Finals

Topic: Investment Risk, Returns and the History of Capital
Markets
Agenda
Financial Markets and the Corporate Manager
Financial Markets: Quick Facts and Implications
Return on Financial Instruments
Historical Record on Financial Returns
Risk Premium: The First Lesson
The Variability of Returns: The Second Lesson
More on Average Returns: Geometric and Arithmetic Means
Capital Market Efficiency

Kyung Hwan Shim, FINS1613S2Yr2018 1
Financial Markets and the
Corporate Manager

Financial Markets and the Corporate Manager
Financial markets:
(i) price financial securities and establish firm value (Week 8);
(ii) guide managers on how to carry out corporate valuations.

Hurdle rates in capital budgeting come from financial markets
(Week 9);
(iii) primary markets are places for raising financing capital (Week
12). Corporations would be empty shells without financial
markets.

Financial Markets: Quick Facts and
Implications

Historical Facts about Financial Markets and
Implications
We can look to financial markets for what’s an appropriate return
(hurdle rate) on non-financial assets.
Historically, financial markets have offered a reward for bearing
risk,
i.e., asset classes with greater investment risk have earned higher
average returns.
Suggests the presence of greater discounting of riskier claims in
the financial markets.
This is consistent with notions of risk aversion.

Historical Facts about Financial Markets and
Implications
Implications for the corporate manager:

– the greater the investment risk, the higher the expectation of
investment returns
– i.e., riskier projects must be assess more harshly. They must
clear a higher hurdle rate or required return.
Projects that fail to offer an adequate return commensurate with

project risk are not viable investments.
These projects destroy firm value.

Returns on Financial Instruments

Computing Realized Dollar Returns and Percentage Returns from
Financial Investments
Total Realized $ return = the return on an investment measured in $.
$ return = $Dividends + $Capital gains
$Capital gains = Price received when sold – Price paid when

bought
When measuring investment performance, it is common to include

capital gains even if the capital gain is a ‘paper’ gain.

Example: A bond was purchased for $950 one year ago. You have
received two coupons of $30 each during the one year period. You
can sell the bond for $975 today. What is your total dollar return?
Income = 30 + 30 = $60
Capital gain = 975 – 950 = $25
Total dollar return = 60 + 25 = $85

It is generally more intuitive to think in terms of % instead of $

returns.
% realized return = the return on an investment measured as a % of

the original investment = $ return/$ invested
Example Cont’d:
Income % return =
Capital Gain % return =
Total % return =

The % return on a stock is
which can be decomposed into two parts:
where

Calculating returns: The price of ABC Ltd shares was $25. After one
year, the share price is $35. Each share paid a $2 dividend during
this period. What was the total realized return on the stock over the
one year period?

Historical Record on Financial
Returns

Historical Record: The Three Asset Classes
Consider the following main asset classes:
(1) The All Ordinaries Index: tracks the top 500 Australian listed
public corporations in terms of total market value;
(2) Australian Government Bonds: A portfolio of government

bonds with an average bond maturity of 5 years;
(3) Cash: A portfolio of 13 bank bills of equal face value with an

average term to maturity of 45 days; and
(4) CPI: an index which tracks the cost of a basket of commonly

used goods and services by the average household.

Historical Record: A First Look - Figure 10.4

Quarter-by-Quarter Returns: All Ordinaries Index
All Ordinaries Index—Figure 10.5

Quarter-by-Quarter Returns: 10-year Government of Australia
Bonds
10-year government bonds—Figure 10.6

Quarter-by-Quarter Returns: Bank Bill Returns
Cash—Figure 10.7

Quarter-by-Quarter Returns: Consumer Price Index
Inflation – Figure 10.8

Risk Premium: The First Lesson

Historical Average Returns
Calculating historical average returns:
Historical average return = simple (arithmetic) average
Return over period i

Historical Average Returns
Annual average returns over the 1985–2012 period

Risk-Free Rate and the Risk Premium
Risk-free rate:
– the rate of return on a riskless investment
– the yield on short-term government treasury bonds is used
as a proxy for the risk-free rate
Risk premium:
– the excess return on a risky asset over the risk-free rate
– the reward for bearing risk
– risk-free investments have zero risk premiums
Historical average risk premiums are easy to compute: take the

average of the observed risk premiums
The First Lesson
Historically, the All Ords Index offered a significant risk premium.
Lesson 1: risky assets, on average, earned a positive risk premium.
In conclusion, on average, there has been a reward for bearing risk

in financial markets.
The Variability of Returns: The
Second Lesson

Return Frequency Distribution of the All Ords Index
A frequency distribution gives the number of times a variable was

observed to be within certain ranges based on historical
observations.
It is possible to visualized realized returns as frequency

distributions.
The spread of the return distribution depicts the variability of the

observed returns.

Return Frequency Distribution of the All Ords Index 1985-2012
Investment risk is
usually measured by
the volatility of the
observed returns.
Figure 10.9—Frequency
distribution of the
quarterly returns on
the All Ordinaries
Index, 1985–2012
(return intervals of
8.66%)

Return Variability: Return Variance and Volatility
• Variance = or 2
– Common measure of return variation
– Commonly called return variance
– Not the same ‘unit’ as returns
• Standard deviation = or
– Square root of the return variance
– Commonly called return volatility
– Same ‘unit’ as returns

Return variance: (‘ ’ = number of return observations)
Standard deviation:

(1) (2) (3) (4) (5)

Average Difference: Squared:
Year Return Return: (2) - (3) (4) x (4)
1 0.10 0.04 0.06 0.0036
2 0.12 0.04 0.08 0.0064
3 0.03 0.04 -0.01 0.0001
4 -0.09 0.04 -0.13 0.0169
Sum: 0.16 Sum: 0.027
Average: 0.04 Variance: 0.009
Standard Deviation: 0.09486833

Return Variability: Historical Return Distributions, Figure 10.10

Return Variability:
The Normal Distribution
Normal Distribution:
– a perfectly symmetric probability distribution
– has a ‘bell-shaped curve’
– completely described by the variable’s mean and variance
Q) Are investment values normally distributed?
Q) Are investment returns normally distributed?

Return Variability:
• The normal distribution Figure 10.11

Return Variability:
Example: Based on the historical return distribution for the All
Ords, what is the return range which captures approx. 66.67% of
the return observations? Assume annual returns and normality.
What about 95% of the return observations?

Return Variability: Down-Side and Up-Side Risk
The top 10 one-day % decreases and increases in the All Ords., 1984-
2012.

Return Variability: The 2008 Financial Crisis
• The S&P 500 lost 50% of its value from November 2007
through March 2009
• On the other hand, long-term US Treasuries gained 40%
during 2008
• A global phenomenon
• Volatile in both directions:
The S&P 500 doubled in value from March 2009 through
February 2011

Return Variability: The 2008 Financial Crisis

The Second Lesson
Across the three asset classes, the risker the investment returns, the
higher were the average returns.
On average, bearing risk in the stock market was very rewarding.
Lesson 2: the riskier the investment, the greater the average risk
premium.
Riskier financial investments offered a higher potential for reward
but, in any given year, there was also a significant chance of large
losses.

More on Average Returns

Geometric and Arithmetic Average Returns: Formulas
Arithmetic Average:
Geometric Average:
Where:
number of periods
return in each period
product like for sum
Calculating a Geometric Average Return
Percent One Plus Compounded

Year Return Return Return:
Mar-93 8.42 1.0842 1.0842
Jun-93 5.35 1.0535 1.1422
Sep-93 13.72 1.1372 1.2989
Dec-93 11.91 1.1191 1.4536
Mar-94 -4.84 0.9516 1.3833
Jun-94 -2.19 0.9781 1.3530
Sep-94 2.72 1.0272 1.3898
Dec-94 -4.48 0.9552 1.3275
(1.3275)^(1/8): 1.0360
Geometric Average Return: 3.60%

Geometric and Arithmetic Average Returns
Arithmetic average
– Return earned in an average period over multiple periods
– Answers the question: ‘What was your return in an average
year over a particular period?’
Geometric average
– Average compound return per period over multiple periods
– Answers the question: ‘What was your average compound
return per year over a particular period?’
• Geometric average < arithmetic average, unless all

observed returns are equal.

Capital Market Efficiency

Efficient Capital Markets
The efficient market hypothesis (EMH)

– Stocks markets are in perfect equilibrium (supply and demand)
– Stocks are ‘fairly’ priced
– Stock markets are informationally efficiency
If true, investors should not expect to earn ‘abnormal’ returns.
EMH does not mean that you can’t make money.
EMH does mean:

– on average, you will earn a return appropriate for the risk undertaken;
– there are no biases in prices that can be exploited to earn abnormal
profits;
– market efficiency will not protect investors from poor choices, i.e. lack
diversification. Kyung Hwan Shim, FINS1613S2Yr2018 44
EMH: Stock Price Reaction to News in Efficient vs Inefficient
Markets – Fig. 10.14

EMH: What Makes Markets Efficient?
What makes financial markets efficient? The short answer is the
prospect of making abnormal profits.
(1) Investors carry on research to become informed;

(2) If investors are uninformed, then stocks become mispriced and
the market will no longer be efficient;
(3) which means more informed investors will have greater
prospects of making abnormal profits from mispriced stocks;
(4) this creates an incentive to become informed;
(5) which begets more research;
(6) which begets markets to become more efficient;
(7) Back to (5), then (6); Back to (5), then (6); ... etc…
Outcome: prices converge to reflect all available information. I.e.,

markets are fully efficient
The Three Forms of Market Efficiency
3 Forms of Market Efficiency:

Strong-form efficiency:
(1) investors can not earn abnormal profits regardless of the

information they possess;
(2) the empirical evidence suggests that markets are NOT

strong-form efficient,
e.g., corporate insiders seem to make abnormal returns

from insider trading.

Semi strong-form efficiency:
(1) investors can not earn abnormal profits by trading on public

information;
(2) implies that fundamental analysis will not lead to abnormal

returns;
(3) the empirical evidence suggests that markets are generally

semi strong-form efficient.

Weak-form efficiency:
(1) investors cannot earn abnormal profits by trading on past

price information;
(2) implies that technical traders* can not make abnormal

profits;
(3) the empirical evidence suggests that markets are generally

weak-form efficient.
*technical traders rely on trading strategies based on past price data.

STRONG
Public & private
information
WEAK
Security market
SEMISTRONG information
Public information
Conclusion
Historically, on average, there has been a reward for bearing risk in
financial market;
The relationship between risk premium and investment risk was

positive.
Market efficiency means that security prices should not be too high or
too low deviating from fundamentals.
Financial markets serve an important purpose for Corporate Finance.

Among many things, the market offers the manager guidance on how
to value projects.
Textbook problems: Questions and Problems: 1-4,7, 9,21,22,23-27.

Critical Thinking and Concepts Review: 1-10.
Topic: Risk, Return and the CAPM
Agenda:
Expected Return and Volatility on Single Assets and Portfolios
Realized vs. Expected Returns
Market Risk vs. Idiosyncratic Risks

Diversification and Portfolio Risk
Measuring and Interpreting the Beta of an Asset
The Capital Asset Pricing Model
The Security Market Line: The Relationship Between Required Returns
and Betas
Expected Return and Volatility
on Single Assets

Future Risks and Returns
Historically,
(i) financial markets have offered a risk premium and;

(ii) greater exposure to investment risk meant higher average returns.
In corporate finance, investments are made with an eye towards the

future.
Therefore, more important than historical returns are expectations of

future investment risks and returns.

Expected Return
Expected return represents the best guess of what the return will turn
out to be.
Expected returns are based on probabilities of possible future

outcomes.
where:
= probability that state ‘ ’ will occur
= expectation of future return if state occurs
= total number of states

Computing Expected Return: Example
Suppose there are 3 possible states of the economy next year with the
following probabilities of realization: Boom w/ probability of 25%;
Neutral, 50%; and Recession, 25%. Historically, stocks A and B have
offered the following average returns in each state of the economy
States
States Recession Neutral Boom
.25 .50 .25
Stock A -20% 15% 35%
Stock B 30% 15% -10%
Assuming the same average returns across states, what is the expected
return of stocks A and B for next year?
+ +
+ +

Expected Return Volatility
Expected return volatility represents the best guess of return risk.
Computed based on outcome probabilities and deviations from

expected return.

Computing Expected Return Volatility: Example Cont’d
+
+

Expected Return and Volatility
on Portfolio of Assets

Portfolio of Assets
A portfolio is a collection of assets.
A portfolio’s risk and return are determined entirely by the risks and
returns of its components.
One can look at the All Ords as a portfolio (of stocks)
Similarly, a company can be viewed as a portfolio of real assets

(human capital, physical capital, patents) or projects (project A,
project B, …).
One can assess the expected performance of a portfolio by the

expected return of its components.

Portfolio Expected Return
Portfolio expected return is a weighted average of the expected

return of each asset in the portfolio.
where
, asset j portfolio weight
return on asset j

Portfolio Expected Return: Example
Back to 1st example. Assume a portfolio with weights

in stocks A and B.
States
States Recession Neutral Boom Expected
Return
.25 .50 .25
Stock A -20% 15% 35%
Stock B 30% 15% -10% 12.50%
Portfolio .3 11.25%
+.7 12.50%
=12.125%

Portfolio Expected Return: Another Example
John has $15,000 invested in stocks with the amounts described in the table
below. What are the portfolio weights in each security? What’s the expected
return on John’s portfolio?
Stock E[r] $ Invested % of Portfolio Value w x E[r]
(w)
Double Click 19.65% $2,000 $2,000 2.62%
$15,000
Coca Cola 8. 96% $3,000 $3,000 1.79%

=20%
$15,000
Intel 9.67% $4,000 $4,000 2.58%
=26.67%
$15,000
Keithley Ind. 8.13% $6,000 $6,000 3.25%

=40%
$15,000
Total $15,000 100% 10.24%
Portfolio Expected Return
Alternatively, one can compute portfolio expected return as a
weighted average of portfolio returns across states.
I.e.,
where
= particular state out of the possible states
= probability that state is realized
= portfolio return in state
= total number of states.

Expected Portfolio Returns: Example
Back to 1st example. Assume a portfolio with weights

in stocks A and B.
States
Return
.25 .50 .25
Stock A -20% 15% 35%
Stock B 30% 15% -10% 12.50%
Portfolio −20%) 15% 35% .25 15%
30% 15% −10%) +.50 15%
15% 15% 3.5% +.25 3.5%
=12.125%

Portfolio Return Volatility
(i) Compute the expected portfolio return for each state
+ +…+
where m denotes the total number of stocks in the portfolio, and

denotes a particular state out of possible outcomes
(ii) Then compute portfolio return volatility using the same

formulation as for individual assets
Portfolio return volatility is NOT a weighted average of the return

volatilities of the assets in the portfolio.
Portfolio Return Volatility: Example
Back to 1st example. Assume a portfolio with weights in
stocks A and B.
States
Return
.25 .50 .25
Stock A -20% 15% 35%
Stock B 30% 15% -10% 12.50%
Portfolio −20%) 15% 35% 12.125%
30% 15% −10%)
15% 15% 3.5%
,

Realized vs. Expected Returns

Realized vs. Expected Return
Realized returns, in general, do not eventuate to be the same as past
expectations of returns. I.e.,
where denotes the time expectation of time return.
The unexpected component of return is
is a ‘surprise’ that is not anticipated at time and it can be

positive or negative.

Realized vs. Expected Return
In efficient markets, abnormal profits have zero expected values.
Therefore, should have a time expected value of zero. That is,
That is, in efficient markets, the current market expectation of future

returns are not biased.
Looked differently, stocks at time are fairly priced based on the

information that is available to investors at time t.

Realized Return vs. Expected Return: Example
Back to 1st example. Suppose that a recession occurred over the

past year. Assume furthermore that the realization of stock returns
was the same as historical averages during recessions. What was
the surprise return for stocks A and B based on last year’s
expectations?
For stock A:
For stock B:
Is this evidence that markets are inefficient?

Market Risk vs. Idiosyncratic
Risks

Investment Risks
Total investment risk = market risk + investment-specific risks
Market risk: risk that influences the overall stock market. Also called
systematic risk.
Examples: unexpected changes in GDP, unemployment, inflation,

interest rates.
Asset-specific risks: risks that affect an individual asset only. Also

called non-systematic or idiosyncratic risks.
Examples: corporate fraud, labor strike in a company, fire in a

production plant, default on corporate debt.

Diversification and Portfolio
Risk

Portfolio Diversification
Diversification: spreading of investment across several assets to
reduce total investment risk.
Recall from the portfolio example:

,
With many assets in a portfolio, the positive and negative idiosyncratic

surprises of each asset cancel each other out.
Hence, the overall risk of a portfolio tends to be much lower than that
of the average asset in the portfolio.
Market risk affects all assets in a portfolio in the same direction. No

matter how well-diversified, market risk cannot be eliminated
completely. Kyung Hwan Shim, FINS1613S2Yr2017 24
Table 11.7

Portfolio Return Volatility
Diversifiable risk
22.90%
17%
Portfolio Market Risk

(Non-diversifiable risk)
1 10 20 30 … 1,000 Number of
stocks in portfolio

Measuring and Interpreting the
Beta of an Asset

The Risk Return Trade Off
Recall that historically there was a reward for bearing risk in
financial markets (Wk 6).
A well-diversified investor in the stock market will only care about

market risk.
The Risk Reward Trade Off:
In financial markets, there is a reward for bearing systematic risk

only. Idiosyncratic risks do not offer a risk premium.
Logic: Investors fear systematic risk only. Idiosyncratic risks are

eliminated through portfolio diversification.
Therefore, markets price instruments to earn a compensation for

exposure to systematic risk
Kyungonly.
Hwan Shim, FINS1613S2Yr2017 28
Measuring Market Risk: The Beta
An asset’s expected risk premium is related to market expected risk premium:
measures the sensitivity of an asset’s risk premium to market risk premium.
Market risk premium is the risk premium on the Market portfolio.
Market portfolio is an aggregation of all the stocks in the stock market. By

definition, the market portfolio has a of 1.
High stocks are particularly sensitive to market fluctuations. Low stocks are
less sensitive to market fluctuations.
The average of all stock s in the stock market is 1.

Market Risk vs. Total Risk
Cyclical stocks tend to have higher betas.
Defensive stocks tend to have lower betas.
While stocks can have different betas, they can also have different
total risks.
For example, a low beta stock may be very risky
whereas a high beta stock may have low overall risk.
A well-diversified investor will only care about stock betas.

Examples of Stock Betas (Estimates)
Table 11.8

Expected Returns and Betas
Portfolio Beta:
Mathematically similar to computing portfolio returns.
Example with 2 securities:

in stock A, with and
in stock B, with and

The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM)
Recall the relation between an asset’s expected risk premium and the
market expected risk premium:
The CAPM describes the relationship between market risk and expected
return:
Factors affecting the expected return on an asset:
(i) pure time value of money, captured by ;

(ii) reward for bearing systematic risk in financial markets, captured by
;
(iii) amount of systematic risk, captured by
Implementing the CAPM
CAPM:
: return on a riskless asset. A good proxy is the yield on short

term government Treasury Bills (T-Bills). In Australia, use bank
bills.
: expected equity risk premium.
In Australia, a good proxy for the equity market is the All Ords
Index. A good proxy in the US is the S&P 500.

CAPM Example
A stock has a of 0.8 and the yield on short-term T-Bills is 4%. If

the market is expected to have a return of 10%, what is the
expected return on this stock?
Predict 𝑗 using the CAPM

CAPM Example
The announcement of new rosy economic conditions was just made.
Economists now predict a higher aggregate well in the economy will
make investors less risk averse. What is the expected return on the
stock if the market risk premium is now expected to be 4%?
A lower equity risk premium means there is a lower compensation

for systematic risk.
Required returns are lower now due to rosy economic conditions.
I.e., investors are willing to pay more for risky investments.

The Security Market Line

Security Market Line and the CAPM
The relationship between expected returns and betas across all

assets can be depicted by a single straight line.
Recall from the CAPM that
s are linear in s.
Security Market Line (SML): The relation between all and all
.

Security Market Line
expected
return
beta

Security Market Line and Market Efficiency
Market efficiency ensures that in equilibrium the reward-to-risk ratio
is the same across all stocks in the market since they are all on the
same Security Market Line.
Assume stocks . Market efficiency means that the reward-to-

risk ratio is given by
SML slope =
If is the market portfolio, then
since Kyung Hwan Shim, FINS1613S2Yr2017 41

Security Market Line and Market Efficiency
Assume two stocks and in an inefficient market , such that:
Since = (assuming no dividends), the above expression is

equivalent to:
, , , ,
, ,
,
For and to be on the same SML, , must be higher and , must be

lower.
Hence is undervalued andKyungisHwan

overvalued.
Shim, FINS1613S2Yr2017 42
Security Market Line and Inefficient Markets
expected
return
Undervalued stock
Overvalued stock
beta

Security Market Line and Inefficient Markets: Example
Assume a market with the following current share prices and
expectations of returns and betas:
Is this an efficient market?
Which stocks is overvalued and which stock is undervalued?

Conclusions
History tells us that on average there was a reward for bearing risk in
financial markets.
This was reward to market risk, not idiosyncratic risks.
Market risk is a fundamental factor that affects all assets in the

economy.
Implications for the corporate manager: Projects must offer a higher

return if it has higher market risk. Projects with higher market risk
must be assess more harshly (must clear a higher hurdle rate).
Textbook exercises:
– All critical thinking problems
– Questions and Problems: 7,10,11,17,18-20,22-24,25,29
Topic: Cost of Capital
Agenda:
Cost of Capital in a Nutshell
Cost of Capital of All-Equity Financed Firms
Cost of Capital of Indebted Firms: the Weighted Average Cost of
Capital (WACC)
• Cost of Equity
• Cost of Debt
• Cost of Preference Shares
Hurdle Rates:
• the Pure Play Approach
• the Subjective Approach


The cost of capital has two main meanings in corporate finance:
- (1) Company’s overall cost of capital: a composite return

required from the firm as a whole.
- (2) Project’s cost of capital: the minimum rate of return required

from a specific project. The project’s hurdle (discount) rate in
NPV calculations.
The cost of capital is an important input in corporate valuations.

Cost of Capital of All-Equity
Financed Firms

Cost of Capital of All-Equity Financed Firms
For an all-equity financed firm:

Owning the business = Owning all of the shares
Business value = Equity value
Business risk = Equity risk
Business systematic risk = Equity systematic risk
Required return on the business’s assets = Required return
on the firm’s equity
I.e., company’s overall cost of capital = required rate of return on

the company’s stocks

Cost of Capital of All-Equity Financed Firms: Example
ABC Ltd. stocks have a = 0.8. If the market risk premium is

expected to be 10% and currently treasury bills are yielding 5%,
what is ABC’s cost of capital?
Answer:
ABC’s cost of capital is 13%.

Cost of Capital of Indebted Firms

Cost of Capital of Indebted Firms: Capital Structure
The cost of capital of an indebted firm is the mixture of returns

needed to compensate both creditors and shareholders.
Capital Structure: how a firm finances its operations. It’s the mix
of debt and equity financing chosen by the firm.
Debt financing comes from bondholders, investors of notes

payables, and other lenders.
Equity financing comes from common and preference

shareholders, and retained earnings.

Cost of Capital of Indebted Firms: Capital Structure
One can view a firm as a portfolio of the firm’s debt , common

equity and preference equity .
Hence, the total market value of the firm amount to
Dividing both sides by gives
and denote the portfolio weights on the firm’s debt,

common equity and preference shares, respectively.

Cost of Capital of Indebted Firms: Capital Structure Example
XYZ Ltd. has outstanding debt amounting to a total market value of

$30M and a total of 10M common shares outstanding currently
trading at $23 per share.
Q) What is the current capital structure of the firm?
A)

Cost of Capital of Indebted Firms
The overall cost of capital of an indebted firm is a mixture of returns

needed to compensate both creditors and shareholders
The Weighted Average Cost of Capital (WACC):
+ +
where and denote the cost of debt capital, equity capital

and preferred equity capital, respectively.

Cost of Capital of Indebted Firms: Example
XYZ Ltd. has outstanding debt amounting to a total market value of

$30M and a total of 10M common shares outstanding currently
trading at $23 per share. The cost of debt and equity capital for XYZ
are 5% and 10% respectively.
Q) What is XYZ’s overall cost of capital?
A)
+
+

Cost of Capital of Indebted Firms:
The Tax Deductibility of Debt

Debt and Taxes
If the firm is not tax-exempt, then debt cost is tax-deductible.
Example:
D = 6250 with
Unlevered Firm Levered Firm
EBIT 5000 5000
Interest 0 500
Taxable Income 5000 4500
Taxes (30%) 1500 1350
Net Income 3500 3150
Cash Flow 3500 3650
Cost of Capital of an Indebted Firm With Corporate Taxes
Debt has an advantage over equity financing because debt reduces

the portion of profits paid to the government.
The actual post-tax cost of debt is lower by
WACC with taxes:
+ +

Cost of Capital of an Indebted Firm With Corporate Taxes
Example : XYZ Ltd. has outstanding debt amounting to a total market

value of $30M and a total of 10M common shares outstanding
currently trading at $23 per share. The cost of debt and equity for
XYZ are 5% and 10%, respectively, and the corporate tax rate is 30%.
Q) What is XYZ’s overall cost of capital?
A)
+
+
Note that with taxes the WACC is now lower by

Estimating the Inputs to WACC:
Cost of Common Equity Capital

Estimating the Inputs to WACC: Cost of Common Equity Capital
The cost of common equity is the return that the common
shareholders expect to earn from investing in the shares of the firm.
One way to estimate the cost of common equity is by relying on the

Dividend Growth Model.
, rearranging we get
: Current stock price

: Next period’s dividend
: Dividend growth rate
: cost of equity

Dividend Growth Model Approach
Advantage:
- Simple and easy to implement
Disadvantages:
- applicable for dividend paying firms only;
- assumes constant dividend growth;
- often relies on historical data for predicting future dividend
growth;
- very sensitive to estimates of ;
- does not explicitly consider risk in the same way as the CAPM
does.

The CAPM Approach:
Advantages:
- explicitly accounts for the risk premium;
- applicable to all companies, not just those with steady dividend
growth.
Disadvantages:
- relies on forecasts of market risk premium and equity beta;
- often forecasts are based on historical data;
- if based on historical data, then applicable only for public firms.

Finding the Inputs to WACC:
Cost of Debt Capital

Estimating the Inputs to WACC: Cost of Debt Capital
The cost of debt is the return demanded by the lenders of the

firm.
For a firm that only has bonds and no other sources of debt, the
cost of debt is the yield to maturity on the company’s bonds.
The coupon rate is not the cost of debt.
If the company’s debt is not traded, then one can use the yield on
bonds of similar firms with similar credit rating.

Finding the Inputs to WACC:
Cost of Preference Equity Capital

Estimating the Inputs to WACC: Cost of Preferred Equity Capital
Preferred stocks tend to pay a fixed dividend, every period, for as

long as the company stays in operation.
Preferred dividends are very stable and rarely missed or modified,

hence one can rely on the perpetuity formula.
The cost of preferred equity is given by the dividend yield. I.e.,

Finding the Inputs to WACC: Putting
It Together

WACC: Putting It Together
Example: ABC’s only debt is a 20-yr bond issuance with a total face
value of $1.2M and an annual coupon rate of 15% (the first coupon
payment was just made). Today, the debt is priced in the market to
yield 8% return.
ABC also has 10,000 preferred shares outstanding priced at $56

each paying a 10% dividend rate on a liquidating (par) value of
$100.
ABC’s 3M common shares outstanding are priced at $3.5 each and

have a beta of 1.4. ABC’s corporate tax rate is 35%.
The market risk premium is expected to be 12% and the risk free
rate is 5%.
Q) What is the return required by ABC’s preferred shareholders?

Q) What is ABC’s before-tax cost of debt?
Q) What is ABC’s cost of common equity capital?
A) Cost of Preferred Equity:
Div 10% 100
rP 17.86%.
P 56
Pre Tax Cost of Debt: 8%, the bonds yield to maturity.
Cost of Common Equity:

rE rf E[rm rf ] 5% 1.4 12% 21.80%.

Q ) What is ABC’s overall cost of capital?
E pE # of common shares oustanding=$3.5 3M=$10.5M
19
15% $1.2M $1.2M
D $2.0067 M
t 1 (1.08)t (1.08)19
P p p # of preferred shares oustanding=$56 10, 000 $.56M
V D E P $2.0067 M $10.5M $.56M $13.0667M

ABC’s overall cost of capital:
D E P
WACC rD (1 T ) rE rP
V V V
2.0067 10.5 .56

8% (1 .35) 21.80% 17.86%
13.0667 13.0667 13.0667
19.08%

Cost of Capital in Project Analysis

Project Cost of Capital: Interpreting the WACC
The WACC is the firm’s cost of capital if the firm needs to raise an
additional dollar today.
The WACC is the correct hurdle rate for projects that have the same
systematic risk as the company’s overall assets.
Therefore, the WACC is typically used as the hurdle rate for

expansions or contractions of existing projects.
The WACC is not be correct hurdle rate for projects with different
systematic risk.

Project Cost of Capital: Defining the Hurdle Rate
The Security Market Line tells us the reward for bearing systematic
risk in financial markets.
At a minimum, projects must earn a return in line with what

investments in financial markets offer for the same amount of
market risk.
Given the right hurdle rate , if then the project creates

firm value.
A positive NPV project is akin to an undervalued stock. It’s similar to

a stock which is plotted above the SML line.

Project Cost of Capital: +/- NPV Projects as Under/Over Valued Assets
Expected
return
Undervalued asset
Overvalued asset
beta

Project Cost of Capital: CAPM and Hurdle Rates
Hurdle rates based on the CAPM:
compensation for the time value of money.
equity risk premium
compensation for bearing systematic risk.
It is difficult to implement the CAPM for projects.
Two alternatives: the Pure Play Approach; and the Risk-Adjustment

Approach.

Project Cost of Capital:
The Pure Play Approach

Project Cost of Capital: The Pure Play Approach
A pure player is a company that operates in a single line of business.

A pure player always invests in similar projects.
Steps in the pure play approach:
1) Find public pure players that invest exclusively in the type of

projects under evaluation.
2) Compute the WACC of these pure players.
3) Compute the average of the WACCs of the pure players.
This approach assumes the cost of capital of pure players represents

what the investors demand from assets in the same risk class as the
project.
Project Cost of Capital: Company WACC vs. Project Cost of Capital
A company’s WACC is the correct hurdle rate for projects that have
the same amount of systematic risk as the overall operations of
the firm.
Consistently relying on the company’s WACC as the hurdle rate for

projects with different risk will
(i) destroy firm value; and
(ii) increase the firm’s overall risk.

Project Cost of Capital: Company WACC vs. Project Cost of Capital

Project Cost of Capital:
The Risk-Adjustment Approach

Project Cost of Capital: The Risk-Adjustment Approach
Companies sometimes adopt an approach that involves making

subjective adjustments to the company’s WACC.
Subjective Approach: add a risk adjustment to the company’s

WACC.
Use positive adjustments for projects deemed to have a higher beta;
or negative adjustments for projects deemed to have a lower beta.
This approach does not rely explicitly on a formula.
The company’s WACC serves as a baseline and adjustments are

made to obtain a hurdle rate closer to the Security Market Line.
Project Cost of Capital: The Risk-Adjustment Approach

Project Cost of Capital: WACC vs. Project Cost of Capital
Example: BigCorp is all-equity financed and operates in a multitude of
sectors. BigCorp has a beta of 1 for the foreseeable future. The risk-
free rate is 5% and the market portfolio is expected to return 10%.
BigCorp is assessing the merits of two projects. Project A has a beta of

2 and project B has a beta of 0.5.
BigCorp's managers are certain that projects A and B will offer a

return of 12% and 9% respectively based on their assessments.
Which project has a +NPV and which one has a -NPV?
What decisions will BigCorp’s management make if they rely on the

WACC as the hurtle rate for both projects?

Project Cost of Capital: WACC vs. Project Cost of Capital
beta

Conclusion
The trade off between risk and return is a fundamental concept in

Corporate Finance.
In line with financial markets, projects must compensate investors

for time value and systematic risk.
Hurtle rates must reflect the systematic risk of projects.
Work on all the Critical Thinking and Concept Review problems.
Questions and Problems: 2,3,4,5,6,7,8,9,10,12b, 12c, 14,

15,16,17,21, 23

Topic: Financial Leverage and Capital Structure
Agenda:
Capital Structure in a Nutshell
Financial Leverage and Its Impact on Equity Risk
Homemade Leverage: Replicating the Financial Leverage of a Firm
Modigliani and Miller’s (M&M) Propositions in an Ideal World
M&M Propositions in a Taxable World
M&M Propositions in a World with Taxes and Bankruptcy

Capital Structure in a Nutshell

The Capital Structure Question
Recall the formulation:
which takes the capital structure of the firm as given.
The is commonly used as the discount rate to value a firm’s

assets. E.g.,
×( )
where denotes the expected value of the firm’s EBIT (a perpetuity).
Question: What is the optimal debt choice ∗ which maximizes firm

value ?
Answer: It must be the debt choice which minimizes .
Financial Leverage and Its Impact on
Equity Risk

What is Financial Leverage?
Capital Structure: The mix of debt and equity which makes up the
total firm value.
Financial Leverage: the extent to which a company is committed to

fixed charges related to interest payments. A consequence of
capital structure choice. Measured by:
– the debt-to-value ratio: , or
– the debt-to-equity ratio:
Market leverage uses market values of and , contrary to book

leverage, which relies on book values from accounting statements.

The Effects of Financial Leverage
Currently the company has no debt. The proposal is to issue debt and use
the proceeds to buy back shares, i.e., undergo a capital restructuring.


From the example:

- when EBIT is high, financial leverage raises ROE and EPS even
higher
- when EBIT is low, financial leverage lowers ROE and EPS even
lower
Financial leverage amplifies the volatility of ROE and EPS caused by

changes in EBIT.
Conclusion: Financial leverage makes the shares of the company

riskier.
Financial Leverage and Break-Even EBIT
Break-even EBIT is the level of EBIT which makes earnings per

share the same between the debt and no debt alternatives:
From the previous example we have,

Financial Leverage and Break-Even EBIT
If we expect EBIT to be greater

than the break-even point,
then leverage is beneficial to
the shareholders
otherwise, leverage is
detrimental.
Since EBIT varies overtime,

financial leverage amplifies the
variability of equity returns.

Homemade Leverage: Replicating
the Financial Leverage of a Firm

Corporate Borrowing vs Homemade Leverage
Homemade leverage: the use of personal borrowing or lending to change
an investor’s exposure to financial leverage

Homemade Leverage: Main Conceptual Points
Shareholders that prefer higher financial leverage can borrow and

then invest the proceeds in additional shares of an unlevered firm.
Similarly, shareholders that prefer lower financial leverage can sell

the shares of a levered firm and lend the proceeds.
That is, investors can create financial leverage on their own

(homemade leverage).
It makes no difference to shareholders whether a firm chooses a

higher or lower financial leverage.
Modigliani & Miller (M&M): With homemade leverage, firm value

is independent of capital structure choice.
Modigliani and Miller’s Propositions
in an Ideal World

Modigliani and Miller
M&M proposed that firm value changes only if there is a change in:
(i) the risk of cash flows, and/or

(ii) the level of cash flows
The total value of a firm is not affected by the amount of debt and
equity. I.e.,
Debt
Debt 0%
Equity
40%
= 40% =
Equity Debt
60% 60%
Equity
100%
Modigliani and Miller’s Proposition I
M&M Proposition I: The firm value is independent of capital

structure choice.
Assume two identical firms and with the same amount of

operating cash flows each year, except firm is levered and firm
is not levered (unlevered). and should have the same market
value, i.e.,
Corollary: Since is the same for both firms, the is also the
same.
Modigliani and Miller’s Proposition II
M&M Proposition II: A firm’s cost of equity is increasing in financial
leverage.
’s Overall Cost of Capital:
‘s Overall Cost of Capital:
s Equity Cost of Capital (M&M Prop. II):
)
Modigliani and Miller’s Proposition II

Modigliani and Miller’s Proposition II and Betas
Based on M&M Proposition II:

.
Substituting in the CAPM equation gives the following:
If there is no fear of bankruptcy then debt is riskless, i.e.
D ,
and equity beta becomes

Modigliani and Miller’s Propositions I and II: Example
No-debt Inc. is an all-equity firm. Its equity beta is .80. The T-bill
rate is 5% and the market risk premium is expected to be 10%.
Assume that No-debt is tax-exempt.
a) What is No-debt’s asset beta?
b) What is No-debt’s WACC?

Modigliani and Miller’s Propositions I and II
Suppose that No-Debt issues a small amount of debt — so small that

investors perceive the bonds to be risk-free. After the issue, debt
comprises 10% of the firm’s capital structure.
a) What is the beta and the required rate of return on the debt?
b) What is the new beta and required rate of return on the firm’s
equity?
c) What is No-Debt’s WACC under the new financing mix. Has the
WACC changed? Interpret the results.
d) Calculate No-Debt’s asset beta given the new financing mix. Has
the beta changed?

Modigliani and Miller’s Propositions I and II with No Taxes
a ) S in c e th e d e b t is r is k le s s , D 0 and RD 5% .
b) 1 D .8 1 1 .8 9
E A E 9
RE RA (R A RD ) D
E
13% (1 3 % 5% ) 1 1 3 .8 9 %
9
c) W A CC 0 . 9 1 3 . 8 9 % 0 . 1 5 % 1 3 % (n o c h a n g e )
T h e g r e a t e r f in a n c ia l le v e r a g e h a s in c r e a s e d R E , b u t it
p la c e s a g r e a t e r w e ig h t o n d e b t , w h ic h h a s a lo w e r c o s t .
T h e n e t e f f e c t is a n u n c h a n g e d W A C C .
d) D E .1 0 .9 .8 9 . 8 (n o c h a n g e ).
A V D V E
in a Taxable World

Corporate Taxes and After Tax Cash Flows
In the real world,

(i) firms must pay taxes; and
(ii) borrowing risks exposing investors to bankruptcy.
We consider the tax implications first.

- Interest expense is tax deductible. This gives rise to tax shields.
- Interest Tax Shield: The tax saving related to borrowing.
- Debt financing increases the amount of free cashflows to all
investors.
- Therefore, debt financing can increase firm value.

Corporate Taxes and After Tax Cash Flows
D = 6250 with
Unlevered Firm Levered Firm
EBIT 5000 5000
Interest 0 500
Taxable Income 5000 4500
Taxes (30%) 1500 1350
Net Income 3500 3150
Cash Flow 3500 3650

Interest Tax Shield and Firm Value
Annual interest tax shield:
6250 in debt @ 8% = 500 in interest expense
Annual tax shield =
PV of Interest Tax Shields in the M&M World:
Assuming tax shields can be valued at
The existence of corporate taxes makes debt financing appealing.

M&M Proposition I with Corporate Taxes
Consider firms and again.
What is and ’s firm value if profits are taxable?
A fter ta x cash flo w fo r U is EBIT (1 T )
EB IT (1 T )
VU PV o f EB IT (1 T )
RU

L 's after tax ca sh flo w :

(EB IT RD D ) (1 T ) RD D EBIT (1 T ) T D RD
cash flow to cash flow to
equ ityho lders d ebth o lders
VL PV o f EBIT (1 T ) PV o f T D RD
M&M Proposition I with Corporate Taxes:
VL VU PV o f Tax Sh ield From D eb t

T D RD
VL VU VU T D
RD

M&M Proposition II with Corporate Taxes
With corporate taxes, the value of the firm is increasing in financial

leverage.
A higher firm value means that the of the firm is decreasing in

financial leverage.
if profits are taxable:
D E
W ACC RD (1 T) RE
V V

Define RU the unleveraged cost of capital, i.e., the of the firm if

.
M&M Proposition II with Corporate Taxes:
D
RE RU (R U RD ) (1 T)
E
Implications for cost of equity are similar to the case without taxes.
Equity risk increases with financial leverage, but less rapidly.


M&M Propositions with Corporate Taxes
Q) What is No-Debt’s firm value before and after the leverage
change if it has perpetual expected pre-tax earnings of $5K and the
corporate tax rate is 30%?
A) With ,
With

M&M Propositions with Corporate Taxes
Alternatively,

in a World with Taxes and
Bankruptcy

Bankruptcy Costs
Direct bankruptcy costs: Expenses related to bankruptcy, such as
legal fees, court fees and other administrative costs.
Indirect bankruptcy costs: Economic costs related to difficulties

running a distressed business. Examples:
– disruptions in operations and loss of customers;
– tighter credit constraints from suppliers and banks;
– loss of employees and customers;
– damage to firm’s reputation;
– foregone +NPV investment opportunities;
– etc...
Both direct and indirect bankruptcy costs have a negative impact on

firm value.
M&M Propositions with Tax and Bankruptcy Costs
Debt
(i) generates tax shields (+);
(ii) also creates costs of financial distress (-)
The optimal amount of debt financing ∗ is a compromise between
tax savings and financial distress costs.
M&M Proposition I with Taxes and Bankruptcy:
∗
If , PV of Tax Shields dominates PV of Distress Costs;
∗
If , PV of Distress Costs dominates PV of Tax Shields.
M&M Proposition with Tax and Bankruptcy Costs

M&M Proposition with Tax and Bankruptcy Costs
The optimal amount of debt is where the PV of tax shield gained

is exactly offset by the rise in the PV of distress cost resulting from
an incremental increase in , i.e.
is also where the firm value is maximized.

M&M Proposition with Tax and Bankruptcy Costs: Example
Assume ABC operates in a M&M world with corporate taxes and

bankruptcy. Research shows that certain levels of debt are associated
with an incremental PV of financial distress costs as shown in the
table below. Based on your research, what is the debt amount that is
closest to optimal for ABC? ABC has a tax rate of 35%.
Debt Incremental PV of
Financial Distress Costs
a) 83.3M 0.50
b) 70.2M 0.42
c) 60.7M 0.34
d) 51.4M 0.30
e) 43.6M 0.23

Conclusion
Financial leverage increases equity risk, equity beta, and the cost of
equity capital.
In an environment with taxes and bankruptcy costs, the ideal mix of

debt and equity is one that:
(i) maximizes firm value or
(ii) minimizes the firm’s
Problems:
• Critical Thinking and Concepts Review: 13.1-13.6
• Questions and Problems: 1-8, 11-17

Topic: Dividends and Dividend Policy
Agenda:
The Different Kinds of Distributions
The Payment Process and the Ex-Dividend Price
Modigliani and Miller’s Dividend Irrelevance Proposition
Homemade Dividends
Real World Factors Affecting Dividends
Establishing Dividend Payments Prudently
Stock Dividends, Stock Splits and Stock Repurchases

The Different Kinds of
Distributions

Regular Cash Dividend: cash payment made directly to

shareholders. Periodic, usually quarterly, payment in normal
course of business.
E.g., Apple’s most recent dividend was $0.73 per share
on Aug. 17, 2018. Apple has been paying regular quarterly
dividends since 1987.
Extra Cash Dividend: non-periodic cash payment normally paid

in conjunction with a regular dividend.
Special Dividend: a one time cash payment arising from an

extraordinary event.
E.g., Microsoft paid $32 Billion on Dec 02, 2004 to
reduce cash stockpile.
Liquidating Dividend: a cash payment arising from the sale of an

asset, division or subsidiary.
E.g., $84 Billion ($24 Billion in cash) by Vodafone from sale
of 45% stake in Verizon Wireless to Verizon Communication
Stock Dividend: an issuance of stocks to existing shareholders
Share repurchase: a cash payment to shareholders by means of

purchasing a portion of shares outstanding
E.g., Since 2012 Apple repurchased more than $275B in
shares. Apple has a cumulative repurchase plan of $300B by the
end of March 2019.

Microsoft Corp.’s Dividends
Microsoft: Trades on Nasdaq with ticker symbol MSFT

Incorporation date: 1981
IPO: date March 13, 1986, offer price $21 per share
First Dividend Payment: $0.08 per share on March 7, 2003
Initiation of Regular Dividends: Fiscal year 2005, $0.08 per share
paid quarterly
Latest Reg Div: Sept 13, 2018, $0.42 per share, total $3.268 B
Special Div: $3.00 per share on Dec 02, 2004, total $32 B

Microsoft Corp.’s Dividends

Payment Process and the Ex-
Dividend Price

Dividend Payment Process
i) The payment is decided by the Board of Directors. An

announcement is made on the declaration date
ii) The dividend is distributed on the payment date to all

shareholders of record as of the record date (which is usually 2-
3 weeks prior to the payment date)
iii) The record date is the date on which holders of record are
designated to receive the dividend
iv) To be a shareholder of record, one must own stocks at the

time the market closes one day prior to the ex-dividend date.
The ex-dividend date is 4 business days prior to the record date

Timeline of Dividend Payments
4 business
days 2-3 weeks
Declaration Ex-dividend Record Date Payment

Date Date Date
stock trades “with dividend” stock trades “ex dividend”

The Ex-Dividend Price

Taxes on Dividend Income and Their Impact on Stock Price
Shares are valued on an after-tax basis, i.e.
× (1 − )
= .
(1 + )
The difference between the with-dividend and the ex-dividend price

on the ex-date is the after-tax amount of the dividend:
= × (1 − ) +
Example: if the stock price is expected to be $25 just before the ex-
dividend date, and the dividend was announced to be $0.5 per share,
and the personal tax rate is 40% for the average investor, then
= $25 − $0.5 × 1 − 40% = $24.70

Modigliani and Miller’s Dividend
Irrelevance Proposition

M&M’s Definition of Dividend Policy
Dividend Policy according to M&M: Dividend policy relates to

choosing a time-pattern of dividend payments.
Dividend policy is the decision to pay dividends vs. retaining the

funds, investing in operations, and paying dividends later.
The size of dividends relates to the profitability of the firm.
Dividend policy, according to M&M, is about timing, not the

general size of the dividends.

M&M Dividend Policy Irrelevance Proposition
M&M’s Assumptions: no taxes, no bankruptcy, and other frictions,

and all firms are identical except for dividend policy.
M&M Dividend Irrelevancy Proposition: The value of the firm is

independent of dividend policy. E.g.,
Logic: Higher (lower) dividends today leads to lower (higher) future

dividends such that the value of the firm today remains unchanged.

MM Dividend Policy Irrelevance Example
Q) XYZ Corp. is all equity financed, has perpetual expected earnings

of $100K which is distributed to shareholders as dividends, and has
200K shares outstanding. The required rate of return on XYZ’s
equity is 10%.
What is the value of the firm assuming that the current year
dividend is about to be made (i.e., the with-dividend value)?
What is the stock price and the dividend amount per share?
$
A) XYZ is worth = $100 + = $1.1
.
$
and = = $1
.
The price and dividend per share are

$1.1
= = $5.5
200
$1
= = $5.0
200
and
$100
= = $0.5
200

Q) XYZ Corp wants to increase current period dividends to $0.6

per share. Any shortage of cash is to be funded with newly issued
shares. What is the total amount needed to fund the extra
dividend?
A) The increase in current period dividend amounts to
($0.6 − $0.5) × 200 = $20,000.
$20,000 is needed to be funded with new shares.

Q) How many new shares must XYZ issue to fund the dividend? And
what is the price of these shares?
A) Denote the number of new shares needed to fund the increase in

dividends and,
the price of the shares issued to fund the dividends.
$1.0 = 200 + ×
$20 = ×
⇒ = $4.9 = 4,081.63
Each of the 4,081.63 new shares will be sold for $4.9.

Q) What is the new future dividend per share?
A) New future dividend per share:
100
= = $0.49
200 + 4,081.63
Dividends decrease from $0.50 to $0.49 per share.
XYZ’s future cash flows will be shared between old and new
shareholders.

Q) Show that XYZ’s current stock price is unaffected by the increase in
the current period dividend.
A) If there is no increase in dividend:
= $5.50, as found earlier.
If there is an increase in current period dividend:

$0.49
= $0.60 + = $5.50
.1
Conclusion: The share price is the same under both dividend policies.
Changing the pattern in dividends has no impact on the share price.

Q) Show that an investor that owns 100 shares of XYZ is indifferent

to the change in dividend policy.
A) Under no dividend increase:

= $5.00, = $0.50
= 100 × ($0.5 + $5.00) = $550
Under change in dividend policy:

= $4.90, = $0.60
= 100 × ($0.60 + $4.90) = $550
The investor’s wealth is unaffected by the change in dividend policy.

Homemade Dividends and
Dividend Irrelevance

Homemade Dividends and M&M Dividend Irrelevance Proposition
Homemade Dividends: Investor’s ability to create own dividends.
An investor that prefers a lower dividend can reinvest some of the

dividends and replicate a lower cash receipt today.
By contrast, an investor that prefers a higher dividend can sell some of

his share holdings and replicate a larger cash receipt today.
In either case, the investor ends up with the amount of cash equal to the
desired amount of dividends.
Conclusion: It makes no difference to shareholders the dividend policy

chosen by the firm.
Investors won’t value a firm at a premium based on its dividend policy.

Homemade Dividends and Dividend Irrelevance: Example
Q) Show that the previous investor can engage in homemade

dividend and replicate the change in dividend if XYZ didn’t change
its dividend policy.
A) Denote the number of shares sold if the investor prefers a

dividend of $0.6 per share.
(100 − ) × $0.50 × $5.5

+

100 × $0.6
=

⇒ =2
Homemade Dividends and Dividend Irrelevance: Example
Q) What is the resulting wealth for this investor?
A) Investor’s wealth after homemade dividend:
(100 − 2) × $5.0 2 × $5.5

+

100 − 2 × $0.5
+ = $550

Conclusion: The investor’s wealth with homemade dividend does not

change.

Real World Factors Affecting
Dividends

Real World Factors Favoring Lower Payments
Taxes: Tax on capital gains is usually lower than tax on dividend

income.
Investors in the upper tax brackets tend to prefer lower dividend

payments.
Flotation costs: All else equal, a high dividend paying firms (high
payout firms) will have to raise external capital more frequently
to fund growth than low payout firms, incurring higher flotation
costs.
Dividend restrictions: Debt covenants tend to limit the amount

of earnings distributed as dividends

Real World Factors Favoring Higher Payments
Desire for current income: Low income investors tend to prefer
high dividends. E.g.,
- Tax exempt investors and individuals in lower tax brackets
(seniors, retirees)
- trust and endowment funds constrained from spending principal
Tax benefits of dividends:

- Tax-exempt investors don’t care about the difference in tax on
dividends and capital gains.
Resolution of uncertainty: perception that dividends today are

better than dividends in the future.
Signaling: Information Content of Dividends
Asymmetric Information: Refers to the notion that corporate

insiders (e.g., managers) are more informed about the firm than
the shareholders.
Information Content of Dividends: Dividends can be used as ways

to communicate to the market about the future profitability of the
firm in a market where there is asymmetric information.
Dividend Signaling: The act of conveying future information about

the company’s profitability by changing current dividends.

Signaling: Information Content of Dividends
Empirical Evidence:
- announcements of dividend increases (decreases) are associated
with rises (drops) in share prices
- Driven by unexpected announcements
- The shares of opaque firms with low analyst coverage tend to

experience a stronger price reaction.
- Announcements of initiation of regular dividends have the

strongest positive impact on share prices.

Dividend Cuts to Finance Investments
Q) Assume an all-equity firm with 500,000 shares trading at

$36/share. Perpetual dividends of $3.60/share have been paid for
several years. The firm has an investment opportunity which will
generate $450,000 every year from the third year onwards. The
firm will have to stop paying dividends for 2 years to fund the
project. Should the firm undertake the project? How will this
impact the share price?
A)
Using the dividend discount model the return on equity is
R = RA = RE = dividend yield = $3.60/$36 = 10%
If the firm does not adopt the project, share price is $36= $3.6/.1,
as given.
Dividend Cuts to Finance Investments
The project’s NPV is:
. $
= − $3.60 × 500,000 × + ×
. . .
= $595,041>0
Conclusion: The company should stop dividends for 2 years and invest
in the project.
The increase in share price is:
$595,041
∆ = = $1.19
500,000
A two-year dividend cut will result in a share price increase to $37.19.

Establishing Dividend Payments
Prudently

Establishing Dividends Prudently
Some guidelines for setting dividends:

Don’t:
- cut or reduce dividends unnecessarily
- forego + NPV projects in order to pay dividends
- raise financing solely to pay dividends
Do:
- set regular dividends conservatively with a keen eye on future
projections
- plan ahead over a long horizon. Include future investment and
capital structure decisions in the plan
- consider extra dividends and/or share repurchases in the plan
Stock Dividends, Stock Splits
and Stock Repurchases

Stock Dividends and Stock Splits
(Reverse) Stock Split: (Aggregation) Issuance of shares to existing
shareholders without a change in owner’s equity.
Results in a change in the number of shares outstanding and a

corresponding change in share price (dilution).
E.g., a 2-for-1 stock split amount to one new share for every one share.
Stock Dividend: Distribution of additional shares to shareholders,

diluting the value of each share.
E.g., a 10% stock dividend amounts to one new share for every ten pre-
existing shares.
A stock dividend is a mini-stock split. With more shares outstanding, the

share price is lower, but the firm’s market value remains unaltered.

Share Repurchases
Share Repurchase: buyback of some shares outstanding.
A share repurchase has the same effect as a cash dividend:

- the company’s cash balance is reduced
- the shareholders as a group have more cash
Share repurchases have become very popular. They are the primary
way to distribute cash to shareholders (e.g., APPL).
Cash dividends in the US: 2/3 of companies back in 1978. 1/5 of

companies in 1999.

Share Repurchases: APPLE’s Shares Outstanding 2013-2018

Cash Dividend: Example
Payout Corp. will go ex-dividend tomorrow. The dividend will

be $1.00 per share, and there are 20,000 shares outstanding.
Today’s market value balance sheet for Payout is shown below:
Assets Liabilities and Equity

Cash $100,000 Equity $1,000,000
Fixed assets $900,000 Debt $0
a) What is Payout’s share price today?

b) What will Payout’s share price be tomorrow? Ignore taxes.

Cash Dividend: Example
a) today’s price = $1,000,000/20,000 = $50 per share.

A shareholder with 100 shares has $5,000
b) tomorrow’s price = $50 - $1 = $49
After the dividend payment, the balance sheet is:

Cash $80,000 Equity $980,000
The shareholder will have $ 5,000.

$100 in cash + 100 x $49 in shares = $ 5,000.
Share Repurchase: Example
Q) Now, suppose that Payout announces a share repurchase of

$20,000 instead of a dividend payment. What effect will this have on
a shareholder that owns 100 shares and sells 2 shares in the
repurchase?
A) After the repurchase, the market value balance sheet is:

Cash $80,000 Equity $980,000
Since $20,000/$50 = 400 shares were repurchased, the price per

share after the repurchase is $980,000/[20,000 - 400] = $50
The investor’s wealth is $5,000.

98 x $50 (in shares) + 2x$50 (in cash)=$5,000.
Stock Dividend: Example
Q) Now suppose that Payout again changes its mind and decides
to issue a 2% stock dividend instead of the cash dividend or share
repurchase. How should this action affect a shareholder that owns
100 shares?
A) With a 2% stock dividend, each shareholder receives 2 new

shares for every 100 shares.
The shareholder’s wealth after the stock dividend is:
102 shares x price per share after stock dividend

What is the share price after the stock dividend?
# of shares after stock dividend = 1.02 x 20,000 = 20,400
Since the combined equity value does not change, the price per
share is
$1,000,000 / 20,400 = $49.019608,
and the shareholder’s wealth is:

102 x $49.019608 = $5,000

Shareholder Shareholder Share

wealth portfolio price
Cash dividend
Before $5,000 100 shares $50
After $5,000 100 shares + $100 cash $49
Share Repurchase
After $5,000 98 shares + $100 cash $50
Stock dividend

After $5,000 102 shares, no cash $49.02

Conclusions
All else equal, higher dividends suggest the firm is more profitable.
M&M’s dividend policy relates to the time-pattern of dividends, not the size
of the dividends per se.
In a perfect world without taxes and other frictions, dividend policy doesn’t
matter.
In the real world, managers must balance between future growth and near
term cash distributions.
Independent of all other factors, steady and predictable dividends are

preferred by stockholders, but managers should not forego + NPV projects
just to pay a higher dividend.
Questions and Problems: 1-3, 6-9, 11, 13.

Topic: Raising Capital
Agenda:
Some Terminology Related to Raising Capital
Venture Capital
Initial Public Offering (IPO) and the IPO process
Other Ways to Raise Capital: Right Offers and Private Placements
The Underwriters
IPO Underpricing
Cost of Raising Capital
Market Reaction to Seasoned Equity Offering
Putting It All Together: Google (Alphabet) Inc.
Some Terminology Related
to Raising Capital

Some Terminology Related to Raising Capital
Venture Capital: early stage financing for (high risk) start-ups.
Initial Public Offering (IPO): the first time a firm raises capital by
issuing shares to the public. Also called cash offering.
‘Going public’ means a private company will have an IPO.
Seasoned Equity Offering (SEO): another equity raising by a firm

that is already publicly traded.
Floating shares: the act of issuing new shares (IPO or SEO).
Flotation costs: costs related to floating shares.

Venture Capital

Early Stage Financing: Venture Capital
Venture capital refers to funds that finance young (or new) high-
risk ventures.
An entrepreneur may seek venture capital to finance growth.
This market is dominated by independent venture capitalists or

venture capital firms, and other institutional investors.
Some investors specialize in investing in different stages of firm

development. I.e.,
– 1st stage or “incubation or seed money” stage;
– 2nd stage or “mezzanine-level financing”,
– etc…

Early Stage Financing: Venture Capital
In liquidation, VCs normally rank ahead of other shareholders.
Most start-ups fail, and VCs lose most or all of their investment in
failed start-ups.
But some ventures become major successes (e.g., Apple, Google,

Amazon.com).
VCs can “cash out” if they realize enough gains or if future prospects
of gains are dim.
Many VCs cash out via a secondary offering after or when the
company goes public.

Factors to Consider When Seeking Venture Capital
Desirable characteristics to look for in a VC:
• Financial strength: Ensures future rounds of financing, if needed.
• Style of VC : VCs can help with strategic decisions and day-to-day

business decisions.
• Expertise: A long and strong track record indicates a good quality

VC.
• Network: VCs can provide connections and access to new

customers, suppliers, lenders, and other important industry
contacts.
• Exit terms: How and under what terms will the VC cash out? VCs do
not tend to be very long-term investors.

Google as a New Venture
Google founders: Larry Page and Sergey Brin.
Month/Year of incorporation: Sept /98.
1st round of financing: $100K in Aug/98 from Andreas Bechtolsheim.
According to Forbes Magazine, Bechtolsheim’s stake in Google

was worth $1.7B on March 10, 2010.
2nd round of financing: $25M in June/99 from Kleiner Perkins

Caufield & Byers (KPCB) and Sequoia Capital.

Initial Public Offering (IPO) and the
IPO process

Basic Steps in Initial Public Offerings
Steps in an IPO:
A) Obtain the approval from the Board of Directors.
B) Prepare and lodge a prospectus with the Australian Securities &

Investments Commission (ASIC)*. In the US: the Security Exchange
Commission (SEC).
*ASIC is Australia’s corporate, markets and financial services regulator.

Steps in an IPO cont’d:
The prospectus contains information about the company’s:
• history;
• previous finances and most recent accounting data;
• directors and management, and their qualification;
• auditors, underwriters and other advisors involved in the issue
• proposed financing, i.e., the amount, uses, etc.
The sole purpose of the prospectus is to inform and educate

prospective investors about the company, not to endorse.

Steps in an IPO cont’d:
C) Lodge a prospectus with the Australia Securities Exchange (ASX).

In the US: with the respective stock exchange.
D) Revise and resubmit the prospectus until the final approval is

received from ASIC and the exchange.
During the Registration Period, the management and the

underwriter(s) can go on Road Shows and engage in Book Building.
E) The shares can be sold to the public once the prospectus is

approved.

Other Ways to Raise Capital:
Right Offers and Private Placements

Right Offers
Right offers allow existing shareholders to purchase additional

shares of the company until a certain date (the expiration date).
A right is an example of a financial option. When, and if,

exercised:
- the holder pays a nominal amount (the subscription price) to
the company and;
- receives the specified number of shares.
Rights are prorated to shareholders based on share ownership.
Right offers are ways to raise equity financing while avoiding

dilution in ownership.
Private Placements
Private placements:
• have lower registration and issuance costs (no prospectus, no
registration, fewer investors)
• are primarily bought by institutional investors
• have more stringent restrictions
• are easier to renegotiate and restructure
• are associated with a higher cost of capital
The decision to go with a private placement is a compromise between

(i) better ability to renegotiate and incur lower direct flotation costs
vs. (ii) a higher cost of capital.
Suitable for smaller and medium-sized firms, or when market

conditions are less than ideal for a public offering.
Total Equity Raising from Australian Markets: Yrs 2004-2014 (in
Billions AU$)

The Underwriters

Underwriters
Underwriters are bankers that work on capital raising deals.
A deal involves at least one underwriter. Groups of underwriters are

sometimes called syndicates.
Offer (or Issue) Price: the price of the securities sold to investors.
Spread: the difference between the offer price and the price received
from the underwriter(s) for each security.
Selling Period: The time period during which underwriters agree not
to sell the securities at a price lower than the offer price.

Types of Deals in Cash Offers
Types of deals:
(i) Firm Commitment (or Bought Deal or Standby Deal):
The issuing company receives the capital in full.
Underwriters assume full financial responsibility for any unsold shares.
Underwriters bear ‘controlled ‘ risks. The offer price is usually set after the
underwriters have studied the market carefully.
(ii) Best Efforts:
Underwriters sell as many shares as possible for the offer price.
Unsold shares are returned to the issuer without financial responsibility.

The Role of the Underwriters
The underwriters provide the following services:
• advise on the method of issuance

i.e., private placement (e.g. Dell), public offering (e.g. UPS),
private auction (e.g. Google);
• help with the marketing and the pricing of the securities

i.e., Prospectus, Road Show, Book Building, intrinsic valuation,
etc;
• help sell the securities

i.e., offer access to the distribution channel through brokerage
firms and other ‘affiliates’.
Google’s IPO and Underwriters
Google’s IPO: Aug 19, 2004, less than 6 years after it was founded.
Google, now Alphabet Inc., is traded on NASDAQ under the ticker

symbols GOOGL and GOOG.
Method: private online auction. 19,605,052 of the 271M shares floated

at $85 per share. The remainder stayed under the control of the
management.
Principle underwriters: Morgan Stanley and Credit Suisse.
Google shares first started trading the next day. The closing price that
day was $100.34.
As of Oct 12, 2018, Google traded at $1,090.74 and the company had a
market cap of $756.69B.
IPO Underpricing

IPO Underpricing
If the offer price is set too high, the shares may go unsold and the issue
may have to be withdrawn (the worst case scenario in best effort deals).
If the offer price is set too low, the shares are sold for less than fair value
and the original owners will suffer loses.
IPO Underpricing: the tendency to set offer prices below market value.
Underpricing is prevalent in IPO markets and results in:

- a wealth transfer from the original owners to the new investors;
- a lower capital raising than the counterfactual.
Hence, one can view IPO underpricing as a cost of raising capital.
E.g., UPS offer price on 10 Nov 1999 was $50 ($25.5 pre-IPO) per
share for 109.4M shares. Closed above $70 on IPO day (+35%). 23
Kyung Hwan Shim, FINS1613S2Yr2018
Average First Day Return of ASX-Listed IPOs by Month

Number of ASX-Listed IPOs by Month

Why does IPO Underpricing Happen?
Caveat: The plots shown previously are based on monthly averages.

In many cases, investors lose money on IPOs.
Possible explanations for IPO underpricing:
1) Investors’ compensation for risk:

IPOs are speculative investments. On average, investors must be
compensated for investing in highly speculative issues.
2) Underwriters misvalue to sell out:

– Reputational reasons for successful IPOs
– underpricing means lower risks for the underwriters
Why does IPO Underpricing Happen?
3) The Winner’s Curse Problem:
In a market with heterogeneous investors, informed investors have

an advantage over the average uninformed investor :
• informed investors know which securities are undervalued;
• whereas uninformed investors don’t.
The average investor ends up with all the overvalued IPOs. The
average investor is a losing winner.
The market is rational about the Winner’s Curse Problem.
To avert market failure, IPO’s, on average, have to be undervalued.

Winner’s Curse Problem: Example
Last year there were two IPOs. John placed buy orders for 1,000
shares for both IPOs.
The first IPO was undervalued by $1 while the second IPO was
overvalued by $3.
John ended up received 1,000 shares of the second IPO, but

because of the higher demand from informed investors, he only
received 100 shares of the first IPO.
What was John’s total dollar return? Conclude.
Gain from IPOs = 100 x $1 + 1,000 x (-$3) = -$2,900
John suffered from the Winner’s Curse Problem.

Factors that Affect the Offer Price
Empirically, IPO offer prices are correlated with:
• more favorable financial and accounting information;
• the reputation of auditors and underwriters in the deal;
• a higher ownership of shares by insiders;
• disclosure of investment plans and proposed use of capital
The above factors ameliorate the asymmetric information problem.


Direct Flotation Costs:
- Spread
- Filing and registration fees, audit and accounting fees, lawyer and
legal fees, etc.
Indirect Flotation Costs:
- Management’s time wasted on the issue

- Underpricing
- Announcement effects (for SEOs): Shares sold at a lower price.

IPO Flotation Costs
Direct costs as a percentage of proceeds raised:

- Small issues: 10-15% for a $1M deal
- Medium issues: 6-8% for a $10M-$50M deal
- Large issues: 2-4% for a $500M deal
Debt flotation costs tend to be lower than equity flotation costs:

- Large issues: less than 1%
These costs do not include indirect costs.

IPO Flotation Costs: Example
Q) XYZ issued 2 Million shares through an IPO. As a firm

commitment, the deal was to purchase the shares for $2.75 with an
offer price of $3.00 per share. What is the spread cost?
A) Spread : per share

Total flotation cost from spread : .
As % of net capital raised: .
As % of gross capital raised: .

Cost of Issuing Securities: IPO Underpricing Example
Q) If the 2M shares reflect 1/2 of the ownership of the firm and each
share jumps to $8 by market close on the IPO day reflecting XYZ’s
true intrinsic value, how much did the IPO cost the firm from
underpricing alone?
A)
Underpricing cost = ($8-$3) x 2M = $10M

Cost of Issuing Securities: IPO Underpricing Example
Q) Is the ‘hot’ IPO something the original owners of XYZ should

exuberate about?
A)
The factual:
capital raised = $3 x 2M = $6M
firm value V=$8 x 4M = 32M
wealth of original owners = $32M/2 = $16M.
The counterfactual, i.e., if offered at p=$8 instead of p=$3:

# of shares issued: $6M/$8 = 750K shares
wealth of original owners = $32M(1-750K/4M)= $26M.
Underpricing the IPO costs the original owners $26M-$16M = $10M.

The original owners bear the full cost of underpricing.
Market Reaction to Announcements
of Seasoned Equity Offering (SEO)

Market Reaction to Announcements of SEOs
Empirical Evidence: On average, share prices react negatively to
announcements of SEO.
Why? Presumably, firms issue stocks to finance positive NPV

projects.
Possible reasons:
a) Issuing stocks signals that the stock price will fall in the future:
Perception that stocks that are likely to rise in price will not be sold.
Why issue stocks if they are going to be worth more? If there is debt
capacity, the firm should borrow instead.
b) Managerial market timing: perception that managers tend to

issue stocks if they perceive stocks to be overvalued
Putting It All Together: Google
(Alphabet) Inc.

Putting It All Together: Google Inc.
Q) What was Andy Bechtolsheim’s own valuation of Google if he received
50% of the firm in the 1st round of financing? If 30%?*
A)
$ ,
If 50%:
%
$ ,
If 30%: 333,333
%
Q) What was KPCB and Sequoia Capital’s valuation of Google if they

collectively took on a 20% firm stake in the 2nd round of financing?*
A)
Q) What was Andy Bechtolsheim’s stake in Google worth at the 2nd round
of financing assuming an initial stake of 30%?*
A)
* This information is fictional. It is for illustrative purposes only.
Putting All Together: Google Inc.
Q) What is Google’s valuation at the time of IPO? How much capital did the
IPO raise?*
A)
271M shares=$23.035B
Capital raised 19,605,052 shares=$1.666B
Q) How much were Andy Bechtolsheim, and KPCB and Sequoia Capital’s
shares worth at the time of IPO assuming that Bechtolsheim originally took
a 30% and KPC and Sequoia collectively took a 20% ownership in Google?*
A)
,

Putting All Together: Google Inc.
Q) If the closing price on the day after the auction is a reflection of Google’s
true intrinsic value, by how much was the IPO undervalued? Conclude.
$ . $
15.29% of true firm value
$ .
Underpricing cost:
Capital raised if no underpricing: 19,605,052 shares=$1.9672B
Capital raised with underpricing: 19,605,052 shares=$1.6664B
Underpricing cost = $1.9B-1.6664B=$300.8M.
Conclusion: Larry Page and Sergey Brin, Andreas Bechtolsheim, KPCB and
Sequoia Capital may rejoice over their new found wealth in Google, but they
collectively lost $300.8M in wealth through the IPO.*

Google’s Angels on March 10, 2010
According to Forbes magazine, on March 10, 2010 Andreas

Bechtolsheim initial investment of $100K was worth $1.7B. Google’s
closing share price was $576.45 that day.
This translates to a proportionate ownership of
KPCB and Sequoia each had 24M shares at the time of IPO. That
translates to a proportionate ownership of
and a total value of
*
* This would be true only if KPC and Sequoia did not sell and/or buy additional shares since the IPO.
Conclusions
An innovative idea can not flourish without financial capital.
Early stage financing comes in the form of venture capital.
The source of capital and the cost of raising capital (both direct and
indirect) depend on the stage of firm development.
A good manager looks for ways to minimize flotation costs while

maximizing firm value.
Critical Thinking and Concepts Review: 1 - 9

Questions & Problems: 1 - 7

Finals

Transféré par

Informations du document

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Finals

Transféré par

Droits d'auteur :

Formats disponibles

Topic: Investment Risk, Returns and the History of Capital

Financial Markets and the Corporate Manager

Financial Markets: Quick Facts and Implications

Return on Financial Instruments

Historical Record on Financial Returns

Risk Premium: The First Lesson

The Variability of Returns: The Second Lesson

More on Average Returns: Geometric and Arithmetic Means

Capital Market Efficiency

Kyung Hwan Shim, FINS1613S2Yr2018 2

(ii) guide managers on how to carry out corporate valuations.

Kyung Hwan Shim, FINS1613S2Yr2018 3

Kyung Hwan Shim, FINS1613S2Yr2018 4

Kyung Hwan Shim, FINS1613S2Yr2018 5

Implications for the corporate manager:

Projects that fail to offer an adequate return commensurate with

Kyung Hwan Shim, FINS1613S2Yr2018 6

Kyung Hwan Shim, FINS1613S2Yr2018 7

Total Realized $ return = the return on an investment measured in $.

$ return = $Dividends + $Capital gains

$Capital gains = Price received when sold – Price paid when

When measuring investment performance, it is common to include

Kyung Hwan Shim, FINS1613S2Yr2018 8

Capital gain = 975 – 950 = $25

Total dollar return = 60 + 25 = $85

Kyung Hwan Shim, FINS1613S2Yr2018 9

It is generally more intuitive to think in terms of % instead of $

% realized return = the return on an investment measured as a % of

Kyung Hwan Shim, FINS1613S2Yr2018 10

which can be decomposed into two parts:

Kyung Hwan Shim, FINS1613S2Yr2018 11

Kyung Hwan Shim, FINS1613S2Yr2018 12

Kyung Hwan Shim, FINS1613S2Yr2018 13

Consider the following main asset classes:

(2) Australian Government Bonds: A portfolio of government

(3) Cash: A portfolio of 13 bank bills of equal face value with an

(4) CPI: an index which tracks the cost of a basket of commonly

Kyung Hwan Shim, FINS1613S2Yr2018 14

Kyung Hwan Shim, FINS1613S2Yr2018 15

All Ordinaries Index—Figure 10.5

Kyung Hwan Shim, FINS1613S2Yr2018 16

Kyung Hwan Shim, FINS1613S2Yr2018 17

Kyung Hwan Shim, FINS1613S2Yr2018 18

Kyung Hwan Shim, FINS1613S2Yr2018 19

Kyung Hwan Shim, FINS1613S2Yr2018 20

Calculating historical average returns:

Historical average return = simple (arithmetic) average

Return over period i

Kyung Hwan Shim, FINS1613S2Yr2018 21

Annual average returns over the 1985–2012 period

Kyung Hwan Shim, FINS1613S2Yr2018 22

Historical average risk premiums are easy to compute: take the

Historically, the All Ords Index offered a significant risk premium.

Lesson 1: risky assets, on average, earned a positive risk premium.

In conclusion, on average, there has been a reward for bearing risk

Kyung Hwan Shim, FINS1613S2Yr2018 25

A frequency distribution gives the number of times a variable was

It is possible to visualized realized returns as frequency

The spread of the return distribution depicts the variability of the

Kyung Hwan Shim, FINS1613S2Yr2018 26

Kyung Hwan Shim, FINS1613S2Yr2018 27

Kyung Hwan Shim, FINS1613S2Yr2018 28

Return variance: (‘ ’ = number of return observations)

Kyung Hwan Shim, FINS1613S2Yr2018 29