break-even EBIT point ($1600), EPS and
ROE are the same under both capital
structures
Note: -640 in breakeven equation = interest
expense

Modigliani-Miller (M&M) Model:

o Financial theory stating the market value of a firm is determined by its
earning power and risk of underlying assets, independent of the way it
chooses to finance its investments or distribute dividends no
difference if firm finances itself w/ D or E
o Assumptions:
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets Perfect competition, firms/investors can
borrow/lend at the same rate, equal access to relevant info, no
transaction costs, no taxes
o Homemade Leverage:

Using personal borrowing of investors to change amount of

financial leverage of the firm can change unleveraged firm into
a leveraged firm
Example: Purchase 40 shares @ $50 with $1200 own cash,
$800 loan
Same ROE as if bought into levered firm D/E ratio
= 2/3
Example, Homemade Unleverage: Invest in 24 shares of
otherwise identical levered firm (24 @ $50 = $1200) +
$800 bonds issued by same firm
Gets same ROE of unlevered firm D/E = 800/1200
= 2/3
These examples are fundamental insight of M&M model
(EXAM)
M&M Proposition I + II No Taxes:
Can create levered or unleavered position by adjusting trading in own
acct.
Homemade leverage suggests capital structure irrelevant in determining
value of firm
Proposition I Firm value NOT affected by leverage VL = VU
o Because S/H can achieve any pattern of payouts w/ homemade
leverage
Proposition II Leverage increases the risk & return to shareholders
rS = return on levered equity cost of equity
r0 = return on unlevered equity cost of capital
rB = interest rate cost of debt
(EQUATION GIVEN) (how to know the
relationship?)
o M&M Interpretation No Taxes
As firm adds debt, remaining equity becomes riskier higher
cost of equity
Increase in cost of remaining equity offsets higher proportion of
firm financed with low-cost debt
As leverage changes, overall cost of capital AND firm value
doesnt change

M&M Proposition I + II with Corporate Taxes

o Proposition I with Tax Firm value increases with leverage
with taxes but no bankruptcy costs
Because S/H can achieve any pattern of payouts w/ homemade
leverage
VU = PV of unlevered firm
(EQUATIONS GIVEN)
EBIT x (1-TC) = Firms cash flows after taxes
r0 = Cost of capital to all-equity firm (discounts after-tax cash
flows)

o Proposition II with Tax Some of the increase in equity risk and

return is offset by interest tax shield (GIVEN)
rB = interest rate (cost of debt)
rS = return on equity (cost of equity)
r0 = return on unlevered equity (cost of
capital)

Effect of financial leverage on Cost

of Debt and Equity Capital with
Corporate Taxes
Note: M&M suggests 100% debt is
optimal but most executives dont
like capital structure of 100% debt
b/c bankruptcy
FINAL EXAM:
o Not much
qualitative
o Know calculations
well

Ch.17 Capital Structure: Limits to the Use of Debt

Costs of Financial Distress Bankruptcy Risk vs. Bankruptcy Cost:

Costs of financial distress cause firms to restrain issues of debt
o Bondholders fairly compensated if realistic about probability + cost of
bankruptcy
Shareholders bear bankruptcy costs
o Direct Costs of Bankruptcy Legal + admin (small % of firms value)
o Indirect Costs Impaired ability to conduct business (lost sales)
Agency costs Conflict of interest between shareholders +
bondholders
Example, Selfish Strategies: Incentive to take large risks,
incentive for underinvestment, milking the property
Note: In bankruptcy, bondholders get their share, S/H get leftovers (if
any!)

Reducing Costs of Debt:

o Protective Covenants -ive (cant do something), +ive (must do
something)
o Debt Consolidation Minimize # of parties, contracting costs fall
o Repurchase debt prior to bankruptcy

Trade-off or Static Trade-off Theory:

o Trade-off between benefits from tax advantage of debt + costs of financial
distress
There is an optimal amount of debt for any individual firm target
debt level
Optimum level of debt referred to as firms debt capacity
1. Tax shield increases value of
levered firm
2. Financial distress costs lower
value of levered firm
3. #1 + #2 above produce
optimal amount of debt at B*
When costs of financial
distress exist, optimal cap.
structure is no longer 100%
debt.
Value of a levered firm:
VL = VU + PV tax savings PV
costs of financial distress

The Pie Model Revisited:

o Taxes + bankruptcy costs can be seen as another claim on the cash flows of
the firm
S = Equity, B = Debt
G = Taxes Paid, L = Paid to Bankruptcy Lawyers
M&M Intution VT depends on cash flows of the firm, capital structure just
slices the pie
FINAL EXAM NOTE: learn quadratic formula
Marketed Claims Claims of S/H and bondholders can be bought and sold (VM)
Non-Marketed Claims Claims by gov. + potential litigants in lawsuits cant
be bought/sold (VN)
VM changes with capital structure (claims of S/H + B/H) (NOT
GIVEN!)
As VM increases, there is an identical decrease in VN (VM taking
more share)

Signalling Firms capital structure optimized where:

Marginal subsidy to debt = marginal cost
o Investors view debt as a signal of a firms value
Firms with low anticipated profits will take on low-level of debt
Firms with high anticipated profits will take on high levels of debt
Manager that takes on more debt to fool investors will pay cost in the
long-run

Free Cash Flow Hypothesis:

o States that an increase in dividends should benefit S/H by reducing ability of
managers to pursue wasteful activities
o Argues an increase in debt will reduce the ability of managers to pursue
wasteful activities more effectively than dividend increases

Pecking-Order Theory:
Firms prefer to issue debt rather than equity if internal financing is
insufficient
Rule 1: First use internal financing
Rule 2: Issue safest securities first Debt, then equity
o Pecking-order theory at odds with trade-off theory:
No target D/E ratio, profitable firms use less debt, companies like
financial slack

Growth and the Debt-to-Equity Ratio:

o Growth implies significant equity financing, even in a world w/ low
bankruptcy costs

 Growth accrues to shareholders increasing equity value

o So, high-growth firms will have lower debt ratios than low-growth firms
Equity increases, debt unchanged D/E ratio falls
o Growth is an essential feature of real world 100% debt financing suboptimal!

The Miller Model: Personal Taxes

o Miller model shows that the value of levered firm (VL) can be expressed in
terms of an unlevered firm (VU) as: (GIVEN)
TS = personal tax rate on equity income
TB = personal tax rate on bond income
(interest)

If TS = TB then can use this formula

(GIVEN)
Effect of Financial Leverage on Firm
Value with Corporate + Personal Taxes:
1. TS = TB Result same as
propositions with corporate
taxes (VL = VU + TCB)
2. Tax benefits at corporate
level reduced b/c personal
tax on interest is higher than
personal tax rate on equity
returns. So value of levered
firm is higher than value of
unlevered firm, but the
increase in value is < Case 1
3. Tax benefits @ corp. level
offset by higher personal tax
rate on interest (relative to
equity returns). Value of firm
unaffected by use of fin.
leverage, same result as MM
proposition w/o corp. tax
4. Personal tax on interest
much higher than corp. tax
rate and personal tax on
equity returns. Tax benefits
at corp. level insufficient to
offset higher personal tax

rate on interest Lower firm

value when financial
leverage used
How firms establish capital
structure:
Most corps. have low
debt-asset ratios, some
no debt
Differences in capital
structure across
industries
Capital structures of
individual firm vary over
time
o Depends on
investment ops. +
need for financing
Firms do behave as if
they have a target debtto-ratio!

Factors in Target D/E Ratio:

o Taxes Tax benefits of interest deductibility depends on amount of taxable
profit
High-profit firms more likely to have higher target ratios than less
profitable firms
o Types of Assets Costs of fin. distress depend on types of assets firm has
Example: High investments in land/buildings have lower financial
distress costs
o Uncertainty of Operating Income Even w/o debt, firms with uncertain
operating income have high probability of fin. distress, so they will have less
debt
o Pecking Order & Financial Slack
Ch. 18 Valuation & Capital Budgeting for Levered Firm:

Adjusted Present Value (APV) Approach:

NPV = Value of project to an unlevered firm
NPVF = PV of financing side effects Tax subsidy to debt,
Costs of issuing new securities, Costs of financial distress,
Subsidies to debt financing
= PV of tax shield (TC x B x rB)
(last formula given!)
Example: Project of unlevered firm Unlevered cost of equity = r0 = 10%, NPV
= -$56.50
This project would be rejected by an all-equity firm
Now imagine firm finances project with $600 of debt at rB = 8%, tax rate 40%

o Method 1: PV of Interest Tax Shield

Interest tax shield = (0.4 x 600 x .08) = $19.20 each year
APV = -56.50 + sum of (19.20/1.08)4 = $7.09
o Method 2: Actual NPV of Loan:
NPVloan = +$600 (600 x 8% x 40%/1.08)4 600/(1.08)4 =
$63.59
APV = -56.50 + 63.59 = $7.09
o Note: Do stuff separately on NPV financial calculator!
So the firm should accept the project when using debt!

Flow to Equity (FTE) Approach: Note: REDO THIS QUESTION IN SLIDES

(PG.
o Discount the cash flow from the project to equity holders of levered firm at
the
cost of levered equity capital, rS
(GIVEN)
Example: $1000 investment, $600 debt and $400 initially from equity
holders
Step 1: Calculate Levered Cash Flows
o CF0 = -$400
o Interest expense paid by S/H each p. Tc x B x rB = 0.6 x 600 x
0.08 = 28.80
CF1 = $125 28.80 = $96.20
CF2 = $250 28.80 = $221.20
CF3 = $375 28.80 = $346.20
CF4 = $500 28.80 - $600 (repay loan) = $128.80
Step 2: Calculate rS (return on equity)
o To calculate debt to equity ratio (B/S) we only have debt
o So calculate Total value to find S V = B + S
V = PV of CFs + Int. Tax Shield4 = PV CF above +
(19.20/1.08)4
V = $1,007.09 = 600 + S S = $407.09
o rS = 0.1 + (600/407.09)(1- 0.4)(0.1 0.08) = 11.77%
Step 3: Valuation of the Firm
o Discount cash flows to equity holders at rS = 11.77%
o PV = -400 + 96.20/.1177 + 221.20/.11772 + 346.20/.11773
128.80/.11774
PV = $28.56

WACC Method:

o To find value of a project, discount unlevered cash flows at WACC

Example: Suppose firms target D/E ratio = 1.50, Tc = 40%, rB = 8%
rWACC = (1/2.5)(11.77%) + (1.5/2.5)(8%)(1 - 0.4) = 7.58%
NPV = -1000 + 125/1.0758 + 221.20/1.07582 +
346.20/1.07583....
o NPV = $6.68
(GIVEN)

Comparison of APV, FTE, and WACC Approaches:

o ALL 3 approaches value a project in the presence of debt financing
Use WACC or FTE if firms target debt-to-value ratio applies to the
project over the life of the project
Use APV if projects level of debt is known over the life of the project
Real world WACC used most
Which approach is best?
APV when level of debt is constant
WACC and FTE when debt ratio is
constant
o WACC most common
o FTE good for highly levered firm
3 methods will result in DIFFERENT NPVS

Alternative APV Formula (more complicated):

o APV = -Cost + PV unlevered project + PV depreciation tax shield

+ PV interest tax

shield

Cost = - Initial investment + Recovery of NWC NWC/(1+rf)t

+ Salvage value Salvage value(1-TC)/(1+r0)t
PV unlevered p. = Cash flows(1-TC)/(1+rS)t Note: rs = cost of equity
discount rate
PV dep. TS = (Depreciation per year x TC)/(1+rf)t Note: rf = risk free
rate
PV int. TS = Interest tax shield/(1+rB)t = (TC x B x rB)/(1+rB)t

Capital Budgeting When the Discount Rate Must Be Estimated:

o Scale-enhancing project Project similar to ones a firm already has
o Real world Executives make assumptions that business risk of a non-scale
enhancing project is similar to the business risk of firms already in that
business
No formula for this maybe select a discount rate slightly higher
assuming that risk is slightly higher as a new entrant
4 Step Procedure to Calculate Discount Rates:
1. Determine Industry Firms cost of equity (rS)
given
2. Determine Industry Firms hypothetical all-equity cost of capital (r0 =
unlevered rS)
Solving for r0 to use later

given
3. Determine rS (cost of equity) for Entrant Firms venture
Use previous r0, solve for rS
given
4. Determine rWACC for Entrant Firms venture
Use previous r0 and rS
given

Beta & Leverage With and Without Corporate Taxes:

o ACTUALLY don't need to know this if this is the flotation cost
stuff????
o Risk-less corporate debt (Debt = 0), relationship between beta of unlevered
firm and beta of levered equity:

Since purple box must be > 1 for levered firm, follows that

Equity

>

Unlevered

firm

o If beta of debt is non-zero, then:

o If project is NOT scale-enhancing, then:

1. Calculate the average unlevered for new industry
2. Calculate the levered for companys new project
3. Calculate the cost of levered equity for companys new project
4. Calculate WACC for companys new project
FINAL EXAM QUESTIONS:
o Nothing QUALITATIVE from this chapter
o Know both methods of APV approach
o Nothing on FLOTATION costs from this chapter

Ch. 19 Dividends & Other Payouts:

Stock Dividend
No cash leaves the firm
The firm increases the number of shares outstanding
Stock splits are larger stock dividends
Cash Dividend
Often paid quarterly and may pay an extra cash dividend
In extreme cases, a liquidating dividend is paid
Declaration Date BOD declares a payment of dividends (obligation
now)
Cum-Dividend Date Last day that the buyer of a share is entitled to the
dividend
Ex-Dividend Date Determines if S/H entitled to dividend payment
Anyone holding shares BEFORE this date is entitled to dividend
First day that the seller of a share is entitled to the dividend
Record Date Person who owns shares on this date receives the
dividend
Note: These days are all BUSINESS DAYS

Price Behavior Around Ex-Dividend Date:

In a perfect world, the stock price would fall by the amount of the
dividend
on the ex-dividend date
o Tax complicates this Price drops less than the dividend and
occurs within the first few minutes of the ex-dividend date

Irrelevance of the Dividend Policy:

o Since investors dont need dividends to convert shares to cash, they
wont pay higher prices for firms with higher dividend payouts
Hence, dividend policy has no impact on value of the firm because
investors can create whatever income stream with homemade
dividends
Firm ($42/share) is about to pay $2 cash
div.
Bob owns 80 shares, prefers a $3 cash
div.
Bobs homemade strategy

 Sell 2 shares ex-dividend

Note: Use this chart on exam!

Modigliani & Miller (MM) Proposition:

o Investors are indifferent to dividend policy
Assumptions:
No taxes, brokerage fees, etc.
Homogenous expectations
Investment policy of the firm set ahead of time
Dividends + investment Policy:
o Firm should NEVER forgo positive NPV projects to increase div. or pay for
first time
o Recall: Investment policy set ahead of time, not changed by changes in
div. policy!
DIVIDENDS are RELEVANT
DIVIDEND POLICY is IRRELEVANT
To get result that dividend policy is irrelevant, 3 assumptions:
o No taxes, no transaction costs, no uncertainty
Repurchase of Stock:
o Instead of declaring cash div., firm can use excess cash by buying back
own shares
Important way of distributing earnings to shareholders
o When tax avoidance is important, share repurchase can be useful with
div. policy
Example: Firm wants to distribute $100,000 to S/H
Distributing $100,000 as cash dividend, balance
sheet:

Distributing $100,000 through share repurchase,

balance sheet:

Methods for Buying Back Shares:

Tender Offers

o If offer price set wrong, and S/H do

not tender enough shares, the offer
can be cancelled
Open-Market Purchase
Targeted Repurchase Greenmail

Why do some companies choose to repurchase over dividends?

o Flexibility Dividends viewed as a commitment and firms reluctant reduce
div. amount
o Executive compensation in form of stock options Firms have significant
employee stock options, tend to prefer repurchasing shares over dividends
o Taxes Repurchases have a tax advantage over dividends
o Repurchase as Investment Recent studies have shown that the long-term
share price performance of securities after a buyback is significantly better
than the share price performance of comparable companies that dont
repurchase
o Offset to Dilution Firms buyback shares to offset the dilutive impact of the
exercise of stock options. (Although this reason has questionable validity).

Firms without Sufficient Cash to Pay Dividend:

o Firms should NOT issue new shares to pay a div b/c of personal taxes
Direct costs of share issuance also add more cost!
Firms with Sufficient Cash to Pay Dividend:
o Not all firms with excess cash have sufficient cash to pay a dividend
o These firms have other options for the cash:
Additional capital budgeting projects, acquire companies, purchase
assets, repurchase shares

In presence of personal taxes

o Managers have incentive to reduce dividends & seek alternative uses for funds
o Rational firms with excess cash would exhaust all other alternatives and still
may have cash leftover for dividends
o More difficult to understand why dividends are paid rather than share
repurchases that are more tax advantageous to the investor

Why investors favour high dividend policies:

o Reasons for low dividend Personal taxes, high issuing costs
o Desire for current income
Some investors prefer steady income of dividends
Homemade dividend argument assumes no transaction costs
E.g. Mutual funds repackage securities at low cost could be lowdividend stocks but controlled policy of realizing gains to pay investors
at specific rate
o Behavioural finance
Investors deal with self-control in investing and consumption

Selling shares to realize cash for consumption May sell too much
Holding high-dividend stocks Stick to personal rule of dont dip into
principal
o Agency costs
Agency Costs of Debt Firms in fin. distress reluctant to cut
dividends Bondholders create loan agreements to protect
themselves stating div. can only be paid if firm has earnings, cash flow,
and working capital above specific levels
Agency Costs of Equity Managers find it easier to waste funds if
low div. payout
Share repurchases would also keep cash from managers + bondholders
o Dividends Signalling
Share price rises when firm starts/resumes dividends, and falls after
announcements of dividend reductions
Firms only raise dividends when future earnings/cash flows expected to
rise enough so dividend not likely to be reduced later
Rise in share price following div. signal Information Content Effect
of dividend

Bird-in-Hand Theory:
o Counters dividend irrelevance theory
o Bird-in-hand theory states investors prefer dividends from stock rather than
capital gains because of inherent uncertainty of capital gains
Investors prefer certainty of div. payments over possibility of
substantially higher capital gains in the future

The Clientele Effect:

o Clienteles for various div. payout policies form this way:
Once clientele satisfied, corp. unlikely to create
value by CHANGING div. policy
Investopedia Companys stock price will move
according to demands/goals of investors,
clientele effect assumes investors attracted to
different company policies, and when that
companys policy changes, investors will adjust
stock holdings accordingly
Fewer firms paying dividends Large firms pay div., smaller firms tend not to
Corporations Smooth Dividends Long-run targets of payout ratios set
o Dividend payments lag earnings (so dont need to reduce div.)

Factors Influencing Dividend Policy:

o Stability of earnings
o Pattern of past dividends
o Level of current earnings
o Level of expected future earnings

o Concerns about impact on share price

Reasons for paying dividends:

o Strive to maintain uninterrupted record of dividend payments
o Investors see dividend changes as signals of future
o Reasons for dividend changes should be adequately disclosed
o Unexpected dividend cuts cause share price to drop
o Unexpected dividend increase cause share price to increase

Stock Dividends + Stock Splits:

o Supporters suggest share has a trading range
Once share price rises above this range, volume of trades declines
as investors cant afford to buy lots of shares
Managers think shares trading in the range attracts individual
investors
o Stock splits actually reduce liquidity
Example: One for four reverse split 4 shares exchanged for 1 new share
Transaction costs may be less after reverse split
Liquidity/marketability improved if price raised to the trading range
Increases share price to more respectable level
Increases share price to above minimum price allowed on stock
exchange, thereby preventing a delisting
To assist w/ buy out of shareholders that own less than certain # of shares