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This full document shows us the essence of corporate finance - Bachelor - Economics & Finance - Kyungpook National University,Daegu, South Korea - Jean Meilhoc

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  • Each of these topics will be discussed in more detail in the following slides. www: Several of the following slides will have hot links to a web site that provides information about different business jobs including descriptions, skills and traits, etc. The address is Video: Advice from recent graduates on what it takes to have a career in finance. The discussion on corporate finance is deferred until later in the chapter.
  • www: Clicking on the “web surfer” icon will take you to the Careers in Business Home page. “Commercial Banking”, “Insurance,” and “Investment Banking” all discuss job opportunities in the Financial Institutions area.
  • Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.
  • Provide some examples of capital budgeting decisions, such as what product or service the firm will sell, should old equipment be replaced with newer, more advanced, equipment, etc. Be sure to define debt and equity. Provide some examples of working capital management issues, such as: whom to grant credit, how much inventory should be carried, when should suppliers be paid, etc.
  • www: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is:
  • www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.
  • www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements. Note that unlimited liability applies to all partners in a general partnership but only to the general partners in a limited partnership Written agreements are essential due to the unlimited liability. Limited partners cannot be involved in the business or else they may be deemed general partners.
  • www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations. Discuss how separation of ownership and management can be both an advantage and a disadvantage: Advantages You can benefit from ownership in several different businesses (diversification) You can take advantage of the expertise of others (comparative advantage) It is easier to transfer ownership Disadvantage Agency problems if management goals and owner goals are not aligned The instructor’s manual provides additional discussion of limited liability companies and S-corporations
  • Try to have the students discuss each of the goals above and the inherent problems of the first three goals: Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow? Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners. Maximize market share – This has been a strategy of many of the companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies may have huge market share (i.e. Amazon) that still does not guarantee positive earnings, so their owners may not be happy. Maximize the current value of the company’s stock There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits. The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm. This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock. Not for profits can also follow the same principle, but their “owners” are the constituencies that they were created to help. The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990s. Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.
  • Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada. A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyer’s agent and a seller’s agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range. Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the Sensor razor. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint; monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
  • Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forgo projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive. Corporate control – ask the students why the threat of a takeover might make managers work toward the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
  • Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade. Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders. Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there. See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ toward becoming for-profit companies and the possible impact on investors. www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
  • Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean that it is liquid. Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the IM for a more complete discussion of this issue.
  • The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct results of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.) Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions. Remember that shareholders’ equity consists of several components and that total equity includes all of these components, not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.
  • The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example. Here is an example of a simplified balance sheet. Some students might make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. Later in the chapter, a hot link is provided to the 2004 annual report for McGraw-Hill. If you don’t have access to the internet for your presentation, I encourage you to bring in some annual reports and let the students see the differences between the simplified statements they see in textbooks and the real thing. This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are.
  • Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities, and equity accounts of the firm. Assets are listed at historical cost less accumulated depreciation – this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the “Total Assets” line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth. Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities change in the market as well. This is especially true for longer-term liabilities. Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the market’s estimation of the current value of ALL of the assets of the firm. The best estimate of the market value of the firm’s assets is market value of liabilities + market value of equity. Market values are generally more important for the decision-making process because they are more reflective of the cash flows that would occur today.
  • Shareholders are the ones that benefit from increases in the market value of a firm’s assets. They are also the ones that bear the losses of a decrease in market value. Consequently, managers need to consider the impact of their decisions on the market value of assets, not on their book value. Here is a good illustration: Suppose that the MV of assets declined to $700 and the market value of long-term debt remained unchanged. What would happen to the market value of equity? It would decrease to 700 – 500 = 200. The market-to-book ratio, which compares the market value of equity to the book value of equity, is often used by analysts as a measure of valuation for a stock. It is generally a bad sign if a company’s market-to-book ratio approaches 1.00 (meaning market value = book value) because of the GAAP employed in creating a balance sheet. It is definitely a bad sign if the ratio is less than 1.00. GAAP does provide for some assets to be marked-to-market, primarily those assets for which current market values are readily available due to trading in liquid markets. However, it does not generally apply to long-term assets, where market values and book values are likely to differ the most.
  • Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.
  • The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example. Remember that these are simplified income statements for illustrative purposes. Earnings before interest and taxes (EBIT) is often called operating income. COGS would include both the fixed costs and the variable costs needed to generate the revenues. Analysts often look at EBITDA (earnings before interest, taxes, depreciation, and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes. The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered. It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRS early in the asset’s life. This reduces the “expense” and thus increases the firm’s reported EPS. This is a good illustration of why it is important to look at a firm’s cash flow and not just its EPS.
  • Point out that taxes can be a very important component of the decision- making process, but that what they learn about tax specifics now could change tomorrow. Consequently, it is important to keep up with the changing tax laws and to utilize specialists in the tax area when making decisions where taxes are involved. www: Click on the web surfer icon to go to the IRS web site for the most up-to-date tax information. It is important to point out that we are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis. Point out that the tax rates discussed in the book are just federal taxes. Many states and cities have income taxes as well and those taxes should figure into any analysis that we do.
  • Tax liability: .15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,356,100 Average rate: $1,356,100 / $4,000,000 = .339025 or 33.9025% The marginal tax rate comes from the table. It is 34% We should use the marginal rate with an expected additional 34,000 in taxes and a change in the average rate to $1,390,100 / $4,000,000 = .347525 or 34.7525%
  • The first equation shows how the cash flow from the firm is divided among the investors that financed the assets. The second equation shows the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project.
  • Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on “I/S” that will take you to that slide. Another one exists on “B/S.” The arrows on the Income Statement and Balance Sheet slides will bring you back here. OCF = 694 + 65 – 212 = 547 NCS = 1709 – 1644 + 65 = 130 Students often have a difficult time understanding why a cash outflow has a positive sign and a cash inflow has a negative sign. Emphasize that we are talking about SPENDING in the net capital spending formula and Investment in NWC. The formula for CFFA takes care of reducing cash flow when NCS is positive and increasing CF when it is negative. Ending NWC = 1403 – 389 = 1014 Beginning NWC = 1112 – 428 = 684 Changes in NWC = 1014 – 684 = 330 Net New Borrowing = ending LT debt – beginning LT debt = 454 – 408 = 46 CF to creditors = 70 – 46 = 24 Net New Equity = 640 – 600 = 40 (Be sure to point out that here we want to determine the amount of equity raised in the capital markets, not retained earnings. CF to Stockholders = 103 – 40 = 63
  • This provides a summary for the various cash flow calculations. It is a good place to refer back when working on cash flows in the capital budgeting section.
  • The instructor’s manual provides an exercise that can be used to illustrate how difficult this analysis can be using published financial statements. It uses the 2004 McGraw-Hill annual report as an example. Here is the additional information required to complete the income statement. You may want to give them this information and have them practice putting together a balance sheet and income statement. They should verify the 250 addition to retained earnings for 2006, and distinguish that from the retained earning balance at the end of 2006. Sales = 5000; Costs = 2000
  • Remind the students that changes in RE are not included because there is no cash flow associated with them. Net new equity consists of the purchase and sale of stock in the market. If the company had repurchased stock during the year, you would need to include the change in the Treasury stock account. An increase in Treasury Stock is a decrease in net new equity since it is a cash outflow from the firm to stockholders.
  • 4.
  • 4. It’s important to point out that there are many different ways to refer to the interest rate that we use in time value of money calculations. Students often get confused with the terminology, especially since they tend to think of an “interest rate” only in terms of loans and savings accounts.
  • 4. Point out that we are just using algebra when deriving the FV formula. We have 1,000(1) + 1,000(.05) = 1,000(1+.05)
  • 4.
  • 4.
  • 4. It is important at this point to discuss the sign convention in the calculator. The calculator is programmed so that cash outflows are entered as negative and inflows are entered as positive. If you enter the PV as positive, the calculator assumes that you have received a loan that you will have to repay at some point. The negative sign on the future value indicates that you would have to repay 1,276.28 in 5 years. Show the students that if they enter the 1,000 as negative, the FV will compute as a positive number. Also, you may want to point out the change sign key (+/-) on the calculator. There seem to be a few students each semester that have never had to use it before. Calculator: N = 5; I/Y = 5; PV = 1,000; CPT FV = -1,276.28
  • 4. Point out that the PV interest factor = 1 / (1 + r) t
  • 4. Key strokes: 1.08 y x 17 +/- = x 150,000 = Calculator: N = 17; I/Y = 8; FV = 150,000; CPT PV = -40,540.34
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  • 4.
  • 4. It is very important at this point to make sure that the students have more than 2 decimal places visible on their calculator. Efficient key strokes for formula: 1,200 / 1,000 = y x 5 = 1/x - 1 = .03714 If they receive an error when they try to use the financial keys, they probably forgot to enter one of the numbers as a negative.
  • 4. Remind the students that ln is the natural logarithm and can be found on the calculator. The rule of 72 is a quick way to estimate how long it will take to double your money. # years to double = 72 / r where r is a percent, not a decimal.
  • 4. Calculator: I/Y = 10; FV = 20,000; PV = - 15,000; CPT N = 3.02 years
  • 4. Click on the tabs at the bottom of the worksheet to move between examples.
  • 5.
  • 5. FV = 100(1.08) 4 + 300(1.08) 2 = 136.05 + 349.92 = 485.97 Year 1 CF: 4 N; -100 PV; 8 I/Y; CPT FV = 136.05 Year 3 CF: 2 N; -300 PV; 8 I/Y; CPT FV = 349.92 Total FV = 136.05 + 349.92 = 485.97
  • 5. The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that. CF 0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17 Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1,226.07 Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1,070.90 Using formulas and one CF at a time: Year 1 CF: FV 5 = 100(1.07) 4 = 131.08; PV 0 = 100 / 1.07 = 93.46; FV 3 = 100(1.07) 2 = 114.49 Year 2 CF: FV 5 = 200(1.07) 3 = 245.01; PV 0 = 200 / (1.07) 2 = 174.69; FV 3 = 200(1.07) = 214 Year 3 CF: FV 5 = 200(1.07) 2 = 228.98; PV 0 = 200 / (1.07) 3 = 163.26; FV 3 = 200 Year 4 CF: FV 5 = 300(1.07) = 321; PV 0 = 300 / (1.07) 4 = 228.87; PV 3 = 300 / 1.07 = 280.37 Year 5 CF: FV 5 = 300; PV 0 = 300 / (1.07) 5 = 213.90; PV 3 = 300 / (1.07) 2 = 262.03 Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1,226.07 Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding) Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1,070.89 Point out that C03 is in years 4 and 5. The “03” indicates the third cash inflow quantity, and will not be the same as the time period whenever a preceding cash flow frequency (e.g. F01) is set to something other than “1.”
  • 5.
  • 5.
  • 5. The students can read the example in the book. After carefully going over your budget, you have determined you can afford to pay $632 per month towards a new sports car. You call up your local bank and find out that the going rate is 1 percent per month for 48 months. How much can you borrow?
  • 5. Calculator: 4(12) = 48 N; 20,000 PV; 8/12 = .666666667 I/Y; CPT PMT = 488.26
  • 5. FV = 2,000(1.075 40 – 1)/.075 = 454,513.04 Remember the sign convention!!! 40 N 7.5 I/Y -2,000 PMT CPT FV = 454,513.04
  • 5. Note that the procedure for changing the calculator to an annuity due is similar on other calculators. Calculator 2 nd BGN 2 nd Set (you should see BGN in the display) 3 N -10,000 PMT 8 I/Y CPT FV = 35,061.12 2 nd BGN 2 nd Set (be sure to change it back to an ordinary annuity) What if it were an ordinary annuity? FV = 32,464 (so receive an additional 2,597.12 by starting to save today.)
  • 5. This is a good preview to the valuation issues discussed in future chapters. The price of an investment is just the present value of expected future cash flows. Example statement: Suppose the Fellini Co. wants to sell preferred stock at $100 per share. A very similar issue of preferred stock already outstanding has a price of $40 per share and offers a dividend of $1 every quarter. What dividend will Fellini have to offer if the preferred stock is going to sell.
  • 5. Where m is the number of compounding periods per year Using the calculator: The TI BA-II Plus has an I conversion key that allows for easy conversion between quoted rates and effective rates. 2 nd I Conv NOM is the quoted rate, ENTER up arrow to C/Y (compounding periods per year), ENTER up arrow to EFF (the effective rate) and then CPT (compute). You can compute either the NOM or the EFF by entering the other two pieces of information, then going to the one you wish to compute and pressing CPT.
  • 5.
  • 5.
  • 5. Point out that the APR is the same in either case, but your effective rate is different. Ask them which account they should use.
  • 5.
  • 5. Remind students that rates are quoted on an annual basis. The given numbers are APRs, not daily or semiannual rates. Calculator: 2 nd I conv 5.25 NOM ENTER up arrow, 365 C/Y ENTER up arrow, CPT EFF = 5.39% 5.3 NOM ENTER up arrow, 2 C/Y ENTER up arrow, CPT EFF = 5.37%
  • 5. 2(12) = 24 N; 16.9 / 12 = 1.408333333 I/Y; 3500 PV; CPT PMT = -172.88
  • 5. 35(12) = 420 N 9 / 12 = .75 I/Y 50 PMT CPT FV = 147,089.22
  • 5. Remind students that the value of an investment is the present value of expected future cash flows. 1 N; 10,000 FV; 7 I/Y; CPT PV = -9,345.79
  • 5. 4 N 8 I/Y 5,000 PV CPT PMT = -1,509.60
  • 5. The reason that the loan balance does not decline to exactly zero is because of the rounding of the interest payments. Technically, the last payment would be 1,509.61 so that the loan balance would be zero after the last payment. This is a common issue.
  • 6.
  • 6. This formalizes the calculations we have been doing.
  • 6. Remember the sign convention on the calculator. The easy way to remember it with bonds is we pay the PV (-) so that we can receive the PMT (+) and the FV(+). Slide 6.8 discusses why this bond sells at less than par
  • 6. Bond characteristics: Coupon rate = 8% with annual coupons; Par value = $1,000; Maturity = 10 years
  • 6. There are the purely mechanical reasons for these results. We know that present values decrease as rates increase. Therefore, if we decrease our yield below the coupon, the present value (price) must increase above par. On the other hand, if we increase our yield above the coupon, the present value (price) must decrease below par. There are more intuitive ways to explain this relationship. Explain that the yield-to-maturity is the interest rate on newly issued debt of the same risk and that debt would be issued so that the coupon = yield.Then, suppose that the coupon rate is 8% and the yield is 9%. Ask the students which bond they would be willing to pay more for. Most will say that they would pay more for the new bond. Since it is priced to sell at $1,000, the 8% bond must sell for less than $1,000. The same logic works if the new bond has a yield and coupon less than 8%. Another way to look at it is that return = current yield + capital gains yield. The current yield, in the case of a par value bond, is just the coupon rate. The capital gains yield has to make up the difference to reach the yield to maturity. Therefore, if the coupon rate is 8% and the YTM is 9%, the capital gains yield must equal 1%. The only way to have a capital gains yield of 1% is if the bond is selling for less than par value. (If price = par, there is no capital gain.)
  • 6.
  • 6.
  • 6.
  • 6. This is standard terminology in the U.S. – but it may not transfer to other countries. For example, debentures are secured debt in the United Kingdom
  • 6. Debenture: secured debt is less risky because the income from the security is used to pay it off first Subordinated debenture: will be paid after the senior debt Bond without sinking fund: company has to come up with substantial cash at maturity to retire debt and this is riskier than systematic retirement of debt through time Callable – bondholders bear the risk of the bond being called early, usually when rates are lower. They don’t receive all of the expected coupons and they have to reinvest at lower rates.
  • 6.
  • 6.
  • 6. You should be willing to accept a lower stated yield on municipals because you do not have to pay taxes on the interest received. You will want to make sure the students understand why you are willing to accept a lower rate of interest. It may be helpful to take the example and illustrate the indifference point using dollars instead of just percentages. The discount you are willing to accept depends on your tax bracket. Consider a taxable bond with a yield of 8% and a tax-exempt municipal bond with a yield of 6% Suppose you own one $1,000 bond in each and both bonds are selling at par. You receive $80 per year from the corporate and $60 per year from the municipal. How much do you have after taxes if you are in the 40% tax bracket? Corporate: 80 – 80(.4) = 48; Municipal = 60
  • 6.
  • 6.
  • 6. The approximation works pretty well with “normal” real rates of interest and expected inflation. If the expected inflation rate is high, then there can be a substantial difference.
  • 6.
  • 6.
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  • 6.
  • 6. www: Click on the web surfer to go to Bloomberg to get the current Treasury yield curve
  • 6.
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  • 7. If you have taught students how to use uneven cash flow keys, then you can show them how to do this on the calculator. The notation below is for the TI-BA-II+ Or CF 0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; NPV; I = 20; CPT NPV = 13.33
  • 7. Remind the students that if dividends are paid quarterly, then the discount rate must be a quarterly rate. Also, if students have been using a financial calculator for most of their calculations, they often forget to convert the interest rate and leave it as a percent, i.e., P = .5 / (10/4) = .2. Ask them if this is a reasonable answer – “Would you only be willing to pay $0.20 for an asset that will pay you $0.50 every quarter forever?”
  • 7. g is the growth rate in dividends; the subscripts denote the period in which the dividend is paid
  • 7. The biggest mistake that students make with the DGM is using the wrong dividend. Be sure to emphasize that we are finding a present value, so the dividend needed is the one that will be paid NEXT period, not the one that has already been paid.
  • 7. As the growth rate approaches the required return, the stock price increases dramatically.
  • 7. As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.
  • 7.
  • 7. Point out that the formula is completely general. The dividend in the numerator is always for one period later than the price we are computing. This is because we are computing a Present Value, so we have to start with a future cash flow. This is very important when discussing supernormal growth. We know the dividend in one year is expected to be $4 and it will grow at 6% per year for four more years. So, D 5 = 4(1.06)(1.06)(1.06)(1.06) = 4(1.06) 4
  • 7. Point out that D 1 / P 0 is the dividend yield and g is the capital gains yield
  • 7.
  • 7. Shareholders have the right to vote for the board of directors and other important issues. Cumulative voting increases the likelihood of minority shareholders getting a seat on the board. Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for a vote. Different classes of stock can have different rights. Owners may want to issue a nonvoting class of stock if they want to make sure that they maintain control of the firm.
  • 7. See the instructors manual for a discussion of the tax law changes regarding dividends received by individuals Dividend exclusion: If corporation A owns less than 20% of corporation B stock, then 30% of the dividends received from corporation B are taxable. If A owns between 20% and 80% of B, then 20% of the dividends received are taxable. If A owns more than 80%, a consolidated statement can be filed and dividends received from B are essentially untaxed.
  • 7. Point out that there are a lot of features of preferred stock that are similar to debt. In fact, many new issues have sinking funds that effectively convert what was a perpetual security into an equity security with a definite maturity. However, for tax purposes, preferred stock is equity and dividends are not a tax deductible expense, unless they meet specific characteristics as discussed in the text.
  • 7. r = [1.5(1.05)/18.75] + .05 = 13.4%
  • Be sure to emphasize that you do not have to actually sell the stock for you to earn the dollar return. The point is that you could.
  • Note that the “dividend” yield is really just the yield on intermediate cash flow
  • You might want to point out that total percentage return is also equal to total dollar return / beginning price. Total percentage return = 6.25 / 35 = 17.86%
  • Ask the students to think about why the different investments have different risk premiums.
  • Remind students that the variance for a sample is computed by dividing by the number of observations – 1 The standard deviation is just the positive square root of the variance
  • (1.08 x 1.12 x .96)^.3333 – 1 = .0511 Mean = ( .08 + .12 + -.04) / 3 = .0533 Variance = (.08 - .0533)^2 + (.12 - .0533)^2 = (-.04 - .0533)^2 / (3 - 1)= .00693 Standard deviation = .00693 ^ .5 = .0833 Probability: a 3% loss (return of -3%) lies one standard deviation below the mean. There is 16% of the probability falling below that point (68% falls between -3% and 13.66%, so 16% lies below -3% and 16% lies above 13.66%).
  • Use the following example to illustrate the mathematical nature of expected returns: Consider a game where you toss a fair coin: If it is Heads then student A pays student B $1. If it is Tails then student B pays student A $1. Most students will remember from their statistics that the expected value is $0 (=.5(1) + .5(-1)). That means that if the game is played over and over then each student should expect to break-even. However, if the game is only played once, then one student will win $1 and one will lose $1.
  • What is the probability of a recession? 0.2 If the risk-free rate is 6.15%, what is the risk premium? Stock C: 9.9 – 6.15 = 3.75% Stock T: 17.7 – 6.15 = 11.55%
  • It’s important to point out that these formulas are for forecast data, and thus use probabilities to weight possible future outcomes, unlike the formulas in chapter 10 that were for historical data (divided by n-1),as past outcomes are all equally likely. Remind the students that standard deviation is the square root of the variance
  • The instructor’s manual provides information on how to compute the portfolio variance using the correlation or covariance between assets.
  • This is based on Fig. 11.2a in the book. Point out that there is a linear relationship between beta and expected return. Ask if the students remember the form of the equation for a line. Y = mx + b E(R) = slope (Beta) + y-intercept The y-intercept is = the risk-free rate, so all we need is the slope
  • Based on the discussion earlier, we now have all the components of the line: E(R) = [E(R M ) – R f ]  + R f
  • 8. This example will be used for each of the decision rules so that the students can compare the different rules and see that conflicts can arise. This illustrates the importance of recognizing which decision rules provide the best information for making decisions that will increase owner wealth.
  • 8. Again, the calculator used for the illustration is the TI- BA-II plus. The basic procedure is the same; you start with the year 0 cash flow and then enter the cash flows in order. F01, F02, etc. are used to set the frequency of a cash flow occurrence. Many calculators only require you to use that if the frequency is something other than 1. Since we have a positive NPV, we should accept the project.
  • 8. The payback period is year 3 if you assume that the cash flows occur at the end of the year, as we do with all of the other decision rules. If we assume that the cash flows occur evenly throughout the year, then the project pays back in 2.34 years. Either way, the payback rule would say to reject the project.
  • 8. The answer to all of these questions is no.
  • 8. No – it doesn’t pay back on a discounted basis within the required 2-year period
  • 8. The answer to the first two questions is yes. The answer to the third question is no because of the arbitrary cut-off date. Since the rule does not indicate whether or not we are creating value for the firm, it should not be the primary decision rule.
  • 8. The example in the book uses straight line depreciation to a zero salvage; that is why you can take the initial investment and divide by 2. If you use MACRS, you need to compute the BV in each period and take the average in the standard way.
  • 8. Students may ask where you came up with the 25%. Point out that this is one of the drawbacks of this rule. There is no good theory for determining what the return should be. We generally just use some rule of thumb. This rule would indicate that we reject the project.
  • 8. The answer to all of these questions is no. In fact, this rule is even worse than the payback rule in that it doesn’t even use cash flows for the analysis. It uses net income and book value.
  • 8. The IRR rule is very important. Management, and individuals in general, often have a much better feel for percentage returns and the value that is created, than they do for dollar increases. A dollar increase doesn’t appear to provide as much information if we don’t know what the initial expenditure was. Whether or not the additional information is relevant is another issue.
  • 8. Many of the financial calculators will compute the IRR as soon as it is pressed; others require that you press compute.
  • 8. The answer to all of these questions is yes, although it is not always as obvious. The IRR rule accounts for time value because it is finding the rate of return that equates all of the cash flows on a time value basis. The IRR rule accounts for the risk of the cash flows because you compare it to the required return, which is determined by the risk of the project. The IRR rule provides an indication of value because we will always increase value if we can earn a return greater than our required return. We should consider the IRR rule as our primary decision criteria, but as we will see, it has some problems that the NPV does not have. That is why we end up choosing the NPV as our ultimate decision rule.
  • 8. You should point out, however, that if you get a very large IRR that you should go back and look at your cash flow estimation again. In competitive markets, extremely high IRRs should be rare. Also, since the IRR calculation assumes that you can reinvest future cash flows at the IRR, a high IRR may be unrealistic.
  • 8. So what should we do – we have two rules that indicate to accept and three that indicate to reject.
  • 8. NPV = 132,000 / 1.15 + 100,000 / (1.15) 2 – 150,000 / (1.15) 3 – 90,000 = 1,769.54 Calculator: CF 0 = -90,000; C01 = 132,000; F01 = 1; C02 = 100,000; F02 = 1; C03 = -150,000; F03 = 1; I = 15; CPT NPV = 1769.54 If you compute the IRR on the calculator, you get 10.11% because it is the first one that you come to. So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV would say to accept and IRR would say to reject.
  • 8. You should accept the project if the required return is between 10.11% and 42.66%
  • 8. As long as we do not have limited capital, we should choose project A. Students will often argue that you should choose B because then you can invest the additional $100 in another good project, say C. The point is that if we do not have limited capital, we can invest in A and C and still be better off. If we have limited capital, then we will need to examine what combinations of projects with A provide the highest NPV and what combinations of projects with B provide the highest NPV. You then go with the set that will create the most value. If you have limited capital and a large number of mutually exclusive projects, then you will want to set up a computer program to determine the best combination of projects within the budget constraints. The important point is that we DO NOT use IRR to choose between projects regardless of whether or not we have limited capital.
  • 8. If the required return is less than the crossover point of 11.8%, then you should choose A If the required return is greater than the crossover point of 11.8%, then you should choose B
  • 8. Even though payback and AAR should not be used to make the final decision, we should consider the project very carefully if they suggest rejection. There may be more risk than we have considered or we may want to pay additional attention to our cash flow estimations. Sensitivity and scenario analysis can be used to help us evaluate our cash flows. The fact that payback is commonly used as a secondary criterion may be because short paybacks allow firms to have funds sooner to invest in other projects without going to the capital markets
  • With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant. Sunk costs – our government provides ample examples of inappropriately including sunk costs in their capital allocation decisions. Opportunity costs – the classic example of an opportunity cost is the use of land or plant that is already owned. It is important to point out that this is not “free.” At the very least we could sell the land; consequently if we choose to use it, we cost ourselves the selling price of the asset, net of possible tax effects. A good example of a positive side effect is when you will establish a new distribution system with this project that can be used for existing or future projects. The benefit provided to those projects needs to be considered. The most common negative side effect is erosion or cannibalism, where the introduction of a new product will reduce the sales of existing, similar products. A good real-world example is McDonald’s introduction of the Arch Deluxe sandwich. Instead of generating all new sales, it primarily reduced sales of the Big Mac and the Quarter Pounder. Had it drawn in adults to eat who were accompanied by their kids who then consume a Happy Meal, then it would have had a positive side effect. It is important to consider changes in NWC. We need to remember that operating cash flow derived from the income statement assumes all sales are cash sales and that the COGS was actually paid in cash during that period. By looking at changes in NWC specifically, we can adjust for the difference in cash flow timing that results from accounting conventions. Most projects will require an increase in NWC initially as we build inventory and receivables. We do not include financing costs in the cash flows of the project. They are impounded, percentage-wise, into the discount rate. Taxes will change as the firm’s taxable income changes. Consequently, we have to consider cash flows on an after tax basis.
  • Ask the students why net fixed assets is decreasing each year. It is important that they understand this when they go to compute the net capital spending in the next slide.
  • OCF = EBIT + depreciation – taxes = 33,000 + 30,000 – 11,220 = 51,780; or OCF = NI + depreciation = 21,780 + 30,000 = 51,780 Note that in the Table in the book, the negative signs have already been carried throughout the table so that the columns can just be added. Ultimately, students seem to do better with this format even though the CFFA equation says to subtract the changes in NWC and net capital spending. Change in NWC = We have a net investment in NWC in year 0 of 20,000; we get the investment back at the end of the project when we sell our inventory, collect on our receivables, and pay off our payables. Students often forget that we get the investment back at the end. Capital Spending – remember that Net capital spending = change in net fixed assets + depreciation. So in year one NCS = (60,000 – 90,000) + 30,000 = 0; The same is true for the other years.
  • The MACRS percentages are given in Table 9-7
  • Note that with MACRS you do not subtract the expected salvage from the initial cost. Also note that the MACRS % is multiplied by the initial cost every year. For some reason, students want to multiply by the book value.
  • The year-5 cash flow is the most difficult for students to grasp. It is important to point out that we are looking for ALL changes in cash flow associated with selling the machine today instead of in 5 years. If we do not sell the machine today, then we will have after-tax salvage of 10,000 in 5 years. Since we do sell the machine today, we LOSE the 10,000 cash flow 5 years from now.
  • The negative signs in the CFFA equation were once again carried through the table. That way outflows are in the table as negative and inflows are positive. OCF = NI + Depr. Exp. From slide 9-22.
  • Click on the excel icon to go to a spreadsheet that includes both the scenario analysis and the unit sales sensitivity analysis presented in the book.
  • If you face hard rationing, you need to reevaluate your analysis. If you truly estimated the required return and expected cash flows appropriately and computed a positive NPV, then capital should be available.
  • 12.
  • 12.
  • 12.
  • 12. Remind students that D 1 = D 0 x (1 + g) You may also want to take this time to remind them that return is comprised of the dividend yield (D 1 / P 0 ) and the capital gains yield (g)
  • 12. So, investors are currently requiring a return of 11.1% on our equity capital.
  • 12. You will often hear this referred to as the Capital Asset Pricing Model Approach as well. www: Click on the web surfer to go to Bloomberg’s website. To get the T-bill rates, go to Market Data, Rates and Bonds, and then look under US Treasuries. To get betas, go to and enter a ticker symbol to get the stock quote and Beta can be found at the bottom. Other sites that provide betas include
  • 12. Since the two models are reasonably close, we can assume that our cost of equity is around 19.5%
  • 12. Point out that the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.
  • 12. Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.
  • 12.
  • 12. Note that for bonds we would find the market value of each bond issue and then add them together. Also note that preferred stock would just become another component of the equation if the firm has preferred stock outstanding. Finally, we generally ignore current liabilities in our computations. However, if a company finances a substantial portion of its assets with current liabilities, they should be included in the process.
  • 12.
  • 12. Point out that if we have other financing that is a significant part of our capital structure, we would just add additional terms to the equation
  • 12. Remind students that bond prices are quoted as a percent of par value
  • 12. Point out that students do not have to compute the YTM based on the entire face amount. They can still use a single bond.
  • 12. Video Note: This is a good place to show the “Economic Value Added” video to reinforce the contents of the Reality Bytes box in the text.
  • 12. It is important to point out that the WACC is not very useful for companies that have several disparate divisions. www : Click on the web surfer icon to go to an index of business owned by General Electric. Ask the students if they think that projects proposed by “GE Infrastructure” should have the same discount rate as projects proposed by “GE Healthcare.” You can go through the list and illustrate why the divisional cost of capital is important for a company like GE. If GE’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.
  • 12. Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B. Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C. So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.
  • 13. Click on the Excel icon to go to a spreadsheet that contains all of the information for the example presented in the book.
  • 13.
  • 13.
  • 13. The main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change; and we haven’t changed the risk of existing cash flows, the value of the firm won’t change.
  • 13. Remind students that case I is a world without taxes. That is why the term (1 – T C ) is not included in the WACC equation.
  • 13. Remind students that if the firm is financed with 45% debt, then it is financed with 55% equity. At this point, you may need to remind them that one way to compute the D/E ratio is %debt / (1-%debt) The second question is used to reinforce that R A does not change when the capital structure changes Many students will not immediately see how to get the % of equity from the D/E ratio. Remind them that D+E = V. We are looking at ratios, so the actual $ amount of D and E is not important. All that matters is the relationship between them. So, let E = 1. Then D/1 = 1.5; Solve for D; D = 1.5. Then V = 1 + 1.5 = 2.5 and the percent equity is 1 / 2.5 = 40%. They often don’t understand that the choice of E = 1 is for simplicity. If they are confused about the process, then show them that it doesn’t matter what you set E equal to, as long as you keep the relationships intact. So, let E = 5; then D/5 = 1.5 and D = 5(1.5) = 7.5; V = 5 + 7.5 = 12.5 and E/V = 5 / 12.5 = 40%.
  • 13.
  • 13. Intuitively, an increase in financial leverage should increase systematic risk since changes in interest rates are a systematic risk factor and will have more impact the higher the financial leverage. The assumption that debt is riskless is for simplicity and to illustrate that even if debt is default risk-free, it still increases the variability of cash flows to the stockholders and thus the systematic risk.
  • 13. Point out once again that this result assumes that the debt is risk-free. The effect of leverage on financial risk will be even greater if the debt is not default-risk free.
  • 13. Point out that the government effectively pays part of our interest expense for us; it is subsidizing a portion of the interest payment.
  • 13. The levered firm has 6250 in 8% debt, so the interest expense = .08(6250) = 500 CFFA = EBIT – taxes (depreciation expense is the same in either case, so it will not affect CFFA on an incremental basis)
  • 13. Point out that the increase in cash flow in the example is exactly equal to the interest tax shield The assumption of perpetual debt makes the equations easier to work with, but it is useful to ask the students what would happen if we did not assume perpetual debt.
  • 13. R U is the cost of capital for an unlevered firm = R A for an unlevered firm V U is just the PV of the expected future cash flow from assets for an unlevered firm.
  • 13.
  • 13.
  • 13.
  • 13. Remind students that a D/E ratio = 1 implies 50% equity and 50% debt. The amount of leverage in the firm increased, the cost of equity increased, but the overall cost of capital decreased.
  • 14. Assuming that the second dividend is a liquidating dividend and the firm ceases to exist after period 2. PV = 10,000 / 1.12 + 10,000 / 1.12 2 = 16,900.51 PV = 9000 / 1.12 + 11,120 / 1.12 2 = 16,900.51
  • 14. If a firm changes its policy, it will just have different investors. Consequently, dividend policy won’t affect the value of the stock.
  • 14. Discuss how an increase in dividends sends a signal that prospects are good and that the firm will be able to maintain the higher dividend. If future dividends are expected to be higher, what should happen to the price? A decrease in dividends is usually an indication that the firm can no longer sustain the current dividend level. If dividends are expected to be lower in the future, what should happen to the stock price?
  • 14. We will talk about the residual policy and the compromise policy in more detail Given the information content of dividends, will a constant growth policy be good for the stockholders? Given the information content of dividends, will a constant payout ratio be good for stockholders?
  • 14.
  • 14. Remind students how to get % debt and % equity given D/E: If D/E = 2/3, the V = 2 + 3 = 5, so D/V = 2/5 = 40% and E/V = 3/5 = 60%
  • 14. www: Click on the web surfer icon to find out about upcoming stock splits and dividends
  • Financial management

    1. 1. Chapter 1 Introduction to Financial Management
    2. 2. Basic Areas Of Finance <ul><li>Corporate finance </li></ul><ul><li>Investments </li></ul><ul><li>Financial institutions </li></ul><ul><li>International finance </li></ul>
    3. 3. Financial Institutions <ul><li>Companies that specialize in financial matters </li></ul><ul><ul><li>Banks – commercial and investment, credit unions, savings and loans </li></ul></ul><ul><ul><li>Insurance companies </li></ul></ul><ul><ul><li>Brokerage firms </li></ul></ul><ul><li>Job opportunities </li></ul>
    4. 4. Financial Manager <ul><li>Financial managers try to answer some or all of financial questions </li></ul><ul><li>The top financial manager within a firm is usually the Chief Financial Officer (CFO) </li></ul><ul><ul><li>Treasurer – oversees cash management, credit management, capital expenditures, and financial planning </li></ul></ul><ul><ul><li>Controller – oversees taxes, cost accounting, financial accounting, and data processing </li></ul></ul>
    5. 5. Financial Management Decisions <ul><li>Capital budgeting </li></ul><ul><ul><li>What long-term investments or projects should the business take on? </li></ul></ul><ul><li>Capital structure </li></ul><ul><ul><li>How should we pay for our assets? </li></ul></ul><ul><ul><li>Should we use debt or equity? </li></ul></ul><ul><li>Working capital management </li></ul><ul><ul><li>How do we manage the day-to-day finances of the firm? </li></ul></ul>
    6. 6. Forms of Business Organization <ul><li>Three major forms in the united states </li></ul><ul><ul><li>Sole proprietorship </li></ul></ul><ul><ul><li>Partnership </li></ul></ul><ul><ul><ul><li>General </li></ul></ul></ul><ul><ul><ul><li>Limited </li></ul></ul></ul><ul><ul><li>Corporation </li></ul></ul><ul><ul><ul><li>Limited liability company </li></ul></ul></ul>
    7. 7. Sole Proprietorship <ul><li>Advantages </li></ul><ul><ul><li>Easiest to start </li></ul></ul><ul><ul><li>Least regulated </li></ul></ul><ul><ul><li>Single owner keeps all the profits </li></ul></ul><ul><ul><li>Taxed once as personal income </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Limited to life of owner </li></ul></ul><ul><ul><li>Equity capital limited to owner’s personal wealth </li></ul></ul><ul><ul><li>Unlimited liability </li></ul></ul><ul><ul><li>Difficult to sell ownership interest </li></ul></ul>
    8. 8. Partnership <ul><li>Advantages </li></ul><ul><ul><li>Two or more owners </li></ul></ul><ul><ul><li>More capital available </li></ul></ul><ul><ul><li>Relatively easy to start </li></ul></ul><ul><ul><li>Income taxed once as personal income </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Unlimited liability </li></ul></ul><ul><ul><ul><li>General partnership </li></ul></ul></ul><ul><ul><ul><li>Limited partnership </li></ul></ul></ul><ul><ul><li>Partnership dissolves when one partner dies or wishes to sell </li></ul></ul><ul><ul><li>Difficult to transfer ownership </li></ul></ul>
    9. 9. Corporation <ul><li>Advantages </li></ul><ul><ul><li>Limited liability </li></ul></ul><ul><ul><li>Unlimited life </li></ul></ul><ul><ul><li>Separation of ownership and management </li></ul></ul><ul><ul><li>Transfer of ownership is easy </li></ul></ul><ul><ul><li>Easier to raise capital </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Separation of ownership and management (agency problem) </li></ul></ul><ul><ul><li>Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate) </li></ul></ul>
    10. 10. Goal Of Financial Management <ul><li>What should be the goal of a corporation? </li></ul><ul><ul><li>Maximize profit? </li></ul></ul><ul><ul><li>Minimize costs? </li></ul></ul><ul><ul><li>Maximize market share? </li></ul></ul><ul><ul><li>Maximize the current value of the company’s stock? </li></ul></ul>
    11. 11. The Agency Problem <ul><li>Agency relationship </li></ul><ul><ul><li>Principal hires an agent to represent their interest </li></ul></ul><ul><ul><li>Stockholders (principals) hire managers (agents) to run the company </li></ul></ul><ul><li>Agency problem </li></ul><ul><ul><li>Conflict of interest between principal and agent </li></ul></ul><ul><li>Management goals and agency costs </li></ul>
    12. 12. Managing Managers <ul><li>Managerial compensation </li></ul><ul><ul><li>Incentives can be used to align management and stockholder interests </li></ul></ul><ul><ul><li>The incentives need to be structured carefully to make sure that they achieve their goal </li></ul></ul><ul><li>Corporate control </li></ul><ul><ul><li>The threat of a takeover may result in better management </li></ul></ul><ul><li>Other stakeholders </li></ul>
    13. 13. Figure 1.2
    14. 14. Financial Markets <ul><li>Cash flows to the firm </li></ul><ul><li>Primary vs. secondary markets </li></ul><ul><ul><li>Listed vs. over-the-counter securities </li></ul></ul><ul><ul><ul><li>NYSE </li></ul></ul></ul><ul><ul><ul><li>NASDAQ </li></ul></ul></ul>
    15. 15. Quick Quiz <ul><li>What are the four basic areas of finance? </li></ul><ul><li>What are the three types of financial management decisions </li></ul><ul><li>What are the three major forms of business organization? </li></ul><ul><li>What is the goal of financial management? </li></ul><ul><li>What are agency problems and why do they exist within a corporation? </li></ul>
    16. 16. Chapter 2 Financial Statements, Taxes, and Cash Flow
    17. 17. Chapter Outline <ul><li>The Balance Sheet </li></ul><ul><li>The Income Statement </li></ul><ul><li>Taxes </li></ul><ul><li>Cash Flow </li></ul>
    18. 18. The Balance Sheet <ul><li>The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time </li></ul><ul><li>Assets are listed in order of liquidity </li></ul><ul><ul><li>Ease of conversion to cash </li></ul></ul><ul><ul><li>Without significant loss of value </li></ul></ul><ul><li>Balance Sheet Identity </li></ul><ul><ul><li>Assets = Liabilities + Stockholders’ Equity </li></ul></ul>
    19. 19. Figure 2.1
    20. 20. U.S. Corporation Balance Sheet – Table 2.1
    21. 21. Market vs. Book Value <ul><li>The balance sheet provides the book value of the assets, liabilities, and equity. </li></ul><ul><li>Market value is the price at which the assets, liabilities or equity can actually be bought or sold. </li></ul><ul><li>Market value and book value are often very different. Why? </li></ul><ul><li>Which is more important to the decision-making process? </li></ul>
    22. 22. Klingon Corporation KLINGON CORPORATION Balance Sheets Market Value versus Book Value Book Market Book Market Assets Liabilities and Shareholders’ Equity NWC $ 400 $ 600 LTD $ 500 $ 500 NFA 700 1,000 Equity 600 1,100 1,100 1,600 1,100 1,600
    23. 23. Income Statement <ul><li>The income statement is more like a video of the firm’s operations for a specified period of time. </li></ul><ul><li>You generally report revenues first and then deduct any expenses for the period </li></ul><ul><li>Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue </li></ul>
    24. 24. U.S. Corporation Income Statement - Table 2.2
    25. 25. Work the Web Example <ul><li>Publicly traded companies must file regular reports with the Securities and Exchange Commission </li></ul><ul><li>These reports are usually filed electronically and can be searched at the SEC public site called EDGAR </li></ul><ul><li>Click on the web surfer, pick a company, and see what you can find! </li></ul>
    26. 26. Taxes <ul><li>The one thing we can rely on with taxes is that they are always changing </li></ul><ul><li>Marginal vs. average tax rates </li></ul><ul><ul><li>Marginal – the percentage paid on the next dollar earned </li></ul></ul><ul><ul><li>Average – the tax bill / taxable income </li></ul></ul><ul><li>Other taxes </li></ul>
    27. 27. Example: Marginal Vs. Average Rates <ul><li>Suppose your firm earns $4 million in taxable income. </li></ul><ul><ul><li>What is the firm’s tax liability? </li></ul></ul><ul><ul><li>What is the average tax rate? </li></ul></ul><ul><ul><li>What is the marginal tax rate? </li></ul></ul><ul><li>If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis? </li></ul>
    28. 28. The Concept of Cash Flow <ul><li>Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements </li></ul><ul><li>The statement of cash flows does not provide us with the same information that we are looking at here </li></ul><ul><li>We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets </li></ul>
    29. 29. Cash Flow From Assets <ul><li>Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders </li></ul><ul><li>Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC </li></ul>
    30. 30. Example: U.S. Corporation <ul><li>OCF ( I/S ) = EBIT + depreciation – taxes = $547 </li></ul><ul><li>NCS ( B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 </li></ul><ul><li>Changes in NWC (B/S) = ending NWC – beginning NWC = $330 </li></ul><ul><li>CFFA = 547 – 130 – 330 = $87 </li></ul><ul><li>CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24 </li></ul><ul><li>CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63 </li></ul><ul><li>CFFA = 24 + 63 = $87 </li></ul>
    31. 31. Table 2.5
    32. 32. Example: Balance Sheet and Income Statement Information <ul><li>Current Accounts </li></ul><ul><ul><li>2005: CA = 1500; CL = 1300 </li></ul></ul><ul><ul><li>2006: CA = 2000; CL = 1700 </li></ul></ul><ul><li>Fixed Assets and Depreciation </li></ul><ul><ul><li>2005: NFA = 3000; 2006: NFA = 4000 </li></ul></ul><ul><ul><li>Depreciation expense = 300 </li></ul></ul><ul><li>LT Liabilities and Equity </li></ul><ul><ul><li>2005: LTD = 2200; Common Stock = 500; RE = 500 </li></ul></ul><ul><ul><li>2006: LTD = 2800; Common Stock = 750; RE = 750 </li></ul></ul><ul><li>Income Statement Information </li></ul><ul><ul><li>EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250 </li></ul></ul>
    33. 33. Example: Cash Flows <ul><li>OCF = 2700 + 300 – 1000 = 2000 </li></ul><ul><li>NCS = 4000 – 3000 + 300 = 1300 </li></ul><ul><li>Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100 </li></ul><ul><li>CFFA = 2000 – 1300 – 100 = 600 </li></ul><ul><li>CF to Creditors = 200 – (2800 – 2200) = -400 </li></ul><ul><li>CF to Stockholders = 1250 – (750 – 500) = 1000 </li></ul><ul><li>CFFA = -400 + 1000 = 600 </li></ul><ul><li>The CF identity holds. </li></ul>
    34. 34. Quick Quiz <ul><li>What is the difference between book value and market value? Which should we use for decision making purposes? </li></ul><ul><li>What is the difference between accounting income and cash flow? Which do we need to use when making decisions? </li></ul><ul><li>What is the difference between average and marginal tax rates? Which should we use when making financial decisions? </li></ul><ul><li>How do we determine a firm’s cash flows? What are the equations and where do we find the information? </li></ul>
    35. 35. Chapter 4 Introduction to Valuation: The Time Value of Money
    36. 36. Basic Definitions <ul><li>Present Value – earlier money on a time line </li></ul><ul><li>Future Value – later money on a time line </li></ul><ul><li>Interest rate – “exchange rate” between earlier money and later money </li></ul><ul><ul><li>Discount rate </li></ul></ul><ul><ul><li>Cost of capital </li></ul></ul><ul><ul><li>Opportunity cost of capital </li></ul></ul><ul><ul><li>Required return </li></ul></ul>
    37. 37. Future Values <ul><li>Suppose you invest $1000 for one year at 5% per year. What is the future value in one year? </li></ul><ul><ul><li>Interest = 1,000(.05) = 50 </li></ul></ul><ul><ul><li>Value in one year = principal + interest = 1,000 + 50 = 1050 </li></ul></ul><ul><ul><li>Future Value (FV) = 1,000(1 + .05) = 1,050 </li></ul></ul><ul><li>Suppose you leave the money in for another year. How much will you have two years from now? </li></ul><ul><ul><li>FV = 1,000(1.05)(1.05) = 1,000(1.05) 2 = 1,102.50 </li></ul></ul>
    38. 38. Future Values: General Formula <ul><li>FV = PV(1 + r) t </li></ul><ul><ul><li>FV = future value </li></ul></ul><ul><ul><li>PV = present value </li></ul></ul><ul><ul><li>r = period interest rate, expressed as a decimal </li></ul></ul><ul><ul><li>T = number of periods </li></ul></ul><ul><li>Future value interest factor = (1 + r) t </li></ul>
    39. 39. Effects of Compounding <ul><li>Simple interest (interest is earned only on the original principal) </li></ul><ul><li>Compound interest (interest is earned on principal and on interest received) </li></ul><ul><li>Consider the previous example </li></ul><ul><ul><li>FV with simple interest = 1,000 + 50 + 50 = 1,100 </li></ul></ul><ul><ul><li>FV with compound interest = 1,102.50 </li></ul></ul><ul><ul><li>The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the first interest payment </li></ul></ul>
    40. 40. Future Values – Example <ul><li>Suppose you invest the $1000 from the previous example for 5 years. How much would you have? </li></ul><ul><ul><li>FV = 1,000(1.05) 5 = 1,276.28 </li></ul></ul><ul><li>The effect of compounding is small for a small number of periods, but increases as the number of periods increases. (Simple interest would have a future value of $1,250, for a difference of $26.28.) </li></ul>
    41. 41. Present Values <ul><li>How much do I have to invest today to have some amount in the future? </li></ul><ul><ul><li>FV = PV(1 + r) t </li></ul></ul><ul><ul><li>Rearrange to solve for PV = FV / (1 + r) t </li></ul></ul><ul><li>When we talk about discounting, we mean finding the present value of some future amount. </li></ul><ul><li>When we talk about the “value” of something, we are talking about the present value unless we specifically indicate that we want the future value. </li></ul>
    42. 42. Present Values – Example <ul><li>You want to begin saving for you daughter’s college education and you estimate that she will need $150,000 in 17 years. If you feel confident that you can earn 8% per year, how much do you need to invest today? </li></ul><ul><ul><li>PV = 150,000 / (1.08) 17 = 40,540.34 </li></ul></ul>
    43. 43. Figure 4.3
    44. 44. Discount Rate <ul><li>Often we will want to know what the implied interest rate is in an investment </li></ul><ul><li>Rearrange the basic PV equation and solve for r </li></ul><ul><ul><li>FV = PV(1 + r) t </li></ul></ul><ul><ul><li>r = (FV / PV) 1/t – 1 </li></ul></ul><ul><li>If you are using formulas, you will want to make use of both the y x and the 1/x keys </li></ul>
    45. 45. Discount Rate – Example <ul><li>You are looking at an investment that will pay $1,200 in 5 years if you invest $1,000 today. What is the implied rate of interest? </li></ul><ul><ul><li>r = (1,200 / 1,000) 1/5 – 1 = .03714 = 3.714% </li></ul></ul>
    46. 46. Finding the Number of Periods <ul><li>Start with basic equation and solve for t (remember your logs) </li></ul><ul><ul><li>FV = PV(1 + r) t </li></ul></ul><ul><ul><li>t = ln(FV / PV) / ln(1 + r) </li></ul></ul><ul><li>You can use the financial keys on the calculator as well, just remember the sign convention. </li></ul>
    47. 47. Number of Periods – Example <ul><li>You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car? </li></ul><ul><ul><li>t = ln(20,000 / 15,000) / ln(1.1) = 3.02 years </li></ul></ul>
    48. 48. Example: Spreadsheet Strategies <ul><li>Use the following formulas for TVM calculations </li></ul><ul><ul><li>FV(rate,nper,pmt,pv) </li></ul></ul><ul><ul><li>PV(rate,nper,pmt,fv) </li></ul></ul><ul><ul><li>RATE(nper,pmt,pv,fv) </li></ul></ul><ul><ul><li>NPER(rate,pmt,pv,fv) </li></ul></ul>
    49. 49. Chapter 5 Discounted Cash Flow Valuation
    50. 50. Multiple Cash Flows <ul><li>Suppose you plan to deposit $100 into an account in one year and $300 into the account in three years. Future value in five years if r=8%? </li></ul><ul><ul><li>FV = 100(1.08) 4 + 300(1.08) 2 = 136.05 + 349.92 = 485.97 </li></ul></ul>
    51. 51. Example <ul><li>Suppose you are looking at the following possible cash flows: Year 1 CF = $100; Years 2 and 3 CFs = $200; Years 4 and 5 CFs = $300. The required discount rate is 7% </li></ul><ul><li>What is the value of the cash flows at year 5? </li></ul><ul><li>What is the value of the cash flows today? </li></ul><ul><li>What is the value of the cash flows at year 3? </li></ul>
    52. 52. Annuities and Perpetuities <ul><li>Annuity – finite series of equal payments that occur at regular intervals </li></ul><ul><ul><li>Ordinary annuity </li></ul></ul><ul><ul><li>Annuity due </li></ul></ul><ul><li>Perpetuity – infinite series of equal payments </li></ul>
    53. 53. Annuities and Perpetuities – <ul><li>Perpetuity: PV = C / r </li></ul><ul><li>Annuities: </li></ul>
    54. 54. Annuity Example <ul><li>You borrow money TODAY so you need to compute the present value. </li></ul><ul><ul><li>48 N; 1 I/Y; -632 PMT; CPT PV = 23,999.54 ($24,000) </li></ul></ul><ul><li>Formula: </li></ul>
    55. 55. Finding the Payment <ul><li>Suppose you want to borrow $20,000 for a new car. You can borrow at 8% per year, compounded monthly (8/12 = .666666667% per month). If you take a 4-year loan, what is your monthly payment? </li></ul><ul><ul><li>20,000 = C[1 – 1 / 1.0066667 48 ] / .0066667 </li></ul></ul><ul><ul><li>C = 488.26 </li></ul></ul>
    56. 56. Future Values for Annuities <ul><li>Suppose you begin saving for your retirement by depositing $2,000 per year in an IRA. If the interest rate is 7.5%, how much will you have in 40 years? </li></ul><ul><ul><li>FV(Ordinary) = 2,000(1.075 40 – 1)/.075 = 454,513.04 </li></ul></ul><ul><ul><li>FV(Due) = 32,464 </li></ul></ul>
    57. 57. Annuity Due <ul><li>You are saving for a new house and you put $10,000 per year in an account paying 8%. The first payment is made today. How much will you have at the end of 3 years? </li></ul><ul><ul><li>FV = 10,000[(1.08 3 – 1) / .08](1.08) = 35,061.12 </li></ul></ul>
    58. 58. Perpetuity – Example 5.7 <ul><li>Perpetuity formula: PV = C / r </li></ul><ul><li>Current required return: </li></ul><ul><ul><li>40 = 1 / r </li></ul></ul><ul><ul><li>r = .025 or 2.5% per quarter </li></ul></ul><ul><li>Dividend for new preferred: </li></ul><ul><ul><li>100 = C / .025 </li></ul></ul><ul><ul><li>C = 2.50 per quarter </li></ul></ul>
    59. 59. Effective Annual Rate (EAR) <ul><li>This is the actual rate paid (or received) after accounting for compounding that occurs during the year </li></ul><ul><li>If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison. </li></ul>
    60. 60. Annual Percentage Rate <ul><li>By definition APR = period rate times the number of periods per year </li></ul><ul><li>Consequently, to get the period rate we rearrange the APR equation: </li></ul><ul><ul><li>Period rate = APR / # of periods per year </li></ul></ul><ul><li>You should NEVER divide the effective rate by the number of periods per year – it will NOT give you the period rate </li></ul>
    61. 61. Computing APRs <ul><li>What is the APR if the monthly rate is .5%? </li></ul><ul><ul><li>.5(12) = 6% </li></ul></ul><ul><li>What is the APR if the semiannual rate is .5%? </li></ul><ul><ul><li>.5(2) = 1% </li></ul></ul><ul><li>What is the monthly rate if the APR is 12% with monthly compounding? </li></ul><ul><ul><li>12 / 12 = 1% </li></ul></ul>
    62. 62. Computing EARs - Example <ul><li>Suppose you can earn 1% per month on $1 invested today. </li></ul><ul><ul><li>What is the APR? 1(12) = 12% </li></ul></ul><ul><ul><li>How much are you effectively earning? </li></ul></ul><ul><ul><ul><li>FV = 1(1.01) 12 = 1.1268 </li></ul></ul></ul><ul><ul><ul><li>Rate = (1.1268 – 1) / 1 = .1268 = 12.68% </li></ul></ul></ul><ul><li>Suppose if you put it in another account, you earn 3% per quarter. </li></ul><ul><ul><li>What is the APR? 3(4) = 12% </li></ul></ul><ul><ul><li>How much are you effectively earning? </li></ul></ul><ul><ul><ul><li>FV = 1(1.03) 4 = 1.1255 </li></ul></ul></ul><ul><ul><ul><li>Rate = (1.1255 – 1) / 1 = .1255 = 12.55% </li></ul></ul></ul>
    63. 63. EAR with APR Remember that the APR is the quoted rate, and m is the number of compounds per year
    64. 64. Decisions, Decisions II <ul><li>You are looking at two savings accounts. One pays 5.25%, with daily compounding. The other pays 5.3% with semiannual compounding. Which account should you use? </li></ul><ul><ul><li>First account: </li></ul></ul><ul><ul><ul><li>EAR = (1 + .0525/365) 365 – 1 = 5.39% </li></ul></ul></ul><ul><ul><li>Second account: </li></ul></ul><ul><ul><ul><li>EAR = (1 + .053/2) 2 – 1 = 5.37% </li></ul></ul></ul><ul><li>Which account should you choose and why? </li></ul>
    65. 65. Computing Payments with APRs <ul><li>Monthly payments. The entire computer system costs $3500. The loan period is for 2 years and the interest rate is 16.9% with monthly compounding. What is your monthly payment? </li></ul><ul><ul><li>Monthly rate = .169 / 12 = .01408333333 </li></ul></ul><ul><ul><li>Number of months = 2(12) = 24 </li></ul></ul><ul><ul><li>3500 = C[1 – 1 / 1.01408333333) 24 ] / .01408333333 </li></ul></ul><ul><ul><li>C = 172.88 </li></ul></ul>
    66. 66. Monthly Compounding <ul><li>Suppose you deposit $50 per month into an account that has an APR of 9%, based on monthly compounding. How much will you have in the account in 35 years? </li></ul><ul><ul><li>Monthly rate = .09 / 12 = .0075 </li></ul></ul><ul><ul><li>Number of months = 35(12) = 420 </li></ul></ul><ul><ul><li>FV = 50[1.0075 420 – 1] / .0075 = 147,089.22 </li></ul></ul>
    67. 67. Pure Discount Loans <ul><li>The principal amount is repaid at some future date, without any periodic interest payments. </li></ul><ul><li>If a T-bill promises to repay $10,000 in 12 months and the market interest rate is 7 percent, how much will the bill sell for in the market? </li></ul><ul><ul><li>PV = 10,000 / 1.07 = 9,345.79 </li></ul></ul>
    68. 68. Amortized Loan - Example <ul><li>Each payment covers the interest expense plus reduces principal </li></ul><ul><li>Consider a 4-year loan with annual payments. The interest rate is 8% and the principal amount is $5000. </li></ul><ul><ul><li>What is the annual payment? </li></ul></ul><ul><ul><ul><li>5,000 = C[1 – 1 / 1.08 4 ] / .08 </li></ul></ul></ul><ul><ul><ul><li>C = 1,509.60 </li></ul></ul></ul>
    69. 69. Amortization Table for Example Year Beg. Balance Total Payment Interest Paid Principal Paid End. Balance 1 5,000.00 1509.60 400.00 1109.60 3890.40 2 3890.40 1509.60 311.23 1198.37 2692.03 3 2692.03 1509.60 215.36 1294.24 1397.79 4 1397.79 1509.60 111.82 1397.78 .01 Totals 6038.40 1038.41 4999.99
    70. 70. Chapter 6 Interest Rates and Bond Valuation
    71. 71. The Bond-Pricing Equation
    72. 72. Valuing a Discount Bond <ul><li>Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1,000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? </li></ul><ul><ul><li>Using the formula: </li></ul></ul><ul><ul><ul><li>B = PV of annuity + PV of lump sum </li></ul></ul></ul><ul><ul><ul><li>B = 100[1 – 1/(1.11) 5 ] / .11 + 1,000 / (1.11) 5 </li></ul></ul></ul><ul><ul><ul><li>B = 369.59 + 593.45 = 963.04 </li></ul></ul></ul><ul><ul><li>Using the calculator: </li></ul></ul><ul><ul><ul><li>N = 5; I/Y = 11; PMT = 100; FV = 1,000 </li></ul></ul></ul><ul><ul><ul><li>CPT PV = -963.04 </li></ul></ul></ul>
    73. 73. Relationship Btn Price and YTM
    74. 74. Relationship Btn Coupon and Yield <ul><li>If YTM = coupon rate, then par value = bond price </li></ul><ul><li>If YTM > coupon rate, then par value > bond price </li></ul><ul><li>If YTM < coupon rate, then par value < bond price </li></ul>
    75. 75. Interest Rate Risk <ul><li>Change in price due to changes in interest rates </li></ul><ul><ul><li>Interest rates up, bond price down! </li></ul></ul><ul><ul><li>Long-term bonds have more interest rate risk than short-term bonds </li></ul></ul><ul><ul><ul><li>More-distant cash flows are more adversely affected by an increase in interest rates </li></ul></ul></ul><ul><ul><li>Lower coupon rate bonds have more interest rate risk than higher coupon rate bonds </li></ul></ul><ul><ul><ul><li>More of the bond’s value is deferred to maturity (thus, for a longer time) if the coupons are small </li></ul></ul></ul>
    76. 76. Figure 6.2
    77. 77. The Bond Indenture <ul><li>Contract between the company and the bondholders and includes </li></ul><ul><ul><li>The basic terms of the bonds </li></ul></ul><ul><ul><li>The total amount of bonds issued </li></ul></ul><ul><ul><li>A description of property used as security, if applicable </li></ul></ul><ul><ul><li>Sinking fund provisions </li></ul></ul><ul><ul><li>Call provisions </li></ul></ul><ul><ul><li>Details of protective covenants </li></ul></ul>
    78. 78. Bond Classifications <ul><li>Registered vs. Bearer Forms </li></ul><ul><li>Security </li></ul><ul><ul><li>Collateral – secured by financial securities </li></ul></ul><ul><ul><li>Mortgage – secured by real property, normally land or buildings </li></ul></ul><ul><ul><li>Debentures – unsecured </li></ul></ul><ul><ul><li>Notes – unsecured debt with original maturity less than 10 years </li></ul></ul><ul><li>Seniority </li></ul>
    79. 79. Bond Characteristics and r <ul><li>The coupon rate is usually set close to the yield, which depends on the risk characteristics of the bond when issued </li></ul><ul><li>Which bonds will have the higher coupon, all else equal? </li></ul><ul><ul><li>Secured debt versus a debenture </li></ul></ul><ul><ul><li>Subordinated debenture versus senior debt </li></ul></ul><ul><ul><li>A bond with a sinking fund versus one without </li></ul></ul><ul><ul><li>A callable bond versus a non-callable bond </li></ul></ul>
    80. 80. Bond Ratings – Investment Quality <ul><li>High Grade </li></ul><ul><li>Medium Grade </li></ul><ul><li>Low Grade </li></ul><ul><li>Very Low Grade </li></ul>
    81. 81. Government Bonds <ul><li>Treasury Securities </li></ul><ul><ul><li>Federal government debt </li></ul></ul><ul><ul><li>T-bills –maturity of one year or less </li></ul></ul><ul><ul><li>T-notes –maturity between one and ten years </li></ul></ul><ul><ul><li>T-bonds- maturity greater than ten years </li></ul></ul><ul><li>Municipal Securities </li></ul><ul><ul><li>Debt of state and local governments </li></ul></ul><ul><ul><li>Varying degrees of default risk, rated similar to corporate debt </li></ul></ul><ul><ul><li>Interest received is tax-exempt at the federal level </li></ul></ul>
    82. 82. Example 6.3 <ul><li>A taxable bond has a yield of 8% and a municipal bond has a yield of 6% </li></ul><ul><ul><li>If you are in a 40% tax bracket, which bond do you prefer? </li></ul></ul><ul><ul><ul><li>8%(1 - .4) = 4.8% </li></ul></ul></ul><ul><ul><ul><li>The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the municipal </li></ul></ul></ul><ul><ul><li>At what tax rate would you be indifferent between the two bonds? </li></ul></ul><ul><ul><ul><li>8%(1 – T) = 6% </li></ul></ul></ul><ul><ul><ul><li>T = 25% </li></ul></ul></ul>
    83. 83. Zero Coupon Bonds <ul><li>Make no periodic interest payments (coupon rate = 0%) </li></ul><ul><li>Sometimes called zeroes, or deep discount bonds </li></ul><ul><li>Treasury Bills and principal-only Treasury strips are good examples of zeroes </li></ul>
    84. 84. Bond Markets <ul><li>Primarily over-the-counter transactions with dealers connected electronically </li></ul><ul><li>Extremely large number of bond issues, but generally low daily volume in single issues </li></ul><ul><li>Treasury securities are an exception </li></ul>
    85. 85. The Fisher Effect <ul><li>The Fisher Effect defines the relationship between real rates, nominal rates and inflation </li></ul><ul><li>(1 + R) = (1 + r)(1 + h), where </li></ul><ul><ul><li>R = nominal rate </li></ul></ul><ul><ul><li>r = real rate </li></ul></ul><ul><ul><li>h = expected inflation rate </li></ul></ul><ul><li>Approximation </li></ul><ul><ul><li>R = r + h </li></ul></ul>
    86. 86. Example 6.6 <ul><li>If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? </li></ul><ul><li>R = (1.1)(1.08) – 1 = .188 = 18.8% </li></ul><ul><li>Approximation: R = 10% + 8% = 18% </li></ul><ul><li>Because the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation. </li></ul>
    87. 87. Term Structure of Interest Rates <ul><li>Term structure is the relationship between time to maturity and yields, all else equal </li></ul><ul><li>Yield curve – graphical representation of the term structure </li></ul><ul><ul><li>Normal – upward-sloping, long-term yields are higher than short-term yields </li></ul></ul><ul><ul><li>Inverted – downward-sloping, long-term yields are lower than short-term yields </li></ul></ul>
    88. 88. Figure 6.6 – Upward-Sloping Curve
    89. 89. Figure 6.6 – Downward-Sloping
    90. 90. Figure 6.7 – Treasury Yield
    91. 91. Factors Affecting Required Return <ul><li>Default risk premium – remember bond ratings </li></ul><ul><li>Taxability premium – remember municipal versus taxable </li></ul><ul><li>Liquidity premium – bonds that have more frequent trading will generally have lower required returns </li></ul><ul><li>Anything else that affects the risk of the cash flows to the bondholders, will affect the required returns </li></ul>
    92. 92. Chapter 7 Equity Markets and Stock Valuation
    93. 93. <ul><li>Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? </li></ul><ul><ul><li>Compute the PV of the expected cash flows </li></ul></ul><ul><ul><li>Price = (14 + 2) / (1.2) = $13.33 </li></ul></ul>One-Period Example
    94. 94. <ul><li>Now what if you decide to hold the stock for two years? In addition to the dividend in one year, you expect a dividend of $2.10 in two years and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay? </li></ul><ul><ul><li>PV = 2 / (1.2) + (2.10 + 14.70) / (1.2) 2 = 13.33 </li></ul></ul>Two-Period Example
    95. 95. <ul><li>Constant dividend </li></ul><ul><ul><li>The firm will pay a constant dividend forever </li></ul></ul><ul><ul><li>This is like preferred stock </li></ul></ul><ul><ul><li>The price is computed using the perpetuity formula </li></ul></ul><ul><li>Constant dividend growth </li></ul><ul><ul><li>The firm will increase the dividend by a constant percent every period </li></ul></ul><ul><li>Supernormal growth </li></ul><ul><ul><li>Dividend growth is not consistent initially, but settles down to constant growth eventually </li></ul></ul>Dividends: Special Cases
    96. 96. <ul><li>If dividends are expected at regular intervals forever, then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formula </li></ul><ul><ul><li>P 0 = D / R </li></ul></ul><ul><li>Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price? </li></ul><ul><ul><li>P 0 = .50 / (.1 / 4) = $20 </li></ul></ul>Zero Growth
    97. 97. <ul><li>Dividends are expected to grow at a constant percent per period. </li></ul><ul><ul><li>P 0 = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + … </li></ul></ul><ul><ul><li>P 0 = D 0 (1+g)/(1+R) + D 0 (1+g) 2 /(1+R) 2 + D 0 (1+g) 3 /(1+R) 3 + … </li></ul></ul><ul><li>With a little algebra and some series work, this reduces to: </li></ul>Dividend Growth Model
    98. 98. <ul><li>Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for? </li></ul><ul><li>P 0 = .50(1+.02) / (.15 - .02) = $3.92 </li></ul>DGM – Example 1
    99. 99. Stock Price Sensitivity to Dividend Growth, g D 1 = $2; R = 20%
    100. 100. Stock Price Sensitivity to Required Return, R D 1 = $2; g = 5%
    101. 101. <ul><li>Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%. </li></ul><ul><li>What is the current price? </li></ul><ul><ul><li>P 0 = 4 / (.16 - .06) = $40 </li></ul></ul><ul><ul><li>Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g </li></ul></ul>Gordon Growth I
    102. 102. <ul><li>What is the price expected to be in year 4? </li></ul><ul><ul><li>P 4 = D 4 (1 + g) / (R – g) = D 5 / (R – g) </li></ul></ul><ul><ul><li>P 4 = 4(1+.06) 4 / (.16 - .06) = 50.50 </li></ul></ul><ul><li>What is the implied return given the change in price during the four year period? </li></ul><ul><ul><li>50.50 = 40(1+return) 4 ; return = 6% </li></ul></ul><ul><li>The price grows at the same rate as the dividends </li></ul>Gordon Growth II
    103. 103. <ul><li>Start with the DGM: </li></ul>Using the DGM to Find R
    104. 104. <ul><li>Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? </li></ul><ul><ul><li>R = [1(1.05)/10.50] + .05 = 15% </li></ul></ul><ul><li>What is the dividend yield? </li></ul><ul><ul><li>1(1.05) / 10.50 = 10% </li></ul></ul><ul><li>What is the capital gains yield? </li></ul><ul><ul><li>g =5% </li></ul></ul>Finding the Required Return
    105. 105. <ul><li>Voting Rights </li></ul><ul><li>Proxy voting </li></ul><ul><li>Other Rights </li></ul><ul><ul><li>Share proportionally in declared dividends </li></ul></ul><ul><ul><li>Share proportionally in remaining assets during liquidation </li></ul></ul><ul><ul><li>Preemptive right – first shot at new stock issue to maintain proportional ownership if desired </li></ul></ul>Features of Common Stock
    106. 106. <ul><li>Dividends are not a liability of the firm until a dividend has been declared by the Board </li></ul><ul><li>Dividends and Taxes </li></ul><ul><ul><li>Dividend payments are not considered a business expense; therefore, they are not tax deductible </li></ul></ul><ul><ul><li>The taxation of dividends received by individuals depends on the holding period </li></ul></ul>Dividend Characteristics
    107. 107. <ul><li>Dividends </li></ul><ul><ul><li>Stated dividend that must be paid before dividends can be paid to common stockholders </li></ul></ul><ul><ul><li>Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid </li></ul></ul><ul><li>Preferred stock generally does not carry voting rights </li></ul>Features of Preferred Stock
    108. 108. <ul><li>You observe a stock price of $18.75. You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return? </li></ul><ul><li>What are some of the major characteristics of common stock? </li></ul><ul><li>What are some of the major characteristics of preferred stock? </li></ul>Quick Quiz
    109. 109. Chapter 10 Market History: Risk and Return
    110. 110. Risk, Return, and Financial Markets <ul><li>We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets </li></ul><ul><li>Lessons from capital market history </li></ul><ul><ul><li>There is a reward for bearing risk </li></ul></ul><ul><ul><li>The greater the risk, the greater the potential reward </li></ul></ul><ul><ul><li>This is called the risk-return trade-off </li></ul></ul>
    111. 111. Dollar Returns <ul><li>Total dollar return = income from investment + capital gain (loss) due to change in price </li></ul><ul><li>Example: </li></ul><ul><ul><li>You bought a bond for $950 one year ago. You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return? </li></ul></ul><ul><ul><ul><li>Income = $30 + $30 = $60 </li></ul></ul></ul><ul><ul><ul><li>Capital gain = $975 – $950 = $25 </li></ul></ul></ul><ul><ul><ul><li>Total dollar return = $60 + $25 = $85 </li></ul></ul></ul>
    112. 112. Percentage Returns <ul><li>It is generally more intuitive to think in terms of percentages than dollar returns </li></ul><ul><li>Dividend yield = income / beginning price </li></ul><ul><li>Capital gains yield = (ending price – beginning price) / beginning price </li></ul><ul><li>Total percentage return = dividend yield + capital gains yield </li></ul>
    113. 113. Example: Calculating Returns <ul><li>You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40. </li></ul><ul><ul><li>What is your dollar return? </li></ul></ul><ul><ul><ul><li>Dollar return = 1.25 + (40 – 35) = $6.25 </li></ul></ul></ul><ul><ul><li>What is your percentage return? </li></ul></ul><ul><ul><ul><li>Dividend yield = 1.25 / 35 = 3.57% </li></ul></ul></ul><ul><ul><ul><li>Capital gains yield = (40 – 35) / 35 = 14.29% </li></ul></ul></ul><ul><ul><ul><li>Total percentage return = 3.57 + 14.29 = 17.86% </li></ul></ul></ul>
    114. 114. Average Returns Investment Average Return Large Stocks 12.3% Small Stocks 17.4% Long-term Corporate Bonds 6.2% Long-term Government Bonds 5.8% U.S. Treasury Bills 3.8% Inflation 3.1%
    115. 115. Historical Risk Premiums <ul><li>Large Stocks: 12.3 – 3.8 = 8.5% </li></ul><ul><li>Small Stocks: 17.4 – 3.8 = 13.6% </li></ul><ul><li>Long-term Corporate Bonds: 6.2 – 3.8 = 2.4% </li></ul><ul><li>Long-term Government Bonds: 6.2 – 3.8 = 2.4% </li></ul><ul><li>U.S. Treasury Bills: 3.8 – 3.8 = 0 (by definition!) </li></ul>
    116. 116. Variance and Standard Deviation <ul><li>We use variance and standard deviation to measure the volatility of asset returns </li></ul><ul><li>The greater the volatility, the greater the uncertainty </li></ul><ul><li>Historical variance = sum of squared deviations from the mean / (number of observations – 1) </li></ul><ul><li>Standard deviation = square root of the variance </li></ul>
    117. 117. Example – Variance and Standard Deviation Note: Average return = .42 / 4 = .105 Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873 Year Actual Return Average Return Deviation from the Mean Squared Deviation 1 .15 .105 .045 .002025 2 .09 .105 -.015 .000225 3 .06 .105 -.045 .002025 4 .12 .105 .015 .000225 Totals .42 .00 .0045
    118. 118. Arithmetic vs. Geometric Mean <ul><li>Arithmetic average – return earned in an average period over multiple periods </li></ul><ul><li>Geometric average – average compound return per period over multiple periods </li></ul><ul><li>The geometric average will be less than the arithmetic average unless all the returns are equal </li></ul><ul><li>Which is better? </li></ul><ul><ul><li>The arithmetic average is overly optimistic for long horizons </li></ul></ul><ul><ul><li>The geometric average is overly pessimistic for short horizons </li></ul></ul><ul><ul><li>So the answer depends on the planning period under consideration </li></ul></ul><ul><ul><ul><li>15 – 20 years or less: use arithmetic </li></ul></ul></ul><ul><ul><ul><li>20 – 40 years or so: split the difference between them </li></ul></ul></ul><ul><ul><ul><li>40 + years: use the geometric </li></ul></ul></ul>
    119. 119. Example: Computing Returns <ul><li>What are the arithmetic and geometric averages for the following returns? </li></ul><ul><ul><li>Year 1 5% </li></ul></ul><ul><ul><li>Year 2 -3% </li></ul></ul><ul><ul><li>Year 3 12% </li></ul></ul><ul><ul><li>Arithmetic average = (5 + (–3) + 12)/3 = 4.67% </li></ul></ul><ul><ul><li>Geometric average = [(1+.05)*(1-.03)*(1+.12)] 1/3 – 1 = .0449 = 4.49% </li></ul></ul>
    120. 120. Comprehensive Problem <ul><li>Your stock investments return 8%, 12%, and -4% in consecutive years. What is the geometric return? </li></ul><ul><li>What is the sample standard deviation of the above returns? </li></ul><ul><li>Using the standard deviation and mean that you just calculated, and assuming a normal probability distribution, what is the probability of losing 3% or more? </li></ul>
    121. 121. Chapter 11 CAPM: Risk and Return
    122. 122. Expected Returns <ul><li>Expected returns are based on the probabilities of possible outcomes </li></ul><ul><li>In this context, “expected” means “average” if the process is repeated many times </li></ul><ul><li>The “expected” return does not even have to be a possible return </li></ul>
    123. 123. Example: Expected Returns <ul><li>Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? </li></ul><ul><ul><li>State Probability C T </li></ul></ul><ul><ul><li>Boom 0.3 0.15 0.25 </li></ul></ul><ul><ul><li>Normal 0.5 0.10 0.20 </li></ul></ul><ul><ul><li>Recession ??? 0.02 0.01 </li></ul></ul><ul><li>R C = .3(.15) + .5(.10) + .2(.02) = .099 = 9.9% </li></ul><ul><li>R T = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7% </li></ul>
    124. 124. Variance and Standard Deviation <ul><li>Variance and standard deviation still measure the volatility of returns </li></ul><ul><li>Using unequal probabilities for the entire range of possibilities </li></ul><ul><li>Weighted average of squared deviations </li></ul>
    125. 125. Example: Variance and Standard Deviation <ul><li>Consider the previous example. What are the variance and standard deviation for each stock? </li></ul><ul><li>Stock C </li></ul><ul><ul><li> 2 = .3(.15-.099) 2 + .5(.1-.099) 2 + .2(.02-.099) 2 = .002029 </li></ul></ul><ul><ul><li> = .045 </li></ul></ul><ul><li>Stock T </li></ul><ul><ul><li> 2 = .3(.25-.177) 2 + .5(.2-.177) 2 + .2(.01-.177) 2 = .007441 </li></ul></ul><ul><ul><li> = .0863 </li></ul></ul>
    126. 126. Portfolios <ul><li>A portfolio is a collection of assets </li></ul><ul><li>An asset’s risk and return are important to how the stock affects the risk and return of the portfolio </li></ul><ul><li>The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets </li></ul>
    127. 127. Portfolio Expected Returns <ul><li>The expected return of a portfolio is the weighted average of the expected returns of the respective assets in the portfolio </li></ul><ul><li>You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities </li></ul>
    128. 128. Portfolio Variance <ul><li>Compute the portfolio return for each state: R P = w 1 R 1 + w 2 R 2 + … + w m R m </li></ul><ul><li>Compute the expected portfolio return using the same formula as for an individual asset </li></ul><ul><li>Compute the portfolio variance and standard deviation using the same formulas as for an individual asset </li></ul>
    129. 129. The Principle of Diversification <ul><li>Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns </li></ul><ul><li>This reduction in risk arises because worse-than-expected returns from one asset are offset by better-than-expected returns from another asset </li></ul><ul><li>However, there is a minimum level of risk that cannot be diversified away - that is the systematic portion </li></ul>
    130. 130. Figure 11.1
    131. 131. Total Risk <ul><li>Total risk = systematic risk + unsystematic risk </li></ul><ul><li>The standard deviation of returns is a measure of total risk </li></ul><ul><li>For well-diversified portfolios, unsystematic risk is very small </li></ul><ul><li>Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk </li></ul>
    132. 132. Measuring Systematic Risk <ul><li>How do we measure systematic risk? </li></ul><ul><li>We use the beta coefficient to measure systematic risk </li></ul><ul><li>What does beta tell us? </li></ul><ul><ul><li>A beta of 1 implies the asset has the same systematic risk as the overall market </li></ul></ul><ul><ul><li>A beta < 1 implies the asset has less systematic risk than the overall market </li></ul></ul><ul><ul><li>A beta > 1 implies the asset has more systematic risk than the overall market </li></ul></ul>
    133. 133. Example: Portfolio Expected Returns and Betas R f E(R A )  A 0% 5% 10% 15% 20% 25% 30% 0 0.5 1 1.5 2 2.5 3 Beta Expected Return
    134. 134. Security Market Line <ul><li>The security market line (SML) is the representation of market equilibrium </li></ul><ul><li>The slope of the SML is the reward-to-risk ratio: (E(R M ) – R f ) /  M </li></ul><ul><li>But since the beta for the market is ALWAYS equal to one, the slope can be rewritten </li></ul><ul><li>Slope = E(R M ) – R f = market risk premium </li></ul>
    135. 135. Capital Asset Pricing Model <ul><li>The capital asset pricing model (CAPM) defines the relationship between risk and return </li></ul><ul><li>E(R A ) = R f +  A (E(R M ) – R f ) </li></ul><ul><li>If we know an asset’s systematic risk, we can use the CAPM to determine its expected return </li></ul><ul><li>This is true whether we are talking about financial assets or physical assets </li></ul>
    136. 136. Example: CAPM <ul><li>Consider the betas for each of the assets given earlier. If the risk-free rate is 3.15% and the market risk premium is 9.5%, what is the expected return for each? </li></ul><ul><ul><li>Security Beta Expected Return </li></ul></ul><ul><ul><li>DCLK 4.03 3.15 + 4.03(9.5) = 41.435% </li></ul></ul><ul><ul><li>KO 0.84 3.15 + .84(9.5) = 11.13% </li></ul></ul><ul><ul><li>INTC 1.05 3.15 + 1.05(9.5) = 13.125% </li></ul></ul><ul><ul><li>KEI 0.59 3.15 + .59(9.5) = 8.755% </li></ul></ul>
    137. 137. SML and Equilibrium
    138. 138. Chapter 8 Net Present Value and Other Investment Criteria
    139. 139. Project Example Information <ul><li>You are looking at a new project and you have estimated the following cash flows: </li></ul><ul><ul><li>Year 0: CF = -165,000 </li></ul></ul><ul><ul><li>Year 1: CF = 63,120; NI = 13,620 </li></ul></ul><ul><ul><li>Year 2: CF = 70,800; NI = 3,300 </li></ul></ul><ul><ul><li>Year 3: CF = 91,080; NI = 29,100 </li></ul></ul><ul><ul><li>Average Book Value = 72,000 </li></ul></ul><ul><li>Your required return for assets of this risk is 12%. </li></ul>
    140. 140. NPV – Decision Rule <ul><li>If the NPV is positive, accept the project </li></ul><ul><li>A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. </li></ul><ul><li>Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. </li></ul>
    141. 141. Computing NPV for the Project <ul><li>Using the formulas: </li></ul><ul><ul><li>NPV = 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 – 165,000 = 12,627.42 </li></ul></ul><ul><li>Using the calculator: </li></ul><ul><ul><li>CF 0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41 </li></ul></ul><ul><li>Do we accept or reject the project? </li></ul>
    142. 142. Payback Period <ul><li>How long does it take to get the initial cost back in a nominal sense? </li></ul><ul><li>Computation </li></ul><ul><ul><li>Estimate the cash flows </li></ul></ul><ul><ul><li>Subtract the future cash flows from the initial cost until the initial investment has been recovered </li></ul></ul><ul><li>Decision Rule – Accept if the payback period is less than some preset limit </li></ul>
    143. 143. Computing Payback for the Project <ul><li>Assume we will accept the project if it pays back within two years. </li></ul><ul><ul><li>Year 1: 165,000 – 63,120 = 101,880 still to recover </li></ul></ul><ul><ul><li>Year 2: 101,880 – 70,800 = 31,080 still to recover </li></ul></ul><ul><ul><li>Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3 </li></ul></ul><ul><li>Do we accept or reject the project? </li></ul>
    144. 144. Decision Criteria Test - Payback <ul><li>Does the payback rule account for the time value of money? </li></ul><ul><li>Does the payback rule account for the risk of the cash flows? </li></ul><ul><li>Does the payback rule provide an indication about the increase in value? </li></ul><ul><li>Should we consider the payback rule for our primary decision rule? </li></ul>
    145. 145. Advantages and Disadvantages of Payback <ul><li>Advantages </li></ul><ul><ul><li>Easy to understand </li></ul></ul><ul><ul><li>Adjusts for uncertainty of later cash flows </li></ul></ul><ul><ul><li>Biased toward liquidity </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Ignores the time value of money </li></ul></ul><ul><ul><li>Requires an arbitrary cutoff point </li></ul></ul><ul><ul><li>Ignores cash flows beyond the cutoff date </li></ul></ul><ul><ul><li>Biased against long-term projects, such as research and development, and new projects </li></ul></ul>
    146. 146. Discounted Payback Period <ul><li>Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis </li></ul><ul><li>Compare to a specified required period </li></ul><ul><li>Decision Rule - Accept the project if it pays back on a discounted basis within the specified time </li></ul>
    147. 147. Computing Discounted Payback for the Project <ul><li>Assume we will accept the project if it pays back on a discounted basis in 2 years. </li></ul><ul><li>Compute the PV for each cash flow and determine the payback period using discounted cash flows </li></ul><ul><ul><li>Year 1: 165,000 – 63,120/1.12 1 = 108,643 </li></ul></ul><ul><ul><li>Year 2: 108,643 – 70,800/1.12 2 = 52,202 </li></ul></ul><ul><ul><li>Year 3: 52,202 – 91,080/1.12 3 = -12,627 project pays back in year 3 </li></ul></ul><ul><li>Do we accept or reject the project? </li></ul>
    148. 148. Decision Criteria Test – Discounted Payback <ul><li>Does the discounted payback rule account for the time value of money? </li></ul><ul><li>Does the discounted payback rule account for the risk of the cash flows? </li></ul><ul><li>Does the discounted payback rule provide an indication about the increase in value? </li></ul><ul><li>Should we consider the discounted payback rule for our primary decision rule? </li></ul>
    149. 149. Advantages and Disadvantages of Discounted Payback <ul><li>Advantages </li></ul><ul><ul><li>Includes time value of money </li></ul></ul><ul><ul><li>Easy to understand </li></ul></ul><ul><ul><li>Does not accept negative estimated NPV investments when all future cash flows are positive </li></ul></ul><ul><ul><li>Biased towards liquidity </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>May reject positive NPV investments </li></ul></ul><ul><ul><li>Requires an arbitrary cutoff point </li></ul></ul><ul><ul><li>Ignores cash flows beyond the cutoff point </li></ul></ul><ul><ul><li>Biased against long-term projects, such as R&D and new products </li></ul></ul>
    150. 150. Average Accounting Return <ul><li>There are many different definitions for average accounting return </li></ul><ul><li>The one used in the book is: </li></ul><ul><ul><li>Average net income / average book value </li></ul></ul><ul><ul><li>Note that the average book value depends on how the asset is depreciated. </li></ul></ul><ul><li>Need to have a target cutoff rate </li></ul><ul><li>Decision Rule: Accept the project if the AAR is greater than a preset rate. </li></ul>
    151. 151. Computing AAR for the Project <ul><li>Assume we require an average accounting return of 25% </li></ul><ul><li>Average Net Income: </li></ul><ul><ul><li>(13,620 + 3,300 + 29,100) / 3 = 15,340 </li></ul></ul><ul><li>AAR = 15,340 / 72,000 = .213 = 21.3% </li></ul><ul><li>Do we accept or reject the project? </li></ul>
    152. 152. Decision Criteria Test - AAR <ul><li>Does the AAR rule account for the time value of money? </li></ul><ul><li>Does the AAR rule account for the risk of the cash flows? </li></ul><ul><li>Does the AAR rule provide an indication about the increase in value? </li></ul><ul><li>Should we consider the AAR rule for our primary decision rule? </li></ul>
    153. 153. Advantages and Disadvantages of AAR <ul><li>Advantages </li></ul><ul><ul><li>Easy to calculate </li></ul></ul><ul><ul><li>Needed information will usually be available </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Not a true rate of return; time value of money is ignored </li></ul></ul><ul><ul><li>Uses an arbitrary benchmark cutoff rate </li></ul></ul><ul><ul><li>Based on accounting net income and book values, not cash flows and market values </li></ul></ul>
    154. 154. Internal Rate of Return <ul><li>This is the most important alternative to NPV </li></ul><ul><li>It is often used in practice and is intuitively appealing </li></ul><ul><li>It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere </li></ul>
    155. 155. IRR – Definition and Decision Rule <ul><li>Definition: IRR is the return that makes the NPV = 0 </li></ul><ul><li>Decision Rule: Accept the project if the IRR is greater than the required return </li></ul>
    156. 156. Computing IRR for the Project <ul><li>If you do not have a financial calculator, then this becomes a trial and error process </li></ul><ul><li>Calculator </li></ul><ul><ul><li>Enter the cash flows as you did with NPV </li></ul></ul><ul><ul><li>Press IRR and then CPT </li></ul></ul><ul><ul><li>IRR = 16.13% > 12% required return </li></ul></ul><ul><li>Do we accept or reject the project? </li></ul>
    157. 157. NPV Profile for the Project IRR = 16.13%
    158. 158. Decision Criteria Test - IRR <ul><li>Does the IRR rule account for the time value of money? </li></ul><ul><li>Does the IRR rule account for the risk of the cash flows? </li></ul><ul><li>Does the IRR rule provide an indication about the increase in value? </li></ul><ul><li>Should we consider the IRR rule for our primary decision criteria? </li></ul>
    159. 159. Advantages of IRR <ul><li>Knowing a return is intuitively appealing </li></ul><ul><li>It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details </li></ul><ul><li>If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task </li></ul>
    160. 160. Summary of Decisions for the Project Summary Net Present Value Accept Payback Period Reject Discounted Payback Period Reject Average Accounting Return Reject Internal Rate of Return Accept
    161. 161. NPV vs. IRR <ul><li>NPV and IRR will generally give us the same decision </li></ul><ul><li>Exceptions </li></ul><ul><ul><li>Non-conventional cash flows – cash flow signs change more than once </li></ul></ul><ul><ul><li>Mutually exclusive projects </li></ul></ul><ul><ul><ul><li>Initial investments are substantially different </li></ul></ul></ul><ul><ul><ul><li>Timing of cash flows is substantially different </li></ul></ul></ul>
    162. 162. IRR and Non-conventional Cash Flows <ul><li>When the cash flows change sign more than once, there is more than one IRR </li></ul><ul><li>When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation </li></ul><ul><li>If you have more than one IRR, which one do you use to make your decision? </li></ul>
    163. 163. Another Example – Non-conventional Cash Flows <ul><li>Suppose an investment will cost $90,000 initially and will generate the following cash flows: </li></ul><ul><ul><li>Year 1: 132,000 </li></ul></ul><ul><ul><li>Year 2: 100,000 </li></ul></ul><ul><ul><li>Year 3: -150,000 </li></ul></ul><ul><li>The required return is 15%. </li></ul><ul><li>Should we accept or reject the project? </li></ul>
    164. 164. NPV Profile IRR = 10.11% and 42.66%
    165. 165. Summary of Decision Rules <ul><li>The NPV is positive at a required return of 15%, so you should Accept </li></ul><ul><li>If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject </li></ul><ul><li>You need to recognize that there are non-conventional cash flows and look at the NPV profile </li></ul>
    166. 166. IRR and Mutually Exclusive Projects <ul><li>Mutually exclusive projects </li></ul><ul><ul><li>If you choose one, you can’t choose the other </li></ul></ul><ul><ul><li>Example: You can choose to attend graduate school at either Harvard or Stanford, but not both </li></ul></ul><ul><li>Intuitively you would use the following decision rules: </li></ul><ul><ul><li>NPV – choose the project with the higher NPV </li></ul></ul><ul><ul><li>IRR – choose the project with the higher IRR </li></ul></ul>
    167. 167. Example With Mutually Exclusive Projects The required return for both projects is 10%. Which project should you accept and why? Period Project A Project B 0 -500 -400 1 325 325 2 325 200 IRR 19.43% 22.17% NPV 64.05 60.74
    168. 168. NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%
    169. 169. Conflicts Between NPV and IRR <ul><li>NPV directly measures the increase in value to the firm </li></ul><ul><li>Whenever there is a conflict between NPV and another decision rule, you should always use NPV </li></ul><ul><li>IRR is unreliable in the following situations </li></ul><ul><ul><li>Non-conventional cash flows </li></ul></ul><ul><ul><li>Mutually exclusive projects </li></ul></ul>
    170. 170. Profitability Index <ul><li>Measures the benefit per unit cost, based on the time value of money </li></ul><ul><li>A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value </li></ul><ul><li>This measure can be very useful in situations in which we have limited capital </li></ul>
    171. 171. Advantages and Disadvantages of Profitability Index <ul><li>Advantages </li></ul><ul><ul><li>Closely related to NPV, generally leading to identical decisions </li></ul></ul><ul><ul><li>Easy to understand and communicate </li></ul></ul><ul><ul><li>May be useful when available investment funds are limited </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>May lead to incorrect decisions in comparisons of mutually exclusive investments </li></ul></ul>
    172. 172. Capital Budgeting In Practice <ul><li>We should consider several investment criteria when making decisions </li></ul><ul><li>NPV and IRR are the most commonly used primary investment criteria </li></ul><ul><li>Payback is a commonly used secondary investment criteria </li></ul>
    173. 173. Chapter 9 Making Capital Investment Decisions
    174. 174. Common Types of Cash Flows <ul><li>Sunk costs – costs that have accrued in the past </li></ul><ul><li>Opportunity costs – costs of lost options </li></ul><ul><li>Side effects </li></ul><ul><ul><li>Positive side effects – benefits to other projects </li></ul></ul><ul><ul><li>Negative side effects – costs to other projects </li></ul></ul><ul><li>Changes in net working capital </li></ul><ul><li>Financing costs </li></ul><ul><li>Taxes </li></ul>
    175. 175. Table 9.1 Pro Forma Income Statement Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT $ 33,000 Taxes (34%) 11,220 Net Income $ 21,780
    176. 176. Table 9.2 Projected Capital Requirements Year 0 1 2 3 NWC $20,000 $20,000 $20,000 $20,000 Net Fixed Assets 90,000 60,000 30,000 0 Total Investment $110,000 $80,000 $50,000 $20,000
    177. 177. Table 9.5 Projected Total Cash Flows Year 0 1 2 3 OCF $51,780 $51,780 $51,780 Change in NWC -$20,000 $20,000 Capital Spending -$90,000 CFFA -$110,00 $51,780 $51,780 $71,780
    178. 178. The Tax Shield Approach <ul><li>You can also find operating cash flows using the tax shield approach </li></ul><ul><li>OCF = (Sales – costs)(1 – T) + Depreciation*T </li></ul><ul><li>This form may be particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield – such as when you are choosing between two different machines </li></ul>
    179. 179. Depreciation <ul><li>The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes </li></ul><ul><li>Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes </li></ul><ul><li>Depreciation tax shield = DxT </li></ul><ul><ul><li>D = depreciation expense </li></ul></ul><ul><ul><li>T = marginal tax rate </li></ul></ul>
    180. 180. Computing Depreciation <ul><li>Straight-line depreciation </li></ul><ul><ul><li>D = (Initial cost – salvage) / number of years </li></ul></ul><ul><ul><li>Very few assets are depreciated straight-line for tax purposes </li></ul></ul><ul><li>MACRS </li></ul><ul><ul><li>Need to know which asset class is appropriate for tax purposes </li></ul></ul><ul><ul><li>Multiply percentage given in table by the initial cost </li></ul></ul><ul><ul><li>Depreciate to zero </li></ul></ul><ul><ul><li>Mid-year convention </li></ul></ul>
    181. 181. After Tax Salvage <ul><li>If the salvage value is different from the book value of the asset, then there is a tax effect </li></ul><ul><li>Book value = initial cost – accumulated depreciation </li></ul><ul><li>After tax salvage = salvage – T(salvage – book value) </li></ul>
    182. 182. Example: Straight-line Depreciation <ul><li>Suppose the appropriate depreciation schedule is straight-line </li></ul><ul><ul><li>D = ($110,000 – 17,000) / 6 = $15,500 every year for 6 years </li></ul></ul><ul><ul><li>BV in year 6 = $110,000 – 6(15,500) = $17,000 </li></ul></ul><ul><ul><li>After-tax salvage = $17,000 - .4(17,000 – 17,000) = $17,000 </li></ul></ul>
    183. 183. Example: Three-year MACRS BV in year 6 = 110,000 – 36,663 – 48,884 – 16,302 – 8,151 = 0 After-tax salvage = 17,000 - .4(17,000 – 0) = $10,200 Year MACRS percent D 1 .3333 .3333(110,000) = 36,663 2 .4444 .4444(110,000) = 48,884 3 .1482 .1482(110,000) = 16,302 4 .0741 .0741(110,000) = 8,151
    184. 184. Example: Seven-Year MACRS BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,823 = 14,718 After-tax salvage = 17,000 - .4(17,000 – 14,718) = 16,087.20 Year MACRS Percent D 1 .1429 .1429(110,000) = 15,719 2 .2449 .2449(110,000) = 26,939 3 .1749 .1749(110,000) = 19,239 4 .1249 .1249(110,000) = 13,739 5 .0893 .0893(110,000) = 9,823 6 .0893 .0893(110,000) = 9,823
    185. 185. Example: Replacement Problem <ul><li>Original Machine </li></ul><ul><ul><li>Initial cost = 100,000 </li></ul></ul><ul><ul><li>Annual depreciation = 9,000 </li></ul></ul><ul><ul><li>Purchased 5 years ago </li></ul></ul><ul><ul><li>Book Value = 55,000 </li></ul></ul><ul><ul><li>Salvage today = 65,000 </li></ul></ul><ul><ul><li>Salvage in 5 years = 10,000 </li></ul></ul><ul><li>New Machine </li></ul><ul><ul><li>Initial cost = 150,000 </li></ul></ul><ul><ul><li>5-year life </li></ul></ul><ul><ul><li>Salvage in 5 years = 0 </li></ul></ul><ul><ul><li>Cost savings = 50,000 per year </li></ul></ul><ul><ul><li>3-year MACRS depreciation </li></ul></ul><ul><li>Required return = 10% </li></ul><ul><li>Tax rate = 40% </li></ul>
    186. 186. Replacement Problem – Pro Forma Income Statements Year 1 2 3 4 5 Cost Savings 50,000 50,000 50,000 50,000 50,000 Depr. New 49,995 66,660 22,230 11,115 0 Old 9,000 9,000 9,000 9,000 9,000 Increm. 40,995 57,660 13,230 2,115 (9,000) EBIT 9,005 (7,660) 36,770 47,885 59,000 Taxes 3,602 (3,064) 14,708 19,154 23,600 NI 5,403 (4,596) 22,062 28,731 35,400
    187. 187. Replacement Problem <ul><li>Year 0 </li></ul><ul><ul><li>Cost of new machine = $150,000 (outflow) </li></ul></ul><ul><ul><li>After-tax salvage on old machine = $65,000 - .4(65,000 – 55,000) = $61,000 (inflow) </li></ul></ul><ul><ul><li>Incremental net capital spending = $150,000 – 61,000 = $89,000 (outflow) </li></ul></ul><ul><li>Year 5 </li></ul><ul><ul><li>After-tax salvage on old machine = $10,000 - .4($10,000 – 10,000) = $10,000 (outflow because we no longer receive this) </li></ul></ul>
    188. 188. Replacement Problem Year 0 1 2 3 4 5 OCF 46,398 53,064 35,292 30,846 26,400 NCS -89,000 -10,000  In NWC 0 0 CFFA -89,000 46,398 53,064 35,292 30,846 16,400
    189. 189. Replacement Problem <ul><li>Now that we have the cash flows, we can compute the NPV and IRR </li></ul><ul><ul><li>Enter the cash flows </li></ul></ul><ul><ul><li>Compute NPV = $54,801.29 </li></ul></ul><ul><ul><li>Compute IRR = 36.27% </li></ul></ul><ul><li>Should the company replace the equipment? </li></ul>
    190. 190. New Project Example <ul><li>Consider the project discussed in the text </li></ul><ul><li>The initial cost is $200,000 and the project has a 5-year life. There is no salvage. Depreciation is straight-line, the required return is 12%, and the tax rate is 34% </li></ul><ul><li>The base case NPV is $15,567 </li></ul>
    191. 191. Summary of Scenario Analysis Scenario Net Income Cash Flow NPV IRR Base case $19,800 $59,800 $15,567 15.1% Worst Case -15,510 24,490 -111,719 -14.4% Best Case 59,730 99,730 159,504 40.9%
    192. 192. Summary of Sensitivity Analysis Scenario Unit Sales Cash Flow NPV IRR Base case 6,000 $59,800 $15,567 15.1% Worst case 5,500 $53,200 -$8,226 10.3% Best case 6,500 $66,400 $39,357 19.7%
    193. 193. Capital Rationing <ul><li>Capital rationing occurs when a firm or division has limited resources </li></ul><ul><ul><li>Soft rationing – the limited resources are temporary, often self-imposed </li></ul></ul><ul><ul><li>Hard rationing – capital will never be available for this project </li></ul></ul><ul><li>The profitability index is a useful tool when faced with soft rationing </li></ul>
    194. 194. Chapter 12 Cost of Capital
    195. 195. Required Return <ul><li>The required return is the same as the appropriate discount rate and is based on the risk of the cash flows </li></ul><ul><li>We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment </li></ul><ul><li>We need to earn at least the required return to compensate our investors for the financing they have provided </li></ul>
    196. 196. Cost of Equity <ul><li>The cost of equity is the return required by equity investors given the risk of the cash flows from the firm </li></ul><ul><li>There are two major methods for determining the cost of equity </li></ul><ul><ul><li>Dividend growth model </li></ul></ul><ul><ul><li>SML or CAPM </li></ul></ul>
    197. 197. The Dividend Growth Model Approach <ul><li>Start with the dividend growth model formula and rearrange to solve for R E </li></ul>
    198. 198. Dividend Growth Model Example <ul><li>Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? </li></ul>
    199. 199. The SML Approach <ul><li>Use the following information to compute our cost of equity </li></ul><ul><ul><li>Risk-free rate, R f </li></ul></ul><ul><ul><li>Market risk premium, E(R M ) – R f </li></ul></ul><ul><ul><li>Systematic risk of asset,  </li></ul></ul>
    200. 200. Example – Cost of Equity <ul><li>Suppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity? </li></ul><ul><ul><li>Using SML: R E = 6% + 1.5(9%) = 19.5% </li></ul></ul><ul><ul><li>Using DGM: R E = [2(1.06) / 15.65] + .06 = 19.55% </li></ul></ul>
    201. 201. Cost of Debt <ul><li>The cost of debt is the required return on our company’s debt </li></ul><ul><li>We usually focus on the cost of long-term debt or bonds </li></ul><ul><li>The required return is best estimated by computing the yield-to-maturity on the existing debt </li></ul><ul><li>We may also use estimates of current rates based on the bond rating we expect when we issue new debt </li></ul>
    202. 202. Cost of Debt Example <ul><li>Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt? </li></ul><ul><ul><li>N = 50; PMT = 45; FV = 1000; PV = -908.75; CPT I/Y = 5%; YTM = 5(2) = 10% </li></ul></ul>
    203. 203. Cost of Preferred Stock <ul><li>Reminders </li></ul><ul><ul><li>Preferred generally pays a constant dividend every period </li></ul></ul><ul><ul><li>Dividends are expected to be paid every period forever </li></ul></ul><ul><li>Preferred stock is a perpetuity, so we take the formula, rearrange, and solve for R P </li></ul><ul><li>R P = D / P 0 </li></ul>
    204. 204. Cost of Preferred Stock - Example <ul><li>Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock? </li></ul><ul><li>R P = 3 / 25 = 12% </li></ul>
    205. 205. Weighted Average Cost of Capital <ul><li>We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm. </li></ul><ul><li>This “average” is the required return on our assets, based on the market’s perception of the risk of those assets </li></ul><ul><li>The weights are determined by how much of each type of financing that we use </li></ul>
    206. 206. Capital Structure Weights <ul><li>Notation </li></ul><ul><ul><li>E = market value of equity = # outstanding shares times price per share </li></ul></ul><ul><ul><li>D = market value of debt = # outstanding bonds times bond price </li></ul></ul><ul><ul><li>V = market value of the firm = D + E </li></ul></ul><ul><li>Weights </li></ul><ul><ul><li>w E = E/V = percent financed with equity </li></ul></ul><ul><ul><li>w D = D/V = percent financed with debt </li></ul></ul>
    207. 207. Example – Capital Structure Weights <ul><li>Suppose you have a market value of equity equal to $500 million and a market value of debt = $475 million. </li></ul><ul><ul><li>What are the capital structure weights? </li></ul></ul><ul><ul><ul><li>V = 500 million + 475 million = 975 million </li></ul></ul></ul><ul><ul><ul><li>w E = E/V = 500 / 975 = .5128 = 51.28% </li></ul></ul></ul><ul><ul><ul><li>w D = D/V = 475 / 975 = .4872 = 48.72% </li></ul></ul></ul>
    208. 208. Taxes and the WACC <ul><li>We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital </li></ul><ul><li>Interest expense reduces our tax liability </li></ul><ul><ul><li>This reduction in taxes reduces our cost of debt </li></ul></ul><ul><ul><li>After-tax cost of debt = R D (1-T C ) </li></ul></ul><ul><li>Dividends are not tax deductible, so there is no tax impact on the cost of equity </li></ul><ul><li>WACC = w E R E + w D R D (1-T C ) </li></ul>
    209. 209. Extended Example – WACC - I <ul><li>Equity Information </li></ul><ul><ul><li>50 million shares </li></ul></ul><ul><ul><li>$80 per share </li></ul></ul><ul><ul><li>Beta = 1.15 </li></ul></ul><ul><ul><li>Market risk premium = 9% </li></ul></ul><ul><ul><li>Risk-free rate = 5% </li></ul></ul><ul><li>Debt Information </li></ul><ul><ul><li>$1 billion in outstanding debt (face value) </li></ul></ul><ul><ul><li>Current quote = 110 </li></ul></ul><ul><ul><li>Coupon rate = 9%, semiannual coupons </li></ul></ul><ul><ul><li>15 years to maturity </li></ul></ul><ul><li>Tax rate = 40% </li></ul>
    210. 210. Extended Example – WACC - II <ul><li>What is the cost of equity? </li></ul><ul><ul><li>R E = 5 + 1.15(9) = 15.35% </li></ul></ul><ul><li>What is the cost of debt? </li></ul><ul><ul><li>N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268 </li></ul></ul><ul><ul><li>R D = 3.927(2) = 7.854% </li></ul></ul><ul><li>What is the after-tax cost of debt? </li></ul><ul><ul><li>R D (1-T C ) = 7.854(1-.4) = 4.712% </li></ul></ul>
    211. 211. Extended Example – WACC - III <ul><li>What are the capital structure weights? </li></ul><ul><ul><li>E = 50 million (80) = 4 billion </li></ul></ul><ul><ul><li>D = 1 billion (1.10) = 1.1 billion </li></ul></ul><ul><ul><li>V = 4 + 1.1 = 5.1 billion </li></ul></ul><ul><ul><li>w E = E/V = 4 / 5.1 = .7843 </li></ul></ul><ul><ul><li>w D = D/V = 1.1 / 5.1 = .2157 </li></ul></ul><ul><li>What is the WACC? </li></ul><ul><ul><li>WACC = .7843(15.35%) + .2157(4.712%) = 13.06% </li></ul></ul>
    212. 212. Divisional and Project Costs of Capital <ul><li>Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations </li></ul><ul><li>If we are looking at a project that is NOT of the same risk as the firm, then we need to determine the appropriate discount rate for that project </li></ul><ul><li>Divisions also often require separate discount rates </li></ul>
    213. 213. Using WACC for All Projects - Example <ul><li>What would happen if we use the WACC for all projects regardless of risk? </li></ul><ul><li>Assume the WACC = 15% </li></ul><ul><ul><li>Project Required Return IRR </li></ul></ul><ul><ul><li>A 20% 17% </li></ul></ul><ul><ul><li>B 15% 18% </li></ul></ul><ul><ul><li>C 10% 12% </li></ul></ul>
    214. 214. Subjective Approach - Example Risk Level Discount Rate Very Low Risk WACC – 8% Low Risk WACC – 3% Same Risk as Firm WACC High Risk WACC + 5% Very High Risk WACC + 10%
    215. 215. Chapter 13 Leverage and Capital Structure
    216. 216. Example: Financial Leverage, EPS, and ROE <ul><li>We will ignore the effect of taxes at this stage </li></ul><ul><li>What happens to EPS and ROE when we issue debt and buy back shares of stock? </li></ul>
    217. 217. Example: Financial Leverage, EPS, and ROE <ul><li>Variability in ROE </li></ul><ul><ul><li>Current: ROE ranges from 6.25% to 18.75% </li></ul></ul><ul><ul><li>Proposed: ROE ranges from 2.50% to 27.50% </li></ul></ul><ul><li>Variability in EPS </li></ul><ul><ul><li>Current: EPS ranges from $1.25 to $3.75 </li></ul></ul><ul><ul><li>Proposed: EPS ranges from $0.50 to $5.50 </li></ul></ul><ul><li>The variability in both ROE and EPS increases when financial leverage is increased </li></ul>
    218. 218. Capital Structure Theory <ul><li>Modigliani and Miller Theory of Capital Structure </li></ul><ul><ul><li>Proposition I – firm value </li></ul></ul><ul><ul><li>Proposition II – WACC </li></ul></ul><ul><li>The value of the firm is determined by the cash flows to the firm and the risk of the assets </li></ul><ul><li>Changing firm value </li></ul><ul><ul><li>Change the risk of the cash flows </li></ul></ul><ul><ul><li>Change the cash flows </li></ul></ul>
    219. 219. Capital Structure Theory Under Three Special Cases <ul><li>Case I – Assumptions </li></ul><ul><ul><li>No corporate or personal taxes </li></ul></ul><ul><ul><li>No bankruptcy costs </li></ul></ul><ul><li>Case II – Assumptions </li></ul><ul><ul><li>Corporate taxes, but no personal taxes </li></ul></ul><ul><ul><li>No bankruptcy costs </li></ul></ul><ul><li>Case III – Assumptions </li></ul><ul><ul><li>Corporate taxes, but no personal taxes </li></ul></ul><ul><ul><li>Bankruptcy costs </li></ul></ul>
    220. 220. Case I – Propositions I and II <ul><li>Proposition I </li></ul><ul><ul><li>The value of the firm is NOT affected by changes in the capital structure </li></ul></ul><ul><ul><li>The cash flows of the firm do not change; therefore, value doesn’t change </li></ul></ul><ul><li>Proposition II </li></ul><ul><ul><li>The WACC of the firm is NOT affected by capital structure </li></ul></ul>
    221. 221. Case I - Equations <ul><li>WACC = R A = (E/V)R E + (D/V)R D </li></ul><ul><li>R E = R A + (R A – R D )(D/E) </li></ul><ul><ul><li>R A is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets </li></ul></ul><ul><ul><li>(R A – R D )(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage </li></ul></ul>
    222. 222. Case I - Example <ul><li>Data </li></ul><ul><ul><li>Required return on assets = 16%, cost of debt = 10%; percent of debt = 45% </li></ul></ul><ul><li>What is the cost of equity? </li></ul><ul><ul><li>R E = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91% </li></ul></ul><ul><li>Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio? </li></ul><ul><ul><li>.25 = .16 + (.16 - .10)(D/E) </li></ul></ul><ul><ul><li>D/E = (.25 - .16) / (.16 - .10) = 1.5 </li></ul></ul><ul><li>Based on this information, what is the percent of equity in the firm? </li></ul><ul><ul><li>E/V = 1 / 2.5 = 40% </li></ul></ul>
    223. 223. Figure 13.3
    224. 224. The CAPM, the SML, and Proposition II <ul><li>How does financial leverage affect systematic risk? </li></ul><ul><li>CAPM: R A = R f +  A (R M – R f ) </li></ul><ul><ul><li>Where  A is the firm’s asset beta and measures the systematic risk of the firm’s assets </li></ul></ul><ul><li>Proposition II </li></ul><ul><ul><li>Replace R A with the CAPM and assume that the debt is riskless (R D = R f ) </li></ul></ul><ul><ul><li>R E = R f +  A (1+D/E)(R M – R f ) </li></ul></ul>
    225. 225. Business Risk and Financial Risk <ul><li>R E = R f +  A (1+D/E)(R M – R f ) </li></ul><ul><li>CAPM: R E = R f +  E (R M – R f ) </li></ul><ul><ul><li> E =  A (1 + D/E) </li></ul></ul><ul><li>Therefore, the systematic risk of the stock depends on: </li></ul><ul><ul><li>Systematic risk of the assets,  A , (Business risk) </li></ul></ul><ul><ul><li>Level of leverage, D/E, (Financial risk) </li></ul></ul>
    226. 226. Case II – Cash Flows <ul><li>Interest is tax deductible </li></ul><ul><li>Therefore, when a firm adds debt, it reduces taxes, all else equal </li></ul><ul><li>The reduction in taxes increases the cash flow of the firm </li></ul><ul><li>How should an increase in cash flows affect the value of the firm? </li></ul>
    227. 227. Case II - Example Unlevered Firm Levered Firm EBIT 5000 5000 Interest 0 500 Taxable Income 5000 4500 Taxes (34%) 1700 1530 Net Income 3300 2970 CFFA 3300 3470
    228. 228. Interest Tax Shield <ul><li>Annual interest tax shield </li></ul><ul><ul><li>Tax rate times interest payment </li></ul></ul><ul><ul><li>6250 in 8% debt = 500 in interest expense </li></ul></ul><ul><ul><li>Annual tax shield = .34(500) = 170 </li></ul></ul><ul><li>Present value of annual interest tax shield </li></ul><ul><ul><li>Assume perpetual debt for simplicity </li></ul></ul><ul><ul><li>PV = 170 / .08 = 2125 </li></ul></ul><ul><ul><li>PV = D(R D )(T C ) / R D = DT C = 6250(.34) = 2125 </li></ul></ul>
    229. 229. Case II – Proposition I <ul><li>The value of the firm increases by the present value of the annual interest tax shield </li></ul><ul><ul><li>Value of a levered firm = value of an unlevered firm + PV of interest tax shield </li></ul></ul><ul><ul><li>Value of equity = Value of the firm – Value of debt </li></ul></ul><ul><li>Assuming perpetual cash flows </li></ul><ul><ul><li>V U = EBIT(1-T) / R U </li></ul></ul><ul><ul><li>V L = V U + DT C </li></ul></ul>
    230. 230. Example: Case II – Proposition I <ul><li>Data </li></ul><ul><ul><li>EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% </li></ul></ul><ul><li>V U = 25(1-.35) / .12 = $135.42 million </li></ul><ul><li>V L = 135.42 + 75(.35) = $161.67 million </li></ul><ul><li>E = 161.67 – 75 = $86.67 million </li></ul>
    231. 231. Figure 13.4
    232. 232. Case II – Proposition II <ul><li>The WACC decreases as D/E increases because of the government subsidy on interest payments </li></ul><ul><ul><li>R A = (E/V)R E + (D/V)(R D )(1-T C ) </li></ul></ul><ul><ul><li>R E = R U + (R U – R D )(D/E)(1-T C ) </li></ul></ul><ul><li>Example </li></ul><ul><ul><li>R E = .12 + (.12-.09)(75/86.67)(1-.35) = 13.69% </li></ul></ul><ul><ul><li>R A = (86.67/161.67)(.1369) + (75/161.67)(.09)(1-.35) R A = 10.05% </li></ul></ul>
    233. 233. Case II – Proposition II <ul><li>Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1. </li></ul><ul><li>What will happen to the cost of equity under the new capital structure? </li></ul><ul><ul><li>R E = .12 + (.12 - .09)(1)(1-.35) = 13.95% </li></ul></ul><ul><li>What will happen to the weighted average cost of capital? </li></ul><ul><ul><li>R A = .5(.1395) + .5(.09)(1-.35) = 9.9% </li></ul></ul>
    234. 234. Case II - Proposition II
    235. 235. Case III <ul><li>Now we add bankruptcy costs </li></ul><ul><li>As the D/E ratio increases, the probability of bankruptcy increases </li></ul><ul><li>This increased probability will increase the expected bankruptcy costs </li></ul><ul><li>At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costs </li></ul><ul><li>At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added </li></ul>
    236. 236. Bankruptcy Costs <ul><li>Direct costs </li></ul><ul><ul><li>Legal and administrative costs </li></ul></ul><ul><ul><li>Ultimately cause bondholders to incur additional losses </li></ul></ul><ul><ul><li>Disincentive to debt financing </li></ul></ul><ul><li>Financial distress </li></ul><ul><ul><li>Significant problems in meeting debt obligations </li></ul></ul><ul><ul><li>Most firms that experience financial distress do not ultimately file for bankruptcy </li></ul></ul>
    237. 237. More Bankruptcy Costs <ul><li>Indirect bankruptcy costs </li></ul><ul><ul><li>Larger than direct costs, but more difficult to measure and estimate </li></ul></ul><ul><ul><li>Stockholders wish to avoid a formal bankruptcy filing </li></ul></ul><ul><ul><li>Bondholders want to keep existing assets intact so they can at least receive that money </li></ul></ul><ul><ul><li>Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business </li></ul></ul><ul><ul><li>Also have lost sales, interrupted operations, and loss of valuable employees </li></ul></ul>
    238. 238. Figure 13.5
    239. 239. Figure 13.6
    240. 240. Bankruptcy Process <ul><li>Business failure – business has terminated with a loss to creditors </li></ul><ul><li>Legal bankruptcy – petition federal court for bankruptcy </li></ul><ul><li>Technical insolvency – firm is unable to meet debt obligations </li></ul><ul><li>Accounting insolvency – book value of equity is negative </li></ul>
    241. 241. Bankruptcy Process <ul><li>Liquidation </li></ul><ul><ul><li>Chapter 7 of the Federal Bankruptcy Reform Act of 1978 </li></ul></ul><ul><ul><li>Trustee takes over assets, sells them, and distributes the proceeds according to the absolute priority rule </li></ul></ul><ul><li>Reorganization </li></ul><ul><ul><li>Chapter 11 of the Federal Bankruptcy Reform Act of 1978 </li></ul></ul><ul><ul><li>Restructure the corporation with a provision to repay creditors </li></ul></ul>
    242. 242. Chapter 14 Dividends and Dividend Policy
    243. 243. Dividend Payment <ul><li>Declaration Date – Board declares the dividend and it becomes a liability of the firm </li></ul><ul><li>Ex-dividend Date </li></ul><ul><ul><li>Occurs two business days before date of record </li></ul></ul><ul><ul><li>If you buy stock on or after this date, you will not receive the upcoming dividend </li></ul></ul><ul><ul><li>Stock price generally drops by approximately the amount of the dividend </li></ul></ul><ul><li>Date of Record – Holders of record are determined and they will receive the dividend payment </li></ul><ul><li>Date of Payment – checks are mailed </li></ul>
    244. 244. Figure 14.2 The Ex-Day Price Drop
    245. 245. Does Dividend Policy Matter? <ul><li>Dividends matter – the value of the stock is based on the present value of expected future dividends </li></ul><ul><li>Dividend policy may not matter </li></ul><ul><ul><li>Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm </li></ul></ul><ul><ul><li>In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future </li></ul></ul>
    246. 246. Illustration of Irrelevance <ul><li>Consider a firm that can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year. Investors require a 12% return. </li></ul><ul><ul><li>Market Value with constant dividend = $16,900.51 </li></ul></ul><ul><ul><li>Market Value with reinvestment = $16,900.51 </li></ul></ul><ul><li>If the company will earn the required return, then it doesn’t matter when it pays the dividends </li></ul>
    247. 247. Low Payout Please <ul><li>Why might a low payout be desirable? </li></ul><ul><li>Individuals in upper income tax brackets might prefer lower dividend payouts, with their immediate tax consequences, in favor of higher capital gains </li></ul><ul><li>Flotation costs – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation costs </li></ul><ul><li>Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends </li></ul>
    248. 248. High Payout Please <ul><li>Why might a high payout be desirable? </li></ul><ul><li>Desire for current income </li></ul><ul><ul><li>Individuals in low tax brackets </li></ul></ul><ul><ul><li>Groups that are prohibited from spending principal (trusts and endowments) </li></ul></ul><ul><li>Uncertainty resolution – no guarantee that the higher future dividends will materialize </li></ul><ul><li>Taxes </li></ul><ul><ul><li>Dividend exclusion for corporations </li></ul></ul><ul><ul><li>Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains </li></ul></ul>
    249. 249. Clientele Effect <ul><li>Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts </li></ul><ul><li>Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts </li></ul>
    250. 250. Implications of the Clientele Effect <ul><li>What do you think will happen if a firm changes its policy from a high payout to a low payout? </li></ul><ul><li>What do you think will happen if a firm changes its policy from a low payout to a high payout? </li></ul><ul><li>If this is the case, does dividend POLICY matter? </li></ul>
    251. 251. Information Content of Dividends <ul><li>Stock prices generally rise with unexpected increases in dividends and fall with unexpected decreases in dividends </li></ul><ul><li>Does this mean that the average investor prefers a high dividend payout ratio? </li></ul><ul><li>No – changes in the dividend send a signal about management’s view concerning future prospects </li></ul>
    252. 252. Dividend Policy in Practice <ul><li>Residual dividend policy </li></ul><ul><li>Constant growth dividend policy – dividends increased at a constant rate each year </li></ul><ul><li>Constant payout ratio – pay out a constant percentage of earnings each year </li></ul><ul><li>Compromise dividend policy </li></ul>
    253. 253. Residual Dividend Policy <ul><li>Determine capital budget </li></ul><ul><li>Determine target capital structure </li></ul><ul><li>Finance investments with a combination of debt and equity in line with the target capital structure </li></ul><ul><ul><li>Remember that retained earnings are equity </li></ul></ul><ul><ul><li>If additional equity is needed, issue new shares </li></ul></ul><ul><li>If there are excess earnings, then pay the remainder out in dividends </li></ul>
    254. 254. Example – Residual Dividend Policy <ul><li>Given </li></ul><ul><ul><li>Need $5 million for new investments </li></ul></ul><ul><ul><li>Target capital structure: D/E = 2/3 </li></ul></ul><ul><ul><li>Net Income = $4 million </li></ul></ul><ul><li>Finding dividend </li></ul><ul><ul><li>40% of $5 million financed with debt ($2 million) </li></ul></ul><ul><ul><li>60% of $5 million financed with equity ($3 million) </li></ul></ul><ul><ul><li>NI – equity financing = $4 million - $3 million = $1 million, paid out as dividends </li></ul></ul>
    255. 255. Compromise Dividend Policy <ul><li>Goals, ranked in order of importance </li></ul><ul><ul><li>Avoid cutting back on positive NPV projects to pay a dividend </li></ul></ul><ul><ul><li>Avoid dividend cuts </li></ul></ul><ul><ul><li>Avoid the need to issue equity </li></ul></ul><ul><ul><li>Maintain a target debt/equity ratio </li></ul></ul><ul><ul><li>Maintain a target dividend payout ratio </li></ul></ul><ul><li>Companies want to accept positive NPV projects, while avoiding negative signals </li></ul>
    256. 256. Stock Repurchase <ul><li>Company buys back its own shares of stock </li></ul><ul><ul><li>Tender offer – company states a purchase price and a desired number of shares </li></ul></ul><ul><ul><li>Open market – buys stock in the open market </li></ul></ul><ul><li>Similar to a cash dividend in that it returns cash from the firm to the stockholders </li></ul><ul><li>This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections </li></ul>
    257. 257. Real-World Considerations <ul><li>Stock repurchase allows investors to decide if they want the current cash flow and associated tax consequences </li></ul><ul><li>Investors face capital gains taxes instead of ordinary income taxes (lower rate) </li></ul><ul><li>In our current tax structure, repurchases may be more desirable due to the options provided stockholders </li></ul><ul><li>The IRS recognizes this and will not allow a stock repurchase for the sole purpose of allowing investors to avoid taxes </li></ul>
    258. 258. Information Content of Stock Repurchases <ul><li>Stock repurchase sends a positive signal that management believes that the current price is low </li></ul><ul><li>Tender offers send a more positive signal than open market repurchases because the company is stating a specific price </li></ul><ul><li>The stock price often increases when repurchases are announced </li></ul>
    259. 259. Stock Dividends <ul><li>Pay additional shares of stock instead of cash </li></ul><ul><li>Increases the number of outstanding shares </li></ul><ul><li>Small stock dividend </li></ul><ul><ul><li>Less than 20 to 25% </li></ul></ul><ul><ul><li>If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares </li></ul></ul><ul><li>Large stock dividend – more than 20 to 25% </li></ul>
    260. 260. Stock Splits <ul><li>Stock splits – essentially the same as a stock dividend except expressed as a ratio </li></ul><ul><ul><li>For example, a 2-for-1 stock split is the same as a 100% stock dividend </li></ul></ul><ul><li>Stock price is reduced when the stock splits </li></ul><ul><li>Common explanation for split is to return price to a “more desirable trading range” </li></ul>