Financial Management

Dulcy van der Werff

University of Leiden

Table of Contents

3 Accounting and Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

4 Measuring Corporate Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
5 The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
8 Net Present Value and Other Investment Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
9 Using Discounted Cash-Flow Analysis to Make Investment Decisions . . . . . . . . . . . . . . . . . . . . . . . . . 7
10 Project Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
12 Risk, Return, and Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
13 The Weighted-Average Cost of Capital and Company Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Introduction

This file is a summary of selected chapters in the book Fundamentals of Corporate Finance [1] for the course
Financial Management, given at the University of Leiden in the fall semester of 2017.

3 Accounting and Finance

Learning objectives:
1. Interpret the information contained in the balance sheet, income statement, and statement of cash flows.
2. Distinguish between market and book values.
3. Explain why income differs from cash flow.
4. Understand the essential features of the taxation of corporate and personal income.

3.1 The Balance Sheet

The balance sheet presents a snapshot of the firm’s assets and liabilities at one particular moment. The
assets - representing the uses of the funds raised - are listed on the left-hand side of the balance sheet.
The liabilities - representing the sources of funding - are listed on the right. Assets that are likely to be
used or turned into cash in the near future are described as current assets, e.g. inventories and accounts
receivable. Those liabilities that are likely to be paid off most rapidly are called the current liabilities,
e.g. accounts payable and debt due for repayment. The difference between the currents assets and current
liabilities is known as the working capital:

working capital = current assets − current liabilities (1)

The difference between the total assets and the total liabilities represents the amount of the shareholders’
equity:

shareholders’ equity = total assets − total liabilities (2)

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A general balance sheet should look something like this:

Items in the balance sheet are valued according to generally accepted accounting principles, commonly called
GAAP. These state that assets must be shown in the balance sheet at their historical cost adjusted for
depreciation. Book values are therefore "backward-looking" measures of value, they are based on the past
cost of the asset, not its current market price of value to the firm. Market values of assets and liabilities
do not generally equal their book values. Book values are based on historical or original values. Market
values measure current values of assets and liabilities. The difference between the market values of assets
and liabilities is the market value of the shareholders’ equity claim. The stock price is simply the market
value of shareholders’ equity divided by the number of outstanding shares.

3.2 The Income Statement

The income statement shows how profitable the firm has been during the past year. It shows the revenues,
expenses, and net income of a firm over a period of time. From the income statement, the earnings before
interest and taxes (EBIT) can be calculated:

EBIT = total revenues − costs − depreciation (3)

To calculate the cash produced by the company, it is necessary to add the depreciation charge (which is
not a cash payment) back to accounting profits and to subtract the expenditure on new capital equipment
(which is a cash payment). Cash outflow is equal to the cost of goods sold, which is shown in the income
statement, plus the change in inventories. The cash that the company receives is equal to the sales shown
in the income statement less the change in uncollected bills.

3.3 The Statement of Cash Flows

The statement of cash flows shows the firm’s cash inflows and outflows from operations as well as from its
investments and financing activities. Cash flow from operations starts with net income but adjusts for those
parts of the income statement that do not involve cash coming in or going out. Therefore, it adds back the
allowance for depreciation because depreciation is not a cash outflow, even though it is treated as an expense
in the income statement. Any additions to current assets (other than cash itself) need to be subtracted from
net income, since these absorb cash but do not show up in the income statement. Conversely, any additions
to current liabilities need to be added to the net income because they release cash. Depreciation is not a
cash payment; it is simply the allocation of to the current year of the original cost of the capital equipment.
However, cash does flow out the door when the firm actually buys and pays for new capital equipment.
Cash flow from operations
− Cash flow for new investment
+ Cash provided by new financing
= Change in cash balance
The value of a company depends on how much cash it can generate for investors after it has paid for any
new capital investments. This cash is called the company’s free cash flow. Free cash flow is available to
be paid out to investors as interest or dividends or to repay debt or buy back stock.

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4 Measuring Corporate Performance
Learning objectives:
1. Calculate and interpret the market value and market value added of a public corporation.
2. Calculate and interpret key measures of financial performance, including economic value added (EVA)
and rates of return on capital, assets, and equity.
3. Calculate and interpret key measures of operating efficiency, leverage, and liquidity.
4. How how profitability depends on the efficient use of assets and on profits as a fraction of sales.
5. Compare a company’s financial standing with its competitors and its own position in previous years.

4.1 Value and Value Added

Shareholder value depends on good investment decisions: How profitable are the investments relative to
the cost of capital? How should profitability be measured? What does profitability depend on? Shareholder
value also depends on good financing decisions: Is the available financing sufficient? Is the financing strategy
prudent? Does the firm have sufficient liquidity?

4.2 Measuring Market Value and Market Value Added

The market capitalization is the total market value of equity, which is equal to the number of shares
outstanding times the price per share. The market value added is the market capitalization minus the
book value of equity. To calculate how much value has been added for each dollar that shareholders have
invested, you must compute the market-to-book-ratio of the company:
market value of equity
market-to-book = (4)
book value of equity

4.3 Economic Value Added and Accounting Rates of Return

The profit after decuting all costs, including the cost of capital, is called the company’s economic value
added of EVA. EVA is also called residual income.
EVA = after-tax interest + net income − (cost of capital × total capitalization)
= after-tax operating income − (cost of capital × total capitalization)
EVA, or residual income, is a better measure of a company’s performance than is accounting income.
Accounting income is calculated after deducting all costs except the cost of capital. By contrast, EVA
recognizes that companies need to cover their opportunity costs before they add value. There is a clear
target: earn at least the cost of capital on assets employed. It can be helpful to measure the firm’s profits
per dollar of assets. Three common measures are the return on capital (ROC), the return on equity
(ROE), and the return on assets (ROA). These are called book rates of return, because they are based
on accounting information.
after-tax operating income
ROC = (5)
total capitalization
net income
ROE = (6)
equity
after-tax operating income
ROA = (7)
total assets

5 The Time Value of Money

Learning objectives:
1. Calculate the future value of money that is invested at a particular interest rate.
2. Calculate the present value of a future payment.
3. Calculate present and future values of a level stream of cash payments.
4. Compute interest rates quoted over different time intervals - for example, monthly versus annual rates.
5. Understand the difference between real and nominal cash flows and between real and nominal interest
rates.

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5.1 Future Values and Compound Interes
The future value (FV) is the amount to which an investment will grow after earning interest:

FV = PV × (1 + r)t (8)
Here, PV is the initial value (see next section), r is the (compound) interest rate and t is the period of
time. Compound growth means that value increases each period by the factor (1 + growth rate). The value
after t periods will equal the initial value times (1 + growth rate)t . When money is invested at compound
interest, the growth rate is the interest rate.

5.2 Present Values

Money in hand has a time value: A dollar today is worth more than a dollar tomorrow. The present
value (PV) is the value today of a future cash flow:
FV
PV = (9)
(1 + r)t
To calculate present value, we discounted the future value at the interest rate r. The calculation is therefore
termed a discounted cash-flow (DCF) calculation, and the interest r is known as the discount rate.
The factor (1 + r)− t is called the discount factor. You should never compare cash flows occurring at
different times without first discounting them to a common date. By calculating present values, we see how
much cash must be set aside today to pay future bills.

5.3 Multiple Cash Flows

To find the value at some future date of a stream of cash flows, calculate the future value
of each cash flow and then add up these future values. When we calculate the present value of a
future cash flow, we are asking how much that cash flow would be worth today. If there is more than one
future cash flow, we simply need to work out what each cash flow would be worth today and then add these
present values. The present value of a stream of future cash flows is the amount you need to
invest today to generate that stream.

5.4 Level Cash Flows: Perpetuities and Annuities

A sequence of equally spaced, level cash flows is called an annuity, e.g. a home mortgage payment. If the
payment stream lasts forever, it is called a perpetuity. The value of a perpetuity can be found with:

Cash payment from perpetuity = interest rate × present value

C = r × PV
For the value of an annuity, we can use a simple formula which states that if the interest rate if r, then the
present value of an annuity that pays C dollars a year for each of t periods is
 
1 1
Present value of t-year annuity = C −
r r(1 + r)t
The expression within the brackets is generally known as the t-year annuity factor. Cases where the first
payment is due immediately instead of at the end of the first period, are know as an annuity due.

Present value of an annuity due = present value of ordinary annuity × (1 + r)

5.5 Effective Annual Interest Rates

Interest rates may be quoted by days, months, years, or other convenient intervals. The effective annual
interest rate is then the rate at which your money grows, allowing for the effect of compounding. This
rate is also known as the annually compounded rate.

1 + effective annual rate = (1 + interval rate)year/interval

The effective annual rate is the rate at which invested funds will grow over the course of a year. It equals
the rate of interest per period compounded for the number of periods in a year.

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5.6 Inflation and the Time Value of Money
If the value of your investment grows by 6% while the prices of goods and services increase by 10%, you
actually lose ground in terms of the goods you can buy. An overall general rise in prices is known as
inflation. The increase in the general level of prices means that the purchasing power of money has eroded.
We speak of deflation when the level of prices has decreased instead of increased. The consumer price
index (CPI) tracks the level of prices. CPI measures the number of dollars it takes to buy a specified
basket of goods and surfaces that is supposed to represent the typical family’s purchases. The percentage
increase in the CPI from one year to the next measures the rate of inflation. Economists sometimes talk
about current or nominal dollars versus constant or real dollars. Current or nominal dollars refer to the
actual number of dollars of the day; constant or real dollars refer to the amount of purchasing power. The
real (not nominal) rate of interest, taking inflation into account, can be calculated by
1 + nominal interest rate
1 + real interest rate =
1 + inflation rate
Current dollar cash flows must be discounted by the nominal interest rate; real cash flows
must be discounted by the real interest rate.

8 Net Present Value and Other Investment Criteria

Learning objectives:
1. Calculate the net present value of a project.
2. Calculate the internal rate of return of a project and know what to look out for when using the internal
rate of return rule.
3. Calculate the profitability index and use it to choose between projects when funds are limited.
4. Understand the payback rule and explain why it doesn’t always make shareholders better off.
5. Use the net present value rule to analyze three common problems that involve competing projects: (a)
when to postpone an investment expenditure, (b) how to choose between projects with unequal lives,
and (c) when to replace equipment.

8.1 Net Present Value

To calculate present value, we discounted the expected future payoff by the rate of return offered by compa-
rable investment alternatives. The discount rate is often known as the opportunity cost of capital. It is
called opportunity cost because if you decide to invest in this project, you will forgo other similar investment
opportunities such as the purchase of Treasury securities. The net present value (NPV) of a project is
found by subtracting the required initial investment from the present value of the project cash flows:

NPV = PV − required investment (10)

The net present value rule states that managers increase shareholders’ wealth by accepting
projects that are worth more than they cost. Therefore, they should accept all projects with
a positive net present value.
A risky dollar is worth less than a safe one. Most investors avoid risk when they can do so without
sacrificing return. Suppose you believe that, for instance, an office development is as risky as an investment
in the stock market and that you forecast a 12% rate of return for the stock market investments. Then 12%
would be the appropriate opportunity cost of capital. That is what you are giving up by not investing in
securities with similar risk.
When dealing with a project that has multiple in- and outgoing cash flows, each individual cash flow must
be discounted with the appropriate discount factor. The NPV can then be calculated by
C1 C2 C3 Cn
NPV = C0 + + + + ... + (11)
1 + r (1 + r)2 (1 + r)3 (1 + r)n
where C0 is the (negative) initial investment and C(1,...,n) are the individual in- and outgoing cash flows,
discounted for the relevant time when they contribute to the project.
Real world decisions are rarely straightforward go-or-no-go choices; you will almost always be forced to choose
among several alternatives. In these cases, you need to rank your alternatives and select the most attractive
one. In principle, the decision rule is easy: When choosing among mutually exclusive projects, choose
the one that offers the highest net present value.

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8.2 The Internal Rate of Return Rule

Instead of calculating a project’s net present value, companies often prefer to ask whether the project’s
return is higher or lower than the opportunity cost of capital. In general, you can compute the rate of
return like this:

profit
Rate of return = (12)
investment

This suggests two rules for deciding whether to go ahead with an investment project:

1. The NPV rule. Invest in any project that has a positive NPV when its cash flows are discounted at
the opportunity cost of capital.
2. The rate of return rule. Invest in any project offering a rate of return that is higher than the
opportunity cost of capital.

Both rules have the same cutoff point. An investment that is on the knife edge with an NPV of zero will
also have a rate of return that is just equal to the cost of capital. The rate of return is the discount
rate at which NPV equals zero. This is known as the internal rate of return, or IRR. It is also
called the discounted cash-flow (DCF) rate of return. If the opportunity cost of capital is less than
the project rate of return, then the NPV of your project is positive. If the cost of capital is greater than the
project rate of return, then the NPV is negative. A high IRR is not an end in itself. You want projects that
increase the value of the firm. Projects that earn a good rate of return for a long time often have higher
NPVs than those that offer high percentage rated of return but die young. When NPV rises as the interest
rate rises, the rate of return rule is reversed: a project if acceptable only if its internal rate of return is less
than the opportunity cost of capital.

8.3 The Profitability Index

The profitability index measures the net present value of a project per dollar of investment:

net present value

Profitability index = (13)
initial investment

The profitability index is also known as the benefit-cost ratio. Economists use the term capital rationing
to refer to a shortage of funds available for investment. In simple cases of capital rationing the profitability
index can provide a measure of which projects to accept. The profitability index was designed to select
projects with the most bang per buck - the greatest NPV per dollar spent. That’s the right objective when
bucks are limited. When they are not, a bigger bang is always better than a smaller one, even when more
bucks are spent. This is a case where project comparison can go awry once we abandon the NPV rule.

8.4 The Payback Rule

A project’s payback period is the length of time before you recover your initial investment. The payback
rule states that a project should be accepted if its payback period is less than a specified cutoff
period. To use the payback rule, a firm has to decide on an appropriate cutoff period. If it uses the same
cutoff regardless of project life, it will tend to accept too many short-lived projects and reject too many
long-lived ones. The payback rule will bias the firm against accepting long-term projects because cash flows
that arrive after the payback period are ignored. In practice payback is most commonly used when the
capital investment is small or when the merits of the project are so obvious that more formal analysis is
unnecessary. Sometimes the managers calculate the discounted-payback period. This is the number of periods
before the present value of prospective cash flows equals or exceeds the initial investment. This measure
asks, How long must the project last in order to offer a positive net present value? This has the advantage
that it will never accept a negative-NPV project. The disadvantage is that it still takes no account of the
cash flows after the cut off date.

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8.5 More Mutually Exclusive Projects

When choosing among mutually exclusive projects, we must calculate the NPV of each alternative and
choose the one with the highest positive NPV. Sometimes it is enough to simply compare the NPV of two
or more projects. In other cases, choices you make today will affect your future investment opportunities.
In that event, choosing between competing projects can be trickier:

– The investment timing problem. When is it best to commit to a positive-NPV investment? The decision
rule for investment timing is to choose the investment date that produces the highest net
present value today .
– The choice between long- and short-lived equipment. We have a rule for comparing assets with different
lives: Select the machine that has the lowest equivalent annual annuity. Think of the equivalent
annual annuity as the level annual charge that is necessary to recover the present value of investment
outlays and operating costs. The annual charge continues for the life of the equipment. Calculate the
equivalent annual annuity by dividing the present value by the annuity factor.
– The replacement problem. When you are considering whether to replace an aging machine with a new
one, you should compare the annual cost of operating the old one with the equivalent
annuity of the new one.

8.6 A Last Look

The table below summarizes the decision rules that were covered in the previous sections.

9 Using Discounted Cash-Flow Analysis to Make Investment Decisions

Learning objectives:

1. Identify the cash flows from a proposed new project.

2. Calculate the cash flows of a project from standard financial statements.
3. Understand how the company’s tax bill is affected by depreciation and how this affects project value.
4. Understand how changes in working capital affect project cash flows.

9.1 Identifying Cash Flows

To calculate net present value, you need to discount cash flows, not accounting profits. If the firm lays out
a large amount of money on a big capital project, you do not conclude that the firm performed poorly
that year, even though a lot of cash is going out the door. Therefore, the accountant does not deduct
capital expenditure when calculating the year’s income but, instead, depreciates it over several years. When
calculating NPV, recognize investment expenditures when they occur, not later when they

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show up as depreciation. Projects are financially attractive because of the cash they generate,
either for distribution to shareholders of for reinvestment in the firm. Therefore, the focus of
capital budgeting must be on cash flow, not profits.
A project’s present value depends on the extra cash flow it produces. You need to forecast first the firm’s
cash flows if you go ahead with the project. The forecast the cash flows if you don’t accept the project. Take
the difference and you have the extra (or incremental ) cash flows produced by the project:

Incremental cash flow = cash flow with project − cash flow without project (14)

To forecast incremental cash flow, you must trace out all indirect effects of accepting the project, such as
erosion of the existing sales or induced later sales. Sunk costs remain the same whether or not you
accept the project. Therefore, they do not affect project NPV. The opportunity cost equals the cash that
could be realized by alternative use of the resource. It is therefore a relevant cash flow for project evaluation.
Net working capital (often referred to simply as working capital ) is the difference between a company’s
short-term assets and its liabilities. The principle short-term assets that you need to consider are accounts
receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and the principal
short-term liabilities are accounts payable (bills that you have not paid) and accruals (liabilities for items
such as wages or taxes that have recently been incurred but have not yet been paid).
Most projects entail an additional investment in working capital. For example, before you can start pro-
duction, you need to invest in inventories of raw materials. Then, when you deliver the finished product,
customers may be slow to pay and accounts receivable will increase. Investments in working capital, just
like investments in plants and equipment, result in cash outflows. The most common mistakes concerning
the cash flow from working capital are:

– Forgetting about working capital entirely.

– Forgetting that working capital may change during the life of the project.
– Forgetting that working capital is recovered at the end of the project. This generates a cash inflow.

The end of a project almost always brings additional cash flows. You might be able to sell some of the plant,
equipment or real estate that was dedicated to it. Or, you may recover some of your investment in working
capital as you sell off you inventories of finished goods and collect on outstanding accounts receivable. Often,
there are also expenses to shutting down a project. A project may also generate extra overhead costs, but
then again it may not. We should be cautious about assuming that the accountant’s allocation of overhead
costs represents the incremental cash flow that would be incurred by accepting the project.
It should go without say that you cannot mix and match real and nominal quantities. Real cash flows must
be discounted at a real discount rate, nominal cash flows at a nominal rate. Discounting real cash flows at
a nominal rate is a big mistake.
Suppose you finance a project partly with debt. How should you treat the proceeds from the debt issue and
the interest and principal payments on the debts? Regardless of the actual financing, you should view the
project as if it were all-equity-financed, treating all cash outflows required for the project as coming from
stockholders and all cash inflows as going to them. Notice that this means that when you are calculating the
working capital associated with the project, you should assume zero short-term debt or holdings of cash.
This procedure focuses exclusively on the project cash flows, not the cash flows associated with alternative
financing schemes. It, therefore, allows you to separate the analysis of the investment decision from that of
the financing decision.

9.2 Calculating Cash Flow

It is helpful to think of a project’s cash flow as composed of three elements:

Total cash flow = cash flows from capital investments

+ operating cash flows
+ cash flows from changes in working capital

To get a project off the ground, a company typically needs to make considerable up-front investments in
plant, equipment, research, marketing, and so on. These expenditures are negative cash flows. The salvage

8
value (net of any taxes if the equipment is sold) represents a positive cash flow to the firm. Operating cash
flow consists of revenues from the sale of the new product less the costs of production and any taxes:

Operating cash flow = revenues − costs − taxes (15)

Undoubtedly, the revenues are expected to outweigh the costs, and therefore operating cash flows are positive.
Many investments do not result in additional revenues; they are simply designed to reduce the costs of the
company’s existing operations. The cost savings therefore represent a positive contribution to the net cash
flow. When the firm calculates its taxable income, it makes a deduction for depreciation. When you work
out a project’s cash flow, there are three possible ways to deal with depreciation.
1. Dollars in minus dollars out. Take only the items from the income statement that represent actual
cash flows. Thus, you simply have eq. (15).
2. Adjusted accounting profits. You can start with after-tax accounting profits and add-back any
non-cash ’accounting expenses’, specifically, the depreciation deduction. This gives

Operating cash flow = after-tax profit + depreciation (16)

3. Add-back depreciation tax shield. Financial managers often refer to this tax saving as the depre-
ciation tax shield. It equals the product of the tax rate and the depreciation charge:

Depreciation tax shield = tax rate × depreciation (17)

This suggests a third way to calculate operating cash flow:

Operating cash flow = (revenues − cash expenses) × (1 − tax rate)
(18)
+ (tax rate × depreciation)
When a company builds up inventories of raw materials or finished product, the company’s cash is reduced;
the reduction in cash reflects the firm’s investment in inventories. Similarly, cash is reduced when customers
are slow to pay their bills - in this case, the firm makes an investment in accounts receivable. Investment
in working capital, just like investment in plant and equipment, represents a negative cash flow. When
inventories are sold off and accounts receivable are collected, the firm’s investment in working capital is
reduced as it converts these assets into cash. So, in general, An increase in working capital is an
investment and therefore implies a negative cash flow; a decrease in working capital implies a
positive cash flow. The cash flow is measured by the change in working capital, not the level
of working capital.

10 Project Analysis
Learning objectives:
1. Appreciate the practical problems of capital budgeting in large corporations.
2. Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by
an error in your forecast.
3. Understand why an overestimate of sales is more serious for projects with high operating leverage.
4. Recognize the importance of managerial flexibility in capital budgeting.

10.1 How Firms Organize the Investment Process

For most sizable firms, investments are evaluated in two separate stages:
1. The capital budget. Once a year, the head office generally asks each of its divisions and plants to provide a
list of the investments that they would like to make. These are gathered into a proposed capital budget.
This budget is then reviewed and pruned by senior management and staff specializing in planning and
financial analysis. Senior management’s concern is to see that the capital budget matches the firm’s
strategic plans. Once the budget has been approved, it generally remains the basis for planning over the
ensuing year.
2. Project authorizations. To get your project approved, you need to draw up a detailed proposal setting
out particulars of the project, cash-flow forecasts, and present value calculations.Your proposal will
need to be backed up with supporting information, such as engineering analyses, cost estimates from a
quantity surveyor, and market research reports.

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10.2 Some ’What-if ’ Questions
’What-if’ questions ask what will happen to a project in various circumstances. What-if analysis is crucial
to capital budgeting, it can help identify the inputs that are worth refining before you commit to a project.
These will be the ones that have the greatest potential to alter project NPV. What-if analysis indicates
where the most likely need for adjustments will arise and where to undertake contingency planning.
Uncertainty means that more things can happen than will happen. Therefore, whenever managers are given
a cash-flow forecast, they try to determine what else might happen and the implications of those possible
events. This is called sensitivity analysis.
Fixed costs are costs that do not depend on the level of output. These are costs such as electricity en
heating. Other costs vary with the level of sales. These are called variable costs. Sensitivity analysis
expresses cash flows in terms of unknown variables and then calculates the consequences of misestimating
those variables.
When variables are interrelated, managers often find it helpful to look at how their project would fare
under different scenarios. Scenario analysis allows then to look at different but consistent combinations
of variables. An extension of scenario analysis is called simulation analysis. Here, instead of specifying
a relatively small number of scenarios, a computer generates hundred or thousand possible combinations
of variables according to probability distributions specified by the analyst. Each combination of variables
corresponds to one scenario.

10.3 Break-Even Analysis

The break-even analysis is an analysis of the level of sales at which the project breaks even. The accounting
break-even point is the level of sales at which profits are zero or, equivalently, at which total revenues equal
total costs. In general,
fixed costs including depreciation
Break-even level of revenues = (19)
additional profit from each dollar of sales
A project that simply breaks even on an accounting basis gives you your money back but does not cover
the opportunity cost of capital tied up in the project. A project that breaks even in accounting terms will
surely have a negative NPV. Instead of asking what sales must be to produce an accounting profit, it is
more useful to focus on the point at which NOV switches from negative to positive. This is called the NPV
break-even point.
A company with high fixed costs is said to have high operating leverage, which is the degree to which
costs are fixed. High operating leverage magnifies the effect on profits of a fluctuation in sales. We can
measure a business’s operating leverage by asking how much profits change for each 1% change in sales. The
degree of operating leverage, often abbreviated as DOL, is this measure:
percentage change in profits
DOL = (20)
percentage change in sales
Notice that operating leverage will affect the risk of a project. The greater the degree of operating leverage,
the greater the sensitivity of profits to variation in sales. Risk depends on operating leverage. If a large
proportion of costs is fixed, a shortfall in sales has a magnified effect on profits.

10.4 Real Options and the Value of Flexibility

Some projects may take on added value because they give the firm the option to bail out if things go wrong
or to capitalize on success by expanding. These options are know as real options. Other real options include
the possibility to delay a project or to choose flexible production facilities.

12 Risk, Return, and Capital Budgeting

Learning objectives:
1. Measure and interpret the market risk, or beta, of a security.
2. Relate the market risk of a security to the rate of return that investors demand.
3. Understand why and how project risk determines the opportunity cost of capital.

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12.1 Measuring Market Risk

Changes in interest rates, government spending, oil prices, foreign exchange rates, and other macroeconomic
events affect almost all companies and the returns on almost all stocks. We can therefore assess the impact of
’macro’ news by tracking the rate of return on a market portfolio of all securities. Our task here is to define
and measure the risk of individual common stocks. Because risk depends on exposure to macroeconomic
events, we measure it as the sensitivity of a stock’s returns to fluctuations in returns on the market portfolio.
This sensitivity is called the stock’s beta, commonly denoted by the Greek letter β.

Some stocks are less affected by than others by market fluctuations. Defensive stocks are not very sensitive
to market fluctuations and therefore have low betas. In contrast, aggressive stocks amplify any market
movements and have higher betas. If the market goes up, it is good to be in aggressive stocks; if it goes
down, it is better to be in defensive stocks (and better still to leave your money in the bank). Aggressive
stocks have high betas, betas greater than 1.0. Their returns tend to respond more than one for one to
returns on the overall market. The betas of defensive stocks are less than 1.0. The returns of these stocks
vary less than one for one with market returns. The average beta of all stocks is - no surprises here - 1.0
exactly.

12.2 Risk and Return

The difference between the return on the market and the interest rate on (risk-free) Treasury bills is termed
the market risk premium. Over the past century the average market risk premium has been 7.6% a year.
That is, 7.6% is the additional return that an investor could reasonably expect from investing in the stock
market rather than Treasury bills.

Market risk premium = rm − rf (21)

where rm is the expected market return and rf is the Treasury bill rate. Beta measures risk relative to the
market. Therefore, the portfolio’s expected risk premium equals its beta times the market risk premium:

Risk premium = r − rf = β(rm − rf ) (22)

The total expected rate of return, r, is the sum of the risk-free rate, rf , and the risk premium, β(rm − rf ):

Expected return = r = rf + β(rm − rf ) (23)

This conclusion is know as the capital asset pricing model, or CAPM. The CAPM has a simple
interpretation: The expected rates of return demanded by investors depend on two things: (1) compensation
for the time value of money (the risk-free rate, rf ) and (2) a risk premium, which depends on beta and the
market risk premium.

By investing some proportion of your money in the market portfolio and lending (or borrowing) the balance,
you can obtain any combination of risk and expected return along the security market line. This line
describes the expected returns and risks from splitting your overall portfolio between risk-free securities and
the market. It also sets a standard for other investments. Investors will be willing to hold other securities
only if they offer equally good prospects. Thus the required risk premium for any investment is given by
the security market line:

Risk premium on investment = beta × expected market risk premium (24)

The basic idea behind the capital asset pricing model is that investors expect a reward for both waiting and
worrying. The greater the worry, the greater the expected return (high risk, high return). If you invest in
a risk-free Treasury bill, you just receive the rate of interest. That’s the reward for waiting (low risk, low
return). When you invest in risky stocks, you can expect an extra return or risk premium for worrying. The
capital asset pricing model states that this risk premium is equal to the stock’s beta times the market risk
premium.

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12.3 The CAPM and the Opportunity Cost of Capital
The discount rate for valuing a proposed capital investment project should be the opportunity cost of
capital, defined as the expected rate of return that the company’s shareholders should achieve by investing
on their own. But the CAPM tells us (confirming common sense) that expected rates of return depend
on risk, that is, on beta. Therefore the opportunity cost of capital for a proposed project should depend
on the project’s beta. The project cost of capital is therefore its minimum acceptable expected rate of
return, given its risk. If the CAPM holds, the security market line defines the opportunity cost of capital.
If a project’s expected rate of return plots above the security market line, then it offers a higher expected
rate of return than investors could get on their own at the same beta.
Most companies estimate a company cost of capital, which depends on the average risk of its investments.
Many companies use the company cost of capital for all capital-investment projects, which is fine provided
that all projects are close enough to average risk. Projects that involve high fixed costs tend to have higher
betas. What matters is the strength of the relationship between the firm’s earnings and the aggregate
earnings of all firms. Cyclical businesses, whose revenues and earnings are strongly dependent on the state
of the economy, tend to have high betas and a high cost of capital. By contrast, businesses that produce
essentials, such as food, beer, and cosmetics, are less affected by the state of the economy. They tend to
have low betas and a low cost of capital.
Expected cash-flow forecasts should already reflect the probabilities of all possible outcomes, good and bad.
If the cash-flow forecasts are prepared properly, the discount rate should reflect only the market risk of the
project. It should not be fudged to offset errors or biases in the cash-flow forecast.

13 The Weighted-Average Cost of Capital and Company Value

Learning objectives:
1. Calculate a firm’s capital structure.
2. Estimate the required rates of return on the securities issued by the firm.
3. Calculate the weighted-average cost of capital.
4. Understand when the weighted-average cost of capital is - or isn’t - the appropriate discount rate for a
new project.
5. Use the weighted-average cost of capital to value a business given forecasts of its future cash flows.

13.1 The Weighted-Average Cost of Capital (WACC)

The choice of the discount rate can be crucial, especially when the project involves large capital expenditures
or is long-lived. We define the company cost of capital as the opportunity cost of capital for the firm’s existing
assets; we use it to value new assets that have the same risk as the old ones. The company cost of capital
is the minimum acceptable rate of return when the firm expands by investing in average-risk projects. The
expected rates of return on investments in financial markets determine the cost of capital for corporate
investments. The company cost of capital is a weighted average of the returns demanded by
debt and equity investors. The weighted average is the expected rate of return investors would
demand om a portfolio of all the firm’s outstanding securities. The cost of capital must be based
on what investors are actually willing to pay for the company’s outstanding securities - that is, based on
the securities’ market values.
Taxes are also important because most companies are financed by both equity and debt. The interest
payments on this debt are deducted from income before tax in calculated. Therefore, the cost to the company
is reduced by the amount of this tax saving. Then, the weighted-average cost of capital, or WACC, is
   
D E
WACC = × (1 − Tc )rdebt + × requity (25)
V V

where D is the amount of debt employed, E the amount of equity, V the total sum of debt and equity
(V = D + E), Tc is the corporate tax rate, rdebt the interest rate of the debt, and requity the cost of equity.
If a project has zero NPV when the expected cash flows are discounted at the weighted-
average cost of capital, then the project’s cash flows are just sufficient to give debtholders and
shareholders the returns they require.

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13.2 Interpreting the Weighted-Average Cost of Capital
The weighted-average cost of capital (WACC) is the rate of return that the firm must expect to earn on its
average-risk investments in order to provide an adequate expected return to all its security holders. Strictly
speaking, the WACC is an appropriate discount rate only for a project that is a carbon copy of the firm’s
existing business. But often it is used as a company wide benchmark discount rate; the benchmark may be
adjusted upward for unusually risky projects and downward for unusually safe ones.
When there are no corporate taxes, the WACC is unaffected by a change in capital structure. Unfortunately,
taxes can complicate the picture. Just remember:

– The WACC is the right discount rate for average risk capital investments.
– The WACC is the return the company needs to earn after tax in order to satisfy all its security holders.
– If the firm increases its debt ratio, both the debt and the equity will become more risky. The debtholders
and equityholders require a higher return to compensate for increased risk.

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 Bibliography

[1] R. Brealey, S. Myers, and A. Marcus. Fundamentals of Corporate Finance. McGraw-Hill Education, 8th
edition, 2015.