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BUSINESS FINANCE FINS1613

SUMMARY

1.1 Finance: A Quick Look

The four main areas of finance are:

Corporate Finance Business Finance o Making corporate decisions.

Raising capital Investment decisions from managers point of view Maximizing firm value Distributing earnings to shareholders

o Financial firms are referred to as the sell side of the market o Investment banks

Investments o Deals with financial assets, such as equity(shares) and debt

Pricing of risk and determination of returns o Financial firms involved are referred to as the buy side of the market. o Superannuation funds, hedge funds, investment management and brokerage firms

Financial Institutions o Businesses that deal in financial matters. o Commercial side: Originations and extensions of loans to businesses o Consumer side: Originations and extensions of mortgage loans or other personal loans. o Determine whether an extension to a loan is warranted based on financial position and performance. o Insurers determine risks and the insurance premiums for that risk.

International Finance o International aspects of corporate finance, investments and financial institutions. o Political risk, exchange rate risk, commodities and international market risk, international business

and market conditions.

o Multinational corporations and financial institutions with overseas operations.

1.2 Business Finance and The Financial Manager

When starting a business you have several financial decisions to make, the most important ones include:

Investment amount and type of investments to make determine size, profits, risk, liquidity

Financing how the firm will raise money affect financing costs and financial risk (Capital Budgeting)

How everyday finance matters are going to be addressed, i.e. collecting money from debtors, etc (Capital Structure)

Dividend how much of profits are given out as dividends vs. retained (Working Capital Management)

The role of financial managers are to answer these questions:

The top financial manager within a firm is usually the chief financial officer (CFO)

Business Finance deals with the decisions made by corporate treasury and capital expenditures.

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Capital budgeting:

The process of planning and managing a firms long term investment decisions.

Management aims to identify whether long term investments are profitable or not

Determine the size of cash flow, the timing of cash flows and the risk of future cash flows.

Capital structure:

The mixture of debt and equity maintained by a firm.

How the firm obtains the financing it needs to support its long term investments.

How much should the firm raise, what are the least expensive sources of funds for the firm.

Working Capital:

A firms short term assets and liabilities

Managing the firms working capital is a day-to day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions.

o How much cash, inventory o Sell on cash or credit to customers o Source of short term financing (Where and How)

1.3 Forms of Business Organisation

Types of companies:

Sole proprietorships: o A business owned by a single individual o Simple to establish, few regulations, owners keeps all profits., avoid corporate income tax o Difficult to raise large capital, unlimited liability, only lasts as long as owner, transfer of

ownership is difficult

Partnerships: o Owned and run by two or more people informal or legally binding o Cheap and easy to establish o General partners have unlimited liability, limited partners have limited liability

A limited partner do not have much say in how the business is run o Difficult to raise capital, only lasts as long as owner, difficult to transfer ownership

Corporations: o A business created as a distinct legal entity owned by one or more individuals or entities.

Has the same rights as a person can borrow money, own property, sue/d, enter partnerships, etc

o Unlimited life, easily transfer ownership, limited liability, easy to raise capital o Liable for corporate tax, and then dividends are taxed when paid to shareholders, difficult to

setup as legal formalities are lengthy and costly

Charter includes: name, purpose, share amounts, directors, whether shares are issued to new investors or existing owners.

o Owners are separate to management.

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1.4 The Goal of Financial Management

Profit Maximisation:

Profit maximisation is a very airy-fairy term and is not specific. o What profits? End of year? Before tax? After tax?

Will it be achieved through cost-cutting which may have negative long-term impacts?

Does it refer to earnings per share or accounting net income?

The Goal of Financial Management in a Corporation:

Maximise the current value of the existing shares o Assuming shareholders purchase shares to make a capital gain and financial managers make

decisions for shareholders

Maximise the market value of the existing shareholders equity. o If the corporation is not listed on an exchange and has no shares.

Social and ethical responsibilities o safety and welfare of employees, customers, environment o Not conducting illegal operations to maximize firm value

ASX introduced a Corporate Governance Council to recommend guidelines on best practice.

1.5 The Agency Problem and Control of the Corporation

Agency Relationships:

The relationship between shareholders and management is called an agency relationship.

Whenever one group (principles) hire another (the agent) to perform a service, there is a potential conflict of interest, such a conflict is called an agency problem.

Management Goals:

Managers are different to shareholders, they may not have the same objectives.

A corporation is considering a new investment, which is relatively risky, but will increase share price. Management does not go ahead with the investment, in the fear that it might fail and they may lose jobs.

o Shareholders lose out on a possible increase in share price. o This is known as an agency cost, when managers fail to take advantage of a valuable opportunity

for the firm.

Do Managers Act in The Shareholders Interest?

Whether managers act in the best interest of shareholders, depends on two issues: o How closely aligned are the management goals with shareholder growth o The job security of management can they be replaced in shareholder interest are not pursued.

Managerial Compensation is dependent on firm productivity and firm profitability. Further, managers are given stock in a company and thus reducing the agency problem (they will act in the best interest

of the shareholders because they are shareholders).

Control of the firm Control rests with shareholders. Shareholders can engage in a proxy fight to replace existing management. Management can also be replaced by M&A activity (particularly

acquisitions), whereby well managed companies acquire poorly managed ones, and former managers

are often left jobless.

Stakeholders:

Entities apart from shareholders or creditors that has a claim on the cash flow of the firm.

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1.6 Financial Markets and The Corporation

Cash Flows to and from the Firm:

1. Firm issues securities to raise cash 2. Firm invest in assets 3. Firms operations generate cash flow 4. Cash is paid to government as taxes, other stakeholders may receive cash 5. Reinvested cash flows are ploughed back into firm 6. Cash is paid out to investors in the form of interest and dividends.

In financial markets it is debt and securities that are bought and sold

Primary versus Secondary Markets:

The term primary market refers to the original sale of securities by governments and corporations o In a primary market transaction, the corporations is the seller and the transaction raises money

for the corporation. The two types of transactions are:

A public offering involves selling securities to the general public (IPOs) A private placement is a negotiated sale involving a specific buyer

o There are a lot of rules and regulations involved with public offerings, and it is expensive and must be registered with Australian Securities and Investment Commission (ASIC)

o Instead corporations often sell securities via private placement to large financial institutions as to avoid legal costs and as it does not have to be registered with ASIC.

The secondary markets are those in which securities are bought and sold after the original sale. o A secondary market transaction involves one owner or creditor selling to another.

The secondary market provides the means for transferring ownership of corporate transactions.

o There are two types of secondary markets: Dealer markets Over the counter (OTC); Dealers buy and sell for themselves, dealer

makes profit on the difference between the buy and sell price (aim to buy low sell high)

Auction market In the auction market brokers and agents match buyers and sellers and charges a fee for this service. Auction markets has a physical location.

The equity shares of all large firms in Australia and New Zealand trade on organized auction markets (exchanges)

o Shares that trade on an organized exchange are said to be listed on that exchange.

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4.1 Future Value and Compounding:

Time Value of Money

A dollar today is worth more than a dollar tomorrow o You could earn interest on the dollar while you waited o Inflation, goods will be more expensive tomorrow.

Future Value (FV)

Refers to the amount of money an investment will grow to over some period of time at some given interest rate.

o Cash value of an investment at some time in the future.

o = (1 + )

The process of leaving your money and accumulating interest in an investment is called compounding. o Compounding the interest means earning interest on interest compound interest o Simple interest is interest earned on the original principal each period. o Compound interest FV Simple Interest FV

4.2 Present Value and Discounting:

Present Value (PV)

Refers to the current value of future cash flows discounted at the appropriate discount rate. o Reverse of future value. How much the money is worth to you today o How much you need now, to obtain an amount in the future.

o =

(1+)

The process of finding the present value of a sum of money is called discounted cash flow (DCF) valuation

o The discounting rate is the rate used to calculate PV in FV cash flows

5.1 Future and Present Values of Multiple Cash Flows:

For multiple cash flows:

1. Determine the FV/PV of each individual cash flow 2. Add the FV/PV of each cash flow to determine the FV/PV of the stream of cash flows.

= 1(1 + )

1 + 2(1 + )2 + +

=1

1 + +

2(1 + )2

+3

(1 + )3+ +

(1 + )

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5.2 Valuing Level Cash Flows: Annuities and Perpetuities:

Level Cash Flows:

Annuity - A series of constant (level) cash flows paid for a finite number of periods o Ordinary annuity Payments are made at the end of each period o Annuities Due Payments are made at the start of each period o FV of annuity due > FV of ordinary annuity b/c payments made earlier and therefore earn more

interest

Perpetuity An annuity with infinite number of periods

PV and FV for Ordinary Annuities

: =

(1 (

1

1 + )

)

: =

((1 + ) 1)

: =

(1 (

1 +

1 + )

)

PV and FV for Annuities Due

: =

(1 (

1

1 + )

) (1 + )

: =

((1 + ) 1)(1 + )

PV for Perpetuities

=

=

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5.3 Comparing Rates: The Effect of Compounding:

Effective Annual Rate (EAR)

The EAR is the actual interest rate you would receive expressed as if it was compounded annually. o It is the actual rate you receive, not the quoted rate.

Annual Percentage Rate

The APR (nominal) is the quoted interest rate per annum with a non-annual compounding. o Semi-annual o Quarterly o Monthly

= (1 +

)

1

Period Rate

The rate charged by the lender in each period o To convert APR into periodic

=

o To convert EAR into periodic

= (1 + )1

1

5.4 Loan Types and Loan Amortisation:

Pure Discount Loans

The borrower receives funds today and repays as a lump sum with interest at some time in the future.

Interest Only Loans

The borrower receives funds today and pays interest only each period and then a lump sum at the end.

Amortised Loans:

The borrower receives fund today and pay interest and part of the principal each period.

6.1 Bills of Exchange and Bill Evaluation:

Bill of exchange

A bill is a certain sum of money to be paid to the bearer at a fixed or determinable time in the future.

Called a discount security because interest in not explicitly paid. o You dont receive the full amount, and then pay back the face value at some time in the future o The difference between the amount received and face value represents the interest

Face Value o The principal amount that is repaid at the end of the agreed term. par value o The amount stated on the bill

Maturity o Date on which the principal amount is paid o Bills are typically issued for a period of days

=

1 +

365

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6.3 Bonds and Bonds Evaluation:

Bonds

A type of interest only loan, where borrower pays interest every period and then principal at the end of loan.

Face Value o The principal amount of a bond that is repaid at the end of term par value.

Coupon o Stated interest payment made on a bond a series of regular interest payments

Coupon rate o The annual coupon divided by the face value of the bond

Maturity o Date on which the principal amount of a bond is paid

Yield to Maturity o The market required rate of return for the bond.

Bond Pricing:

Since a bond consists of coupon payments that are regular interest payments, this equates to an annuity.

The principal to be repaid at maturity represent a lump sum payment.

=

[1

1

(1 + )] +

(1 + )

Relationship between Price of Bond and Yield

If ytm = coupon rate o Par value = bond price

If ytm > coupon rate o Par value > bond price o Discount bond

If ytm < coupon rate o Par value < bond price o Premium bond

Bond price fluctuates inversely with changes to ytm.

Interest Rate Risk:

The risk that arises for bond owners from fluctuating interest rates.

Longer maturity bonds have more interest rate risk than shorter bonds o Effects of discounting are greater on cash flows that are further away in time

Lower coupon rate bonds have more interest risk than higher coupon rate bonds o If coupon rate is lower, the bonds value has a greater relative weight on the par value, increasing

the effects of discounting.

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6.4 More on Bond Features:

Bonds are debt investment instruments. A corporation that issues a bond is the borrower/debtor, while the bearer is the lender or creditor

Debt does not represent ownership interest in the firm

The interest payment is the cost of using debt as a source of funds. o Having debts creates risk for financial failure

Bond Characteristics

Maturity: short v intermediate v long term

Placement: private v public

Issuer: corporations v governments

Security: secured v unsecured o In the event that the issuer defaults the investors have a claim on the issuers assets that will

enable them to get their money back.

Seniority: senior v junior o Preference in position over other lenders

Credit Rating: investment grade v low grade junk bonds

Issuer exercisable features: callability, covenants o Ability to repurchase bond before maturity, part of the trust deed limiting certain actions.

Exotic Features: convertible, floating, and others o Bond can be swapped for shares, adjustable coupon payments.

6.8 Inflation and Interest Rates:

Nominal Interest Rates

They are the interest rate that are quoted in the market o They are not adjusted for inflations

Real Interest Rates

The real rate of return is the percentage change in how much you can buy with the number of dollars you have

o The interest rates that have been adjusted for inflations

The Fisher Effect:

The relationship between nominal and real interest rates

1 + = (1 + )(1 + ) Where = inflation

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6.9 Determinants of Bond Yields:

The Term Structure of Interest Rates

Relationship between yield to maturity and time to maturity o On default free, pure discount securities

Normal yield curve upward sloping structure o Long term yields are higher than short term yields

Inverted yield curve downward sloping structure o Short term yields are higher than long term yields

Factors Affecting Required Returns

Default risk premium The portion of a nominal interest rate that represents compensation for the possibility of default

Liquidity premium The portion of a nominal interest rate that represents comp ensation for the lack of liquidity

Maturity premium Longer term bonds will tend to have higher yields.

7.1 Ordinary Share Valuation:

As a shareholder you can receive cash in two ways o Dividends the company pays o Selling you shares

The value of a share is then the present value of the dividends and the proceeds from selling that share.

0 =1 + 1

1 +

Dividend Discount Model

If we continue to just take dividends forever and delay the time at which we sell our share, then the price of the share is given by:

0 =1

1 + +

2(1 + )2

+ +

(1 + )=

(1 + )

=1

Constant Dividends (Zero Growth)

Same dividend at regular intervals forever o Treat it as a perpetuity

0 =

Constant Growth Dividends

Dividends is expected to grow at a constant rate every period

= 0(1 + )

The constant growth model has the general equation:

=(1 + )

=

+1

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Note:

=1

+

o Dividend yield return from dividends o Capital gains yield growth rate

Supernormal Dividend Growth

Dividend growth in non-constant initially, but it settles down to a constant growth eventually

7.2 Some Features of Ordinary and Preference Shares:

Shares

A share is a stake in a company o An owner who has the right to pick the manages and receive any profits

Ordinary Shares

Voting rights: o Shareholders elect directors o One share one vote o Proxy voting voting on behalf of other shareholder(s)

The right to share proportionally in dividends paid

Rights to remaining assets after liquidation residual claim

Preference Shares

Shares with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes without voting rights

o Dividends are paid to preference shareholder first, then to ordinary shareholders.

Dividends

Common dividends o Dividends that are declared by the board of directors and paid to ordinary shareholders o There is no liability of the firm until declared

Preference Dividends o Paid to preference shareholders first o They are not a liability and can be deferred indefinitely o Dividends tend to be cumulative

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10.1 Returns:

Financial Market

The financial market is the place where you can raise capital o It determines the prices of bonds and stocks

Understanding this can help make better decisions pertaining the financial market. o There is a trade-off between risk and return o The higher the risk, the higher the expected return.

Dollar Returns:

The return on an investment expressed in dollar terms as: o Dollar Returns = Dividend Income + Capital Gain/Loss

Capital gains is the difference between the price received when sold and price when bought

Percentage Returns

Total % Return = Dividend yield + Capital Gain Yield

=+1 + +1

=+1

=+1

10.3 Average Returns: The First Lesson:

Historical Average Return:

Arithmetic average

=

=1

Risk-Free Rate

Rate of return on a riskless investment

Zero risk premium

Risk Premium

The excess return on top of risk-free rate

Award for bearing investment risk

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10.4 The Variability of Returns:

Variance (2) The average squared distance between the actual return and the average return

o Variability of returns

() = ( )

2=1

1

Standard Deviation

The positive square root of the variance o Return volatility o Often preferred because it is in the same units as average returns

() = ()

Normal Distribution

A symmetrical, bell shaped frequency distribution that is completely defined by its average (mean - ) and standard deviation ().

It is useful for describing the probability of ending up in a given range.

Returns generally have a normal distribution

10.5 More on Average Returns:

Arithmetic Average Return

The return earned in average period over multiple periods o What was your return in average year

Overly optimistic for long horizons

Geometric Average Return

The average compound return earned per year over multiple periods o What was your average compound return per year o Geometric < Arithmetic

Overly pessimistic for short horizons

= [(1 + )

=1

]

1

1

Depending on time period:

15 20 years: use arithmetic average

20 40 years: split the difference between them

> 40 years: use geometric average

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10.6 Capital Market Efficiency:

Efficient Capital Market

Market in which security prices reflect available information

The Efficient Market Hypothesis:

Stock prices are in perfect equilibrium

Stocks are fairly priced

Stock markets are information efficient

Share prices will always reflect information in the market, hence investors should not expect to earn positive abnormal returns

You can still make returns, return is dependent upon the level of risk you are bearing.

Poor investment decisions will still lead to poor returns.

Strong Market Efficiency

All private and public information is reflected in the prices

You cannot make abnormal profits

Semi-Strong Market Efficiency

All public information is reflected in the prices

You cant make abnormal profits from public information (fundamental analysis)

Weak Market Efficiency

Share prices only reflect historical price and trade information

Cannot make abnormal profits based on past price information

Technical analysis will not lead to abnormal profits

Empirical evidence suggests markets are generally weak.

8.1 Net Present Value

Role of financial manager

Capital budgeting o Choosing what to invest in

Capital structure o Deciding how to finance the investments

Working capital management o Managing every day activities and funds

Dividend policy o How profits will be returned to investors

Capital Budgeting Design Criteria

Does the decision rule factor in the time value of money

Does it factor in risk

Does the decision rule tell us if we are creating value for the firm

Independent Projects

Projects that have no impact on another projects cash flows

The decision to accept/reject project will have no impact on other projects

Firm can accept one or more, or it could reject all

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Mutually Exclusive Projects

Projects that when you accept, you must decline all other ones o Could be because of financial constraints or limitation to available assets

Projects should be ranked in order to determine which one to take

Net present value (NPV):

NPV is the value of an investment taking into account the discounted value of all future cash flows

If NPV > 0 then accept as will generate more cash than it costs

If NPV = 0 then the project will break even

If NPV < 0 then reject

If mutually exclusive, choose project with highest NPV

Calculating NPV

Estimate future cash flows

Estimate required return for the level of risk you are bearing

Find PV of cash flows and subtract from initial investment

=

(1 + ) 0

=1

Advantages

Meets all decision rule criteria

NPV is consistent with firms objective of maximizing shareholders wealth

Preferred method

8.2 The Payback Rule:

Payback period

The amount of time it takes for an investment to produce enough cash to cover the initial cost of the investment

Calculating Payback period

Estimate future cash flows

Subtract future cash flows from initial cost until initial cost is recovered

Decision Rule

Accept project is payback period is less than some predetermined limit

Advantages

Easy to understand

Adjusts for cash flow uncertainty

Biased towards liquidity

Disadvantages

Ignores time value of money

Requires predetermined threshold

Ignores cash flow after threshold

Biased towards long term projects

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8.3 The Average Accounting Return (AAR):

Average accounting return is defined as:

=

Average book value depends on how the asset is depreciated o Take arithmetic mean of first book value and last book value

Decision Rule

Accept the project if the AAR is greater than the target rate

Advantages

Easy to calculate

Required information is readily available

Disadvantages

Not a true rate of return

Time value of money ignored

Uses an arbitrary threshold

Based on book values, not market values

8.4 The Internal Rate of Return (IRR):

The IRR is the discount rate that makes the NPV = 0. o Involves trial and error, or excel

Decision Rule

Accept the project if IRR is greater than the required return

IRR and NPV

IRR and NPV lead to identical decisions iff o Conventional cash flow first is negative, rest is positive o Independent project

If there is a conflict, USE NPV

Multiple IRR

Non-conventional cash flows lead to multiple IRRs o Another cash flow begins after the initial outflow

IRR is no longer useful in this case

Mutually exclusive projects

Using IRRs becomes a problem because the timing and size of cash flow becomes important

At some required return the NPVs will crossover and one project will suddenly become more appealing than the other.

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Advantages

Easy to understand

Knowing a return is intuitively appealing

If the IRR is high enough dont need to calculate required return

Disadvantages

Can produce multiple IRRs

Cannot rank mutually exclusive projects

Modified IRR

Helps control problems of IRR

Discount approach o Discount future outflows to present value and add to initial outflows

Reinvestment method o Compound all cash flows except the first forward to the end

Combination method o Discount outflows to present and compound inflows to the end

Discount rates are externally supplied

MIRR v IRR

MIRR avoids multiple IRRs

Managers prefer rate of return comparisons and MIRR is better for this

Different ways to calculate MIRR o Which one is best?

Interpreting MIRR becomes harder

8.5 The Profitability Index:

The profitability index is defined as the present value of future cash flows divided by the initial investment

Measures the value created per dollar invested

=

Decision Rule

Accept project is PI>1.0

Advantages

Closely related to NPV

Useful when funds are limited

Disadvantages

The profitability index does not consider the scale of the project, which can lead to incorrect comparisons of mutually exclusive projects.

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9.1 Project Cash Flows:

Relevant Cash Flows

A project where the cash flows of the project will increase the firms overall cash flows if the project is taken on

Incremental Cash Flows

The difference between a firms future cash flows with the project and without the project

How much the project will generate for the firm

Standalone Principle

The assumption that you can evaluate a project based on its incremental cash flows

9.2 Incremental Cash Flows:

Sunk Costs

A cost that has already been incurred and cannot be recovered o Not a relevant cash flow o Exclude from DCF analysis

E.g. Consulting fees that have already been paid

Opportunity Costs

The most valuable alternative that is given up if a particular investment is taken o Should be considered in DCF analysis

E.g. Using a pre-owned building for a project o Opportunity we could sell the building o Opportunity cost is the amount the building will sell for today

Side Effects

The cash flows of a new project that come at the expense of the a firms existing project o Should be considered in DCF analysis

E.g. When you launch a new product line, you must consider the loss in sales of other product lines as a result of this new product

Net Working Capital

Changes in the short term that represent the cost of running the day to day business o Should be included in DCF analysis

Financing Costs

We do not include interest paid or any other financing costs, such as dividends or principal repaid on debt securities

Financing effects have already been taken into account by the discount rate.

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9.3 Pro Forma Financial Statements and Project Cash Flows

Projected Financial Statements

Pro forma financial statements are useful for projecting future years operations

To prepare these statements we require an estimate on o Unit sales o Selling price per unit o The variable cost per unit o Total fixed costs

Free Cash Flows

Cash flow from assets

The incremental effect of a project on a firms available cash.

()= () () () +

9.4 More on Project Cash Flows

Operating Cash Flows

Cash flows generated from a firms normal day to day operations

Adjust net profit by non-cash items to do not correspond to actual cash flows o Depreciation

1. = + 2. = ( ) (1 ) +

Depreciation

Even though depreciation is deducted from net profit, it is not an actual cash outflow o Thus we add it back to see how much cash has actually been generated

The benefit of deducting depreciation is that it reduced the tax paid o Depreciation tax shield

Straight line write off a fixed amount per year until book value is nil

Diminishing value depreciate a fixed percentage of book value per year

Net Working Capital (NWC)

The difference between a firms current assets and current liabilities o Capital available in short term to run business

Current accounts such as accounts receivable/payable and inventories

= We must adjust for NWC because:

o We make sales on credit and match it with an appropriate expense, however this is not necessarily when the cash comes in

o There is a timing difference between accounting revenues/expenses and cash inflows/outflows

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How to adjust for NWC o Increases in current assets (accounts receivable/inventories) represent cash outflow deduct o Decreases in current assets represents in cash inflow add o Increases in current liabilities (accounts payable) represent cash inflows add o Decrease in current liabilities represent cash outflows - deduct

Capital Expenditure (CAPEX)

Payments of cash for long term assets (property, factory, equipment, etc)

Do not immediately appear as expenses, but depreciate slowly

Cash flow occurs immediately o Capital expenditure represents negative cash flow at the start

After Tax Salvage

Assets that are no longer need can be sold o Pay tax on capital gains

=

=

= ( )

9.5 Evaluating NPV Estimates:

NPV

The NPVs we calculate are just estimates, there is little certainty in the accuracy of the estimate and hence we must conduct further analysis.

Typically a positive NPV is a good sign that we should take up the project, though we need to further look at:

o Forecasting risk How sensitive the NPV is change in cash flows The more sensitive the greater the forecasting risk

o Sources of value Why does this project create value

9.6 Scenario and other What-If Analyses:

Scenario Analysis

The determination of what happens to NPV estimates when we ask what-if questions.

We look at NPV from the best, worst and cases in between

Scenario analysis tells us what can possibly happen to our project, but it does not tell us whether we should take it not,

Sensitivity Analysis

Investigation of what happens to NPV when only one variable is changed.

The greater the volatility in NPV when that one variable changes the larger the forecasting risk associated with that variable and the more attention we should give in regards to its estimation.

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Problems with Scenario and Sensitivity Analysis

Neither can provide a decision rule

Ignores diversification o Measures only stand-alone risk

If your scenarios end up with mostly positive NPVs you should feel comfortable with taking the project

If there is a variable that leads to a negative NPV with only small changes you may want to forego the project.

9.7 Additional Considerations in Capital Budgeting:

Managerial Options and Capital Budgeting

Opportunities that managers can exploit if certain things happen in the future

Up until now we have assumed the project is static and that the projects basic features cannot be changed, however in reality managers can modify the project as new information becomes available.

Ignoring these options in our DCF analysis means that we underestimate our NPV.

Option to Expand

If a project has a positive NPV, can we expand the project or repeat it to get a larger NPV

Option to Abandon

If we start a project, can we abandon (or scale back) the project if it does not cover its own expenses, Option to Wait

The project can be postponed, to see if conditions improve.

Equivalent Annual Annuity (EAA)

The level of annual cash flows that generate the same present value as a project

It is used to evaluate alternative projects with different lives.

=

1

[1

1

(1+)]

When making a decision we must factor: o The required life of the project o The replacement costs

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11.1 Expected Returns and Variances:

Expected Return

The expected return on an asset is given by:

() =

=1

Expected return is the return you would expect to get if you repeat s process many times

Expected Return Risk

() = [ ()]2

=1

11.2 Portfolios

Portfolio

Group of assets such as shares and bonds held by an investor o Portfolio weight percentage of the total value of portfolio in a particular asset.

The risk and return of a portfolio are entirely determined by the risk and return of the individual assets that make up the portfolio.

Portfolio Expected Returns

The portfolio expected return is weighted average of the expected return of each asset in the portfolio

= . ()

=1

Where:

o Wj is the portfolio weight of asset j o Rj is the return of asset j o M = total number of assets

The expected return on a portfolio can also be calculated by determining the portfolio return in each of the future states and then computing the expected value as we did for individual securities.

() = . ,

=1

Where:

o i= particular state out of the possible n states o is the probability that state i can occur o is the expected future return of the asset if state i occurs o n = total number of possible states

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Portfolio Risk

We first find the expected portfolio return, then compute the portfolio return standard deviation using the same formula as individual assets:

() = . ()

=1

() = [, ()]2

=1

11.3 Announcements, Surprises and Expected Returns:

Expected and Unexpected Returns:

The expected return and the realized future return are usually not equal.

There is an unexpected component that is not anticipated at time t that occurs at time t+1 o Denoted by +1 o +1 = (+1) +1

In efficient markets abnormal profits have zero expected value, hence:

o E(+1) = 0 o This suggests current market expectations are not biased

11.4 Risk: Systematic and Unsystematic:

Total Risk

Total risk = assets market risk + assets specific risk

Market Risk

A risk that influences a large number of assets. Also called systematic risk

E.g. GDP, unemployment, interest rates, exchange rates, etc

Asset Specific Risk

A risk that affects at most a small number of assets. Also called unsystematic/diversifiable risk.

E.g. Employment Strike within company

11.5 Diversification and Portfolio Risk

Diversification

Spreading an investment across a number of assets will eliminate some but not all, of the risk.

With many assets in a portfolio positive/negative shocks specific to each asset will cancel each other out, reducing overall risk

o More assets, less unsystematic risk

Market risk affects all securities, thus no matter how many assets in a portfolio, market risk cannot be eliminated.

24

11.6 Systematic Risk and Beta

Systematic risk principle

The expected return on a risky asset depends only on the assets systematic risk.

Measuring Systematic Risk

The beta coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average risky asset

o In other words it is a measure of a stocks risk relative to the market portfolio.

We define the market portfolio to have a beta of 1 o Thus stocks with > 1 are particularly sensitive to market fluctuations o Stocks with < 1 are less sensitive.

The risk premium of an asset is tied to the market risk premium:

=

=

[ ] = [ ]

What is the relationship between beta and risk?

Beta only measures the risk of a stock relative to market fluctuations.

However, a stock with a low beta may still be risk overall and a stock with a high beta might have lower overall risk.

You tend to find high beta stocks in companies that are in high procyclical industries

Portfolio Beta

The weighted average of the betas of the securities in the portfolio.

= .

=1

11.7 The Security Market Line

Capital Asset Pricing Model (CAPM)

It is the relationship between an assets risk premium and the market risk premium

[ ] = [ ]

The CAPM defines the relationship between risk and return for any asset.

[] = + [ ]

This means that returns come from either: o Compensation on time value of money,

o Assets risk premium, [ ]

25

Security Market Line

The relationship between expected returns and betas can be graphically represented by a straight line. o This representation is called the Security Market Line(SML)

The reward to risk ratios must be the same across all assets since they are all on the same SML o This is just the gradient of the SML

o = []

If the portfolio is the market portfolio then the SML slope changes to:

= []

o Since = 1

SML Graph

R (%)

[Required return]

Undervalued

Overvalued

Risk ()

= 1

Key Terminology

Expected return return market expects from the asset in the future calculated from price and expected cash flows IRR

Realized return past return received by investors in the asset mean of actual previous returns

Required return return calculated from theory based on assets market risk

12.1 The Cost of Capital:

Cost of Capital & Required Return:

Investors in the market invest to attain financial gains. The investment generates capital for the firm. Since investors expect return on their money, this represents the cost of capital.

The cost of capital is the return the capital must generate in order to compensate investors.

If the return exceeds the cost of capital, then the project has generated adequate returns increased firm value.

o This only occurs when the return exceeds what the financial market offers for projects with similar risk (betas)

Implications of cost of capital

A project must offer a greater return the greater the systematic risk in the project. o Greater systematic risk project must be assessed more harshly.

Thus the higher the beta, the higher the discount rate.

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Projected Discount Rate

In general, no abnormal returns should be made from the financial market. o NPV = 0 o Return = IRR

A positive NPV project is where IRR > r, this is an undervalued asset, it is a line above the SML

Now the project discount rate is the return on financial securities with similar market risk. o R is the discount rate the market would use to price the project as if it was like a bond or a

stock.

Use CAPM model to determine projected discount rate. o rf is the investors compensation for the time value of money o project * E(rm rf) is the compensation for taking risk.

Hurdle Rate

The minimum required return on a project given its risk.

The companys overall cost of capital

The market determined rate of return on the companys existing assets.

The return the company must deliver in order to meet the return the market has deemed based off their financial securities.

All Equity Based Firm

Firm is purely financed through equity

Thus owning equity means you own proportion of firm

Value of firm is the value of the equity

Risk of firm is the risk of the equity

Cost of capital is the return on equity using CAPM model

12.2 Cost of Equity:

Cost of Equity

The return that equity investors require on their investment in the firm.

1) Dividend Growth Model Approach

=+1

=

1

+

Advantages

o Simple to use

Disadvantages

o Can only use for dividend paying firms o Only work if the dividend grows at a constant rat o Sensitive to growth rate hard to estimate o Doesnt explicitly adjust for risk

27

2) The SML Approach o Use CAPM model

Advantages

o Accounts for risk o Applicable to all companies o Can be used for individual projects

Disadvantages

o Poor estimates of market risk premium and beta leads to inaccurate value of cost of equity o Many people use historical data o Applicable only if stock prices are observed.

12.3 The Cost of Debt and Preference Shares:

Cost of Debt

The return that lenders require on the firms new debt

It is the yield to maturity (YTM) on a companys bonds

If the companys debt are not traded, then use the yield on corporate bonds of similar firms with similar credit rating.

Cost of Preference Shares:

Preferred stocks are stocks with dividend priority over common stocks. o They pay a fixed dividend rate, every period, for as long as the firm exists.

Since it is a constant dividend

0 =

=

12.4 The Weighted Average Cost of Capital (WACC):

Debt and Equity Financed Firms

Capital structure refers to the mix of debt and equity used to generate capital.

Firm value o V = D + E + P o D, E and P denote the market value of debt, equity and preferred equity

Dividing by V we get:

1 =

+

+

= + +

The firms cost of capital is found by using WACC

= + +

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Taxes and the WACC

Debt financing has an advantage over equity financing because it reduced the portion of the profits that must be paid to the government. Hence the actual WACC post tax is:

= (1 ) + +

Interpreting WACC

WACC represents the companys cost of capital if it needs to raise one new dollar today using debt and equity.

o It is also the return that the firms assets must earn today to maintain current firm value

We can use WACC as the discount rate to find the NPV of projects with the same business risk as the existing assets of the firm

If the projects risk is different from firms existing assets, the manager can determine an appropriate cost of capital.

The WACC is the correct project discount rate if the project has the same market risk as the companys existing business

The WACC is not the correct discount rate for projects with different market risk

Consistently using the WACC for projects with different risk will decrease firm value and increase firm risk.

12.5 Divisional and Project Cost of Capital

The Pure Play Approach

A pure player is a company that operates in a single line of business where they invest in projects with the same risk

Steps in the Pure Play Approach

Find public companies that invest exclusively in the type of project under evaluation o This is so as they are likely to have the same market risk as the project

Compute the WACC of these pure players

Average the pure players cost of capital

Use it to discount the projects cash flows

The Subjective Approach

Since it is difficult to find discount rates for individual projects, companies sometime adopt an approach that involves making subjective adjustments to the WACC

Steps in the Subject Approach

Add risk factor to the WACC o Use positive adjustments for riskier projects o Use negative adjustments for safer projects

The adjustment is subjective and is project specific

Good judgment must be exercised when implementing the subjective approach.

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15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital

Venture Capital

Financing for new, often high risk start up projects.

Entrepreneurs at their early stage may seek finance from business angels o Individuals who provide funds for early development of new high risk ventures

Similarly they may seek finance at a later stage from venture capitalists mezzanine level financing

Although there is an active venture capital market, the access to venture capital is very limited as they have a lot of criteria

Venture Capitalists

Venture capitalists are typically wealthy investors, VC firms and institutional investors(managed funds)

In the event of liquidation venture capitalists rank ahead of other equity holders.

Since new ventures are of high risk, most of them fail and VCs lose a lot of money, hence they get first priority upon liquidation.

VC may choose to cash out if they realize enough financial gains or if future prospects look dim. Choosing a Venture Capitalist

Financial strength is important

Style is important o Will they be involved in day to day activities or will they watch from behind

References are important o How successful was the VC with previous investments o How much knowledge do they have of the industry

Contacts are important o Can they provide important customers, suppliers and other industry contacts

Exit strategy is important o Since most VC are not long term investors, how and under what terms will the VC cash out of

the business.

15.2 Selling Securities to the Public: The Basic Procedure:

1. Obtain approval from the board of directors 2. Prepare and lodge a disclosure document, called a prospectus, with the Australian Securities &

Investments Commission (ASIC).

a. If its a public offering, a prospect must also be lodged with the Australia Securities Exchange (ASX)

3. Revise the prospectus to obtain final approval from the ASIC and ASX. This occurs during the registration period, which is the period from the lodgment of the prospectus to its approval and

registration.

4. Selling efforts get underway once the final prospectus is approved by the ASIC and the ASX.

Prospectus

Financial information

History of the company

Qualifications of the directors and management

Description of the proposed financing and its uses

The purpose of the prospectus is to inform and education prospective investors of the company.

30

15.3 Initial Public Offering (IPO), Rights Issues and Private Placements:

Initial Public Offering

The initial issue of securities offered for sale to the general public on a cash basis

Issuing shares for the first time

Also refers to a company going public

Rights Issue

In a rights issue the firm offers existing shareholders the opportunity to buy additional shares in the company.

Rights are issued on a proportional basis to the investors existing holdings.

If the rights are renounceable then the existing shareholders have the option to sell.

Private Placements

Privately placed equity or debt has no filling requirements

Registration costs are lower no prospectus, registration

Issue costs are lower less buyers and no underwriter

Life insurance companies, pension and mutual funds are the major suppliers

Easy to negotiate in case of default or restructuring

Higher yields due to lower liquidity

From the issuers view, it is a trade-off between higher yields v better renegotiation and lower flotation costs

Best suited for small/medium sized firm since flotation costs tend to be higher for such firms

15.4 Underwriters

Underwriters are bankers that work on an issue and usually buy up unsold securities subject to certain condition at an agreed price

o It can be a single or group (syndicate) of underwriters

The spread is the difference between what the underwriter pays and the offer price o The offer price is the actual price the issue is sold to investors

Selling period is the period of time in which underwriters agree not to sell securities for less than the offer price

Firm Commitment

Also known as standby underwriting. The underwriter buys any unsold securities at the close of issue, assuming full financial responsibility for any unsold securities.

The offer price is carefully considered by the underwriters to manager their risk of having to buy unsold shares

Most common

Best Efforts

The underwriter sells as much of the issue as possible but does agree to buy all the unsold securities.

Role of Underwriters

Intermediaries between a company selling securities and the investing public

Help market and price the new securities

Help sell the new securities

They are paid the spread usually a proportion of the total value of shares sold.

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15.5 IPO and Under-pricing:

Under-pricing

When the market values the shares higher than the offer price o Shares are sold for less than they are actually worth.

Fairly common, wealth is effectively transferred from original investors to new investors

Implies less capital is raised indirect cost of capital

Pricing is difficult because: o Overpricing could result in unsold shares o Under-pricing results loss in capital gains.

IPO Under-pricing

To encourage investors to buy the shares to compensate for the high risk

Underwriters underprice to sell all shares o Reputational reasons for successful IPOs o Under-pricing means lower risk for underwriters

Mitigating the winners curse which is where you end up overbidding and lose money. However underpricing leads to oversubscription so you dont overbid.

Factors that affect the Offer Price

Favourable available accounting information

Good auditors and underwriters

Great ownership retention by the founders and the management

Disclosure of use of proceeds for proposed investments

15.7 The Cost of Issuing Securities:

Flotation Costs

The costs associated when issuing new securities.

Direct Costs

Spread offer price minus price received

Filing fees, audit and accounting fees, legal fees, etc

Indirect Cost

Cost of managers time

Under-pricing

Announcement price effects

Overallotment provisions o Underwriters may buy additional shares to cover excess demands. Cost can apply to these

additional shares

Prices for IPO

Small issues : 10-15% of $1M

Medium issues: 6-8% of $10-50M

Large issues: 2-4% of $500M

This does not include indirect costs

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Debt v Equity

Issuing debt is significantly much cheaper than equity.

However advantage may be offset by an excessively high yield

Seasoned Equity Offerings (SEO)

Prices drop typically by 1-3% o Issuing equity signal that the stock price will drop in the future

Nobody sells shares when they know price is still going up Semi strong market

o Market timing shares are sold when they are overvalued o Profitable firms should finance operations via debt

Why use stocks if they are going to rise in value and increase cost of capital.

13.1 The Capital Structure Question:

Capital Structure

A companys choice of the mix of debt and equity that makes up the total firm value.

Financial Leverage

The extent to which a company has debt and has obligations to pay interest

It is measured by: o The debt to equity ratio o The debt to value ratio

Market leverage uses market values

Book leverage uses book values

13.2 The Effect of Financial Leverage:

Effect of Financial Leverage

Financial leverage amplifies the effect of changes in sales on return on equity(ROE) and earnings per share(EPS)

Debt financing makes the equity of the firm more risky. o The impact of when the firm is doing poorly is much worse than when the firm is doing well.

Break- Even EBIT

This is the level of EBIT that results in the same EPS for debt and no debt financing.

=

If EBIT > than break even, then beneficial to shareholders

If EBIT < than break even, then detrimental to shareholders

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Corporate Borrowing and Homemade Leverage

The use of personal borrowing/lending to change the overall amount of financial leverage to which an investor is exposed through his equity holding.

Any stockholder can create homemade leverage to his preference and replicate the payoffs of the firm with financial leverage

o Consequently capital structure is irrelevant to shareholders o Capital structure should not be used to value a firm

Modigliani and Miller proposed this

13.3 Capital Structure and the Cost of Equity Capital:

Capital Structure Theory

Modigliani and Miller argue that the value of the firm is determined by the cash flows to the firm and the risk of the firms assets.

o Nothing else should effect the firm

Implies the firm value can only change when: o Change in risk of the cash flows o Change in cash flows

MM Proposition 1

Consider two identical companies with the same operating cash flow every period, except firm L is levered and firm U in unlevered then:

= =

Total value is not effect by capital structure.

WACC is neither effected

MM Proposition 2

A firms cost of equity capital is a positive linear function of its capital structure o Financial leverage

Cost of capital for firm U:

= = Cost of capital for firm L:

= =

+

o Equity cost of capital:

= +

( )

MM Proposition 2 & Betas

Substituting the CAPM formula

= + ( )

= + ( ) +

( + ( ) )

34

If there is no risk to debt then, =

= + (1 +

) ( )

= (1 + (1 )

)

13.4 Corporate Taxes and Capital Structure:

Interest Tax Shield

The tax saving attained by a firm from the tax deductibility of interest expenses.

MM Proposition 1 & Taxes

= + ( ) = +

= () (1 ) + ( )

MM Proposition 2 & Taxes

The firm value is a linear function in financial leverage due to greater tax shields o WACC decreases with financial leverage

=

(1 ) +

Define to be the unlevered cost of capital, when D/E = 0, (this is just cost of equity)

= +

( ) (1 )

Cost of equity rises as a firm relies more heavily on debt

13.5 Bankruptcy Costs

Bankruptcy costs affect firm value negatively

Direct Costs

The costs that are directly associated with bankruptcy, such as legal and administrative expenses.

Indirect Costs

The costs of avoiding bankruptcy filing incurred by a financially distressed firm o Disruptions in operations o Loss of employees o Damage to firms reputation o Foregone investment opportunities

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Changes to MM Theory

Tax saving increase with financial leverage

Cost of financial distress increase increases with financial leverage

There is a trade-off between tax saving and increased cost of financial distress

13.6 Optimal Capital Structure

Static Theory of Capital Structure

A firm borrows up to a point when the tax benefit from an extra dollar in debt is exactly equal to the cost that come from the increased probability of financial distress.

Optimal Capital Structure

The optimal amount of debt that increases the firm value o This is the point at which money from tax benefit is offset by cost from financial distress.

= + ( ) ( )

This is also the point at which cost of capital is minimised.

14.1 Cash Dividends and Dividend Payments: Regular Dividends

Payment made out of a firms earning to its owners, in the form of either cash or shares.

Periodic in nature usually quarterly

Extra Cash Dividends/Special Dividends

Non-periodic, non-recurring cash payment

Special dividends are a onetime cash payment arising from an extraordinary event

Liquidating Dividends

A cash payment arising from the sale of an asset, division, subsidiary or business

Stock Dividends

The issue of stocks to existing shareholders instead of dividends

Not an IPO

Share Repurchases

A cash payment to shareholders to purchase a portion of shares outstanding.

Dividend Payment: A Chronology

Declaration date is the date on which the board of directors passes a resolution to pay a dividend

Ex-dividend date

date is the date on is the last date for a shareholder to buy a share and be entitled to receive a dividend o 4 days before the record date.

Record which shareholders must be on record to receive a dividend o 2-3 weeks before the payment date

Date of payment is the date on which dividend cheques are mailed or deposited directly in shareholders bank accounts

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Stock Prices: With Dividend and Ex-Dividend

Stock prices are valued on an after tax basis :

o = (1)

(1+)=1

In reality the difference between the dividend and ex-dividend share price is the after tax dividend

o = (1 ) +

14.2 Does Dividend Policy Matter?

Dividends Matter

The present value of the share is based on the present value of expected future dividends

Irrelevance of Dividend Policy

Dividend policy is the decision to pay dividends vs. retaining funds to reinvest in the firm and pay dividends later

Dividend policy relates to the time pattern of dividend payout

Any increase in dividend at some point in time is exactly offset by a decrease somewhere else, so the net effect, after accounting for the time value of money, is zero.

M&M Dividend Policy Irrelevance Proposition

The time pattern of dividend payouts.

Assumptions o No tax, transaction costs or bankruptcy and all firms are identical

Dividend policy is irrelevant in M&M world

o =

If investors can create homemade dividends (raise cash by selling shares), then they do not need firms to pay cash dividends

Real World Factor that Favour a Low-Payout

Taxes o Capital gains taxes are usually lower than taxes on dividend income o Investors in the upper tax brackets might prefer lower dividend payouts

Flotation Costs o Firms that pay high dividends may end up raising external capital more frequently to fund

growth, incurring higher flotation costs than low payout firm

Dividend Restrictions o Debt covenants, federal and state laws may limit the percentage of income that can be paid out as

dividends

Real World Factors that Favour a High-Payout

Desire for current income o Individuals in lower tax brackets o Investors that are constrained from spending (trust and endowment funds)

Uncertainty resolution o No guarantee that higher dividends will materialise

Taxes and legal benefits from high dividends o Dividend exclusions for corporations o Tax exempt investor dont worry about differential tax treatment between dividends and capital

gains income

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Clientele Effects

Argument that shares attract particular groups, based on dividend yield and the resulting tax effects. o Some investors prefer low payouts o Other investors prefer high payouts

Changing dividend policy result in different investors o It does not affect the value of stock

Signalling: Information Content of Dividends

Dividends becomes an important form of communication about firms future prospects

Managers tend to have better information about the firm that outside investors (market is semi-strong)

Empirical Evidence on Dividend Announcements

Announcement of dividend increase/decrease are related to rise/fall of stock price

Unexpected announcements of dividend increase/decrease have more significant effect on stock price o Most significant effect on stock price comes when non-dividend paying stocks announce i

nitiation of dividend payments

Dividend Policy in Practice

Plan and budget ahead of time over a longer period. o Include future investment and capital structure decisions

Set dividends conservatively eyeing future figures

Avoid cut backs on positive NPV projects to pay dividends

Avoid dividend cutbacks / Avoid the need to sell equity

Set regular dividends conservatively

Consider incorporating extra dividends and/or share repurchases in the plan

14.3 Share Repurchases: An Alternative to Cash Dividends:

Share Repurchases

A firms purchase of its own shares

Has same effect as cash dividend o Cash account from firm is reduced and shareholders have more cash

Book value of equity decreases in both cases

14.5 Bonus Issues and Share Splits

Stock Split

Issuance of additional shares to a firms shareholders, without changing the owners equity

No cash is exchanged, only a change in the number of shares issues and a change in the value of share occurs

Stock Dividend

Distribution of additional shares to the firms shareholder, diluting the value of each share outstanding

The cash is kept in the firm for investment, shareholders receive additional shares

Mini stock split o No cash is involved and book value of equity does not exchange o With more shares outstanding, market value per share drops, but total firm value remains same.