BUSINESS FINANCE – FINS1613SUMMARY

Business finance – control of company’s money and monetary affairs Financial decisions:

o Investment – amount and type of investments to make determine size, profits, risk, liquidityo Financing – how the firm will raise money affect financing costs and financial risko Dividend – how much of profits are given out as dividends vs retained

Influences of business finance:o Globalisation – extension of markets and company interests around the world due to ↑

transportation and communication, demand for ↑ quality goods, ↓ costs of new products, can operate in several countries and ↓ risk

o New and improved technology – improves the flow of information between companies and improves the processing of data ↑ accuracy and speed

Responsibilities in business finance:o Financial staff employed to acquire and operate resources in the most effective manner:

Forecasting and planning Investment and funding decisions Coordinating and controlling operations Dealing with financial markets Managing risk

Types of companies:o Sole proprietorships:

Owned and run by one owner Simple to establish, few regulations, avoid corporate income tax Difficult to raise ↑ sums, unlimited liability, only lasts as long as owner

o Partnerships: Owned and run by two or more people informal or legally binding Cheap and easy to establish Difficult to raise ↑ sums, unlimited liability, only lasts as long as owner, difficult to transfer

ownership o Corporations:

Legally registered company, distinct group of owners and managers Unlimited life, easily transfer ownership, limited liability Liable for corporate tax, legal formalities are lengthy and costly

o Hybrid organisations: Formed using combination of above 3 picked to maximize advantages to the firm

Capital budgeting – long term investment decisions, whether long term investments are profitable or not Capital structure – how capital is sourced within firm (equity vs debt) Working Capital – short term assets and liabilities

Objectives of the firm:o Primary – maximize shareholder valueo Social and ethical responsibilities – safety and welfare of employees, customers, environment

Agency issues:o Whenever one group (principles) hire and other (the agent) to perform a service, there is a potential

conflict of interest agency problem o For management and shareholders:

Separation of ownership and control – managers are different to owners may not have same objectives

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Managers may act in own interests – need to be observed (monitoring costs) Can set up contracts to control the managers – costly Solutions: compensation packages re incentives, exert influence, fire managers, threaten

hostile takeover (as usually fired after acquisition)o For creditors:

Creditors have claim on assets if firm goes bankrupt Rate of interest charged depends on riskiness of firm’s current and future project and

expected capital structure But creditors do not control company, shareholders through managers do conflict of

interests between creditors and shareholder/managers Once creditors have lent money, they do not get any higher returns if the firm invests in risky

projects can refuse to fund in the future, ↑ interest rates, or use restrictive covenants Maximizing firm value:

o Managers want to maximize share price not always the same as maximizing value of shareholder’s investment agency issues

o Determination of share price: Expected cash flows generated by assets Timing of these cash flows earlier preferable Riskiness of cash flows

o Determination of cash flows: Investment decisions The way investments are funded debt vs equity Dividend policy

o Share price, EPS, cash flows are ↑ correlated all ↑ when sales ↑o Take care when using EPS or cash flows as an indicator of share price as also depends on expected

future earnings and cash flows Times lines:

o Cash flows are written immediately bellows tick markso Unknown cash flows are denoted with a question marko Interest rates are written above the line and between tick marks if alter, the rate new rate will be

shown between the next tick markso If rate left blank after, assume same rate as before

Time value of money:o Dollar today is worth more than a dollar tomorrowo Present value – amount you have todayo Interest rate – amount bank pays on money invested each yearo Interest received – amount received during the yearo Future value – amount you will have in the futureo Number of periods – in the analysiso FV = PV (1+r) simple interesto FV = PV (1+r)^n compound interesto To discount: FV = PV (1+r)^-n

Annuities:o Sequence of equal payments made at fixed times for a specified number of periodso Ordinary annuity – payments are made at the end of each time period PV = R [1 – (1+r)^-n]

/ rFV = R [(1+r)^n -1] / r

o Annuity due – payments are made at the beginning of each time period PV = (1+r) R [1 – (1+r)^-n] / r

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FV = (1+r) R [(1+r)^n -1] / ro FV of annuity due > FV of ordinary annuity b/c payments made earlier and therefore earn more

interest Perpetuity – annuity that goes on making payments forever A = R / r Uneven cash flows:

It is more likely that investments will generate uneven cash flows Calculate PV by adding together all PVs of future cash flows Make changes if time periods change change r (periodic rate) and n The ↑ compounding period, ↑ the payout

Interest rates:o Nominal – rate quoted by institutions need to know compounding period to be meaningfulo Effective – rate of interest actually being earned i = (1 +

r/m)^m –1,where m compounding periodo Periodic – rate charged by lender in each period eg) semi-annual, monthlyo Periodic = nominal / compounding periods

Bonds:o Form of debt financing contract in which the borrower agrees to pay a specified amount of

interest and principle, on designated rates, to the holdero Eg) Treasury bill / Government bonds – issues by govt, ↓ default risko Eg) Corporate bonds – issues by companies, different levels of default risk depending on

characteristics of the firmo Characteristics of bonds:

Par value – stated face value, value paid at maturity Maturity date – specified date when par value is repaid Coupon payment – interest paid at each payment date Zero coupon bond – no coupon payments sold at substantial discount to allow for ↑ capital

gains Coupon interest rate – interest / face value Floating rate bonds – interest rate adjusted periodically to take into account changes in

interest rates (some have limits – caps and floors) Call provision – provision which allows the issuing company to call the bonds for

redemption usually pay more than par value to compensate Sinking fund – company pays amount into fund periodically which is used to retire a

proportion of the firm’s bonds eg) call provisiono Valuing bonds:

Present value of all future cash flows ie. par value and coupon payments C [1 – (1+r)^-n] / r + FV / (1+r)^n Where:

C is interest payment par value x coupon rate r is bond’s market rate of interest n is the number of periods until maturity FV is the face or par value paid at maturity

If all values are not expressed annually, then change C, r, n to reflect thiso Issues in bonds valuation:

Changes in market rates – inverse relationship between interest rates and bonds values ↑ r = ↓ b or ↓ r = ↑ b (due to discounting factor)

Interest rate risk – r can alter in the future and can alter the value of b: Price effects – valuation of future cash flows is calculates using a new market rate of

interest

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Reinvestment effects – coupons can be reinvested at the new market rate rather than the old one

Causes of interest rate risk:o Term to maturity – longer term to maturity, the greater the effect of the

change in r will be prices of longer bonds are more sensitive to changes in r o Default risk – chance that issuer will fail to make a payment ↑ risk, ↓ value

o Term structure of interest rates: Relationship between the term to maturity and the interest rate for securities of the same risk Suggested determinants: (all theories about how r is set)

Market expectation hypothesis – says r is set so that investors all receive the same return (av) regardless of security risk?

Liquidity premium hypothesis – says investors must be given reward (premium) for longer investments (due to ↑ risk)

Market segmentation hypothesis – r in each market is determined independently due to preferred habits of investors in that market

Influence of inflation – inflation alters the term structure of r as lenders require ↑ nominal r to compensate ↑ expected inflation, ↑ nominal r

o Default structure of interest rates – relationship between default risk and r ↑ probability of default, ↑ yield

o Other factors affecting interest rate structure: The marketability of securities:

Yield differentials = different marketability Only buy ↓ marketability if yield ↑ than that of ↓ marketability Bond have ↓ return than shares due to ↓ risk

Shares:o A share is a stake in a company an owner who has the right to pick the manages and receive any

profitso Types of companies:

Privately held companies (Closely held) – usually small firm owned by a few who are closely involved with the running of the company

Publicly owned companies – listed on stock exchange ↑ number of owners who employ managers to run the firm

o Types of shares: Ordinary shares – own the firm, voting rights, residual claim on earnings, no guarantees Preference shares – usually do not have voting rights, preferred right to dividends (usually a

stated percentage of face value) hybrido Characteristics of shares:

Market price – value at which traded on the exchange Intrinsic (theoretical) value – share value based on the companies fundamentals estimates

by each investor using their expectations Dividends – payments made to shareholders reflecting performance over the previous year

in cash or stock form Growth rate – expected rate of dividend growth in the future Required rate of return – minimum rate of return on the stock for an investor to buy the share

based on alternative investments and risko Valuation of shares:

Capital gains (loss) – difference between price bought and sold for Dividends – decision made by management no guarantees To value a share, work out PV of all future cash flows to infinity, we may ignore the final

sell price and just future dividends to infinity

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With constant dividend growth rate: P0 = D1 / (ks – g) must be div in 1 period from now Dt = D0 (1+g)^t to work out the future dividend Non-constant growth rate – value determined by splitting up into different periods

constant and non-constant periods Using price-earning ration:

Pt = (P / E) x EPS Dt = (1-r)Et , where r is the proportion of earning retained and Et is earnings

About the 2 models: Combing the 2 models P0 = (1-r)Et(1+g) / (ks–g) Same uncertainty with both models, just use different indicators

Capital Budgeting:o The decision whether or not to invest in a project that will generate cash flowso If just one project to consider accept or reject?o Capital budgeting with multiple projects:

Independent projects – have no impact on each other, decides whether to accept or reject each project independent one or more, or none

Mutually exclusive projects – company can only accept one investment and must accept all the others due to financial constraints or limitations of financial assets

o Types of investments: Replacement of assets:

Maintenance of existing business – replace equipment: should we continue operation, using same process? usually yes

Cost reduction – replace inefficient equipment to ↓ costs Expansion:

Expansion of existing markets or products – investment almost always necessary for expansion complex estimations

Expansion into new markets or products – can be expensive as cash flows are often delayed for some time can involve a change of structure

Safety and environmental projects – must comply with govt legislation mandatory investments so firm has no choice but to invest no matter no cash flow return still analyse best way and effect

Other investments – use best analysis approach suited to investment if not one of the above categories

o Summary of process: estimate all future cash flows, determine discount rate via riskiness, estimate PV, compare PV with initial outlay, if PV > initial outlay than accept

o Techniques for capital budgeting: Payback period:

Payback period is the number of years to repay original investment After this is profit, hence the shorter the better Payback period = initial outlay / cash flow ie. CF0 / CFt, if constant cash flow If non-constant cash flow – use cumulative: Payback period = year before recovery +

unrecovered at beg of Y / flow next year ie. Y + UCF / CF If mutually exclusive, then pick with shorted period Disadvantages – merely a break-even analysis ie. no discounting, doesn’t take into

account any flows after re-paid (even if outlay) Discounted payback period:

Extension of payback period deals with second problem Future cash flows are discounted before they are cumulated this means that how

we fund the project is taken into account

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Same decision rule as above Disadvantages – doesn’t take into account payments after the initial investment is re-

paid Net present value (NPV):

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

Calculate sum of PV of all cash flows including initial outlay If NPV > 0 then accept as will generate more cash than it costs If NPV = 0 then the project will break even If NPV < 0 then reject If mutually exclusive, choose project with highest NPV

Internal rate of return (IRR): IRR is the discount rate that results in the project generating returns that exactly equal

the costs of the project ie. the discount rate that gives a NPV of 0 If IRR > discount rate, then invest Hurdle rate – minimum acceptable IRR for a project CF0 + CF1 / (1+IRR)^1 + … + CFn / (1+IRR)^n = 0 If mutually exclusive, choose project with highest IRR Disadvantages – assumes cash flows can be reinvested at the IRR rate (most likely at

discount rate), possible to get more than one answer if non-normal cash flows Comparing NPV and IRR:

o Set up axis with IRR on horizontal, NPV on vertical for 2 projectso Crossover rate – IRR that gives equal NPVso For 2 independent projects, NPV and IRR approach give same answero For mutually exclusive projects:

Using IRR, will pick project with ↑ IRR Using NPV, depends on discount rate depends on discount rate in relation to crossover

rate Different methods may disagree on which project to select use other factors eg)

distribution of cash flowso Where large cash outflow at beginning, and large cash outflow later on, IRR can give 2 answerso IRR also assumes that cash flows from the investments are reinvested at IRR, whilst NPV assumes

reinvested at discount more realistic o Therefore NPV seems more preferable

Modified IRR:o Finds the discount rate at which PV of the projects costs = PV of terminal valueo MIRR = (TV / PV costs)^1/n – 1o When comparing projects:

Independent – if exceeds hurdle rate Mutually exclusive – highest MIRR

o IRR vs MIRR – MIRR superior because: MIRR assumes cash flows are reinvested at discount rate MIRR will not generate multiple answers

o NPV vs MIRR – re mutually exclusive If equal size and life span – same result If same size but different life span – same result if use terminal year of longer project as

terminal year of both give shorter project $0 flows If same life span but different sizes – may not agree NPV seems easier to use and better

Uncertainty and cash flows:

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o In reality it is difficult to know cash flows exactly estimate free cash flowso Estimating – Free cash flows = after tax income + depreciation – capital expenditure – change in net

working capitalo Identifying cash flows:

Factors that alter project free cash flows: Project requires fixed assets negative cash flow Depreciation – dollar value of assets used up ↓ tax liability so is added to project’s

net income ∆NOWC – ∆CA - ∆CL If interest charges are removed before discounting, do not remove again when

estimating cash flowso Incremental cash flows:

The only cash flows that are relevant are those which will be created if the project goes ahead incremental cash flows

Factors: Sunk costs – not incremental cash flows as do not affect project Existing assets of the firm – could be used for other projects opportunity costs so

is included in project cost The project may impact on other part of the firm (+ or -) must be considered in

deciding whether to accept or rejecto Timing of cash flows:

Important cash flows should be analysed exactly when they take place not so simple: costly and difficult to gather info

Different types of capital budgeting projects:o Incremental cash flows also affected by nature of project:

Expansion project – uses new assets to ↑ sales incremental cash flows are in/out flows the project creates

Replacement project – replacement of existing assets with new ones incremental cash flows are only the extra in/out flows from new asset

Evaluating capital budgeting projects:o Initial investment = upfront costs + necessary ↑ in NOWCo Operating cash flows – incremental cash flows over the life-span of the project (includes any

terminal cash flows)o Net cash flows each year – sum of cash flows in each area above use these net cash flows in NPV

calculationo Example in lecture notes…

Ending a project early:o If project not performing as expected, or more profitable project arises, firm can elect to abandon /

retire the existing projecto Abandonment / retirement – company stops a project before it reaches the endo Should be abandoned at the point when NPV of future cash flows < 0 (unprofitable)o There may be some costs in abandoning project – loss of establishment costs, opportunity costs eg)

lost revenue Project risk analysis:

o Corporate risk: Level of risk that a project represents for the firm as a whole Important because: undiversified shareholders exposed, influences share price, impacts firm

stability Very difficult to measure as firms involved with many projects, difficult to assess true risk

of only one7

o Stand-alone risk: Risk involved in the project alone Important because: easy to measure, highly correlated with other types of risk eg) corporate

and market Techniques for measuring stand-alone risk:

Sensitivity analysis – measures impact on NPV of a change in one factor Scenario analysis – measures impact on NPV when several aspects are changes

base (most likely), best, worst case Monte Carlo simulations – mathematical simulations that are repeated numerous

times to determine how NPV changes under certain conditions o Market risk:

Level of risk that the project represents to a well-diversified shareholder who realises that the project is just one investment

Important because this type of risk cannot be eliminated by diversification spreading investments of portfolio across different areas and markets to ↓ risk

o Using project risk in capital budgeting: Risk is reflected in capital budgeting by adjusting discount rate to evaluate risk cash flows

risky project has ↑ discount rateo Timing investments:

Sometimes a company will be able to choose when to invest ie. wait Decision tree – diagram that is used to show different possible outcomes each branch

represents possible outcome for comparison Shows probability of each outcome so can estimate NPV for each outcome add together

for expected NPV But, if the option would lose money (ie. negative NPV), then the firm would not invest so

branch becomes 0, not negative The result shows the NPV for investment in year 1 so discount back 1 year for NPV now Select option with highest NPV ie. wait a year or now Only wait if there is no downside to waiting ie. first move advantage

Optimal capital budgeting:o Optimal capital budget – all profitable independent project + any selected mutually exclusive

projects essential for company to decide on funding requirements so it can raise funds in most effective way

o Steps: Determine firm’s discount rate Scale rate to represent the risk of each division in the firm Calculate cash flows and NPV for the firm’s accepted projects = Optimal capital budget

o Capital rationing: Situation in which company has limit to how much it can spend on projects ie. can’t raise

large amounts of capital, especially small poor performing firms Such a firm must select projects with ↑ NPVs with funding requirements it can meet

Taxation and capital budgeting:o Classical approach – company pays corporate tax on earnings, shareholders pay income tax on any

dividends paid double taxingo Dividend imputation system:

Treats investors as if they are partners in the system Company pays corporate tax, issues remainder as dividends to shareholders Fully-franked dividends – dividends whereby tax has already been paid in full (vs unfranked

dividends)

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Shareholders are informed about their franking credits (ie. proportion of income tax that has already been paid) these are offset against shareholders personal income tax, avoiding double taxing

This can impact on firm’s cash flows and therefore on capital budgetingo Different types of companies:

Fully integrated with tax system and issue fully franked shares Not integrated with tax system eg) sole trader, partnership do not issue franking credits Partially integrated with tax system – shareholders cannot take full advantage of franking

systemo Re capital budgeting:

Capital budgeting should be treated in different ways depending on whether company issues fully franked or unfranked dividends

If using imputation system – ∆ in tax liability will ∆ franking credits issued to shareholders. Shareholder wealth is maximized by ↑ pre-tax profits and cash flows but ↓ tax deductions ie. need to consider capital budgeting using pre-tax cash flows

If not issuing franking credits – eg) sole trader, partnership. Owners wealth is usually directly linked to after-tax profits evaluate projects using after-tax cash flows

If partially integrated firm – company needs to estimate its effective corporate tax rate, reflecting proportion of franking credits that can be effectively used by shareholders use this effective rate in capital budgeting decisions

Week 7: Dollar return:

o Amount received – amount investedo Better if receive ↑ off a ↓ outlay, or quicker than longer

Rate of return:o Scale the dollar return by the amount investedo Rate of return = dollar return / amount investedo Allows comparison

Risk:o Uncertainty regarding the outcome --> anticipated loss is not risk, only unexpected losso Also seen as variation from the most likely (expected) outcomeo Usually two sided in finance ie. someone loses, someone wins

Measuring uncertainty – probabilityo Sum of all probabilities = 1o Discrete vs continuous probability --> in practice continuous

Statistics:o Average outcome:

Expected rate of return = k(^) = Σ (pi x ki)o Uncertainty of outcome:

Deviation = ki – k(^) Variance (average squared deviation) = σ² = Σ Pi(ki – k(^))² Standard deviation = σ (square root of variance) Standard deviation measure stand alone risk (risk for only one stock) Standardise risk by scaling by expected return:

Chance/Prob of loss – Coefficient of variation: CV = σ / k(^) Ex-ante expectation vs Ex-post realisation:

Ex-ante expectations – assume we know future probability distribution But in reality, we need to estimate from past data ie. ex-post realisations --> to do

this, assume the outcomes are independent – they had the same ex-ante probability9

From a time series of past return:o Estimated k(^) = [ Σ ki ] / no Estimated σ = S = √ Σ (ki – k(^))² / n –1 (root all)

Risk aversion and risk premium:o We assume investors are risk averseo Risk averse investor prefers certain prospect to an uncertain one with the same expected returno Such an extra return = risk premium

Portfolio risk:o Real investors invest in a bundle of stocks --> a portfolio o Investors are concerned with portfolio risk --> by how much will an asset ↑ the risk of the total

portfolio?o Weight of a security is proportion by value:

Weight ws = value of security / value of portfolio Sum of all weights = 1 Return of portfolio is the weighted average of returns:

kp = Σ wiki

Correlation:o Correlation is measured by the correlation coefficient (r):

-1 < r < 1 (or equal to) Perfectly positively correlated (r = 1) – stock returns move in step Perfectly negatively correlated (r = -1) – stock returns move proportionally in opposite

directions Low or zero correlation – returns change independently Real correlations:

Averages in stock market is 0.65, average σ = 0.35 Diversification:

o Since stocks have correlation < 1, combining them will ↓ risk of portfolio vs the stand alone risk of the stock

o But because all stocks significantly positively correlated, there is a limit to the amount of risk reduction

Risk reduction from diversification

Standard Deviation

Firm unique diversifiable risk

Market riskNo of stocks

o Market (systematic) risk – eg) r changes, growth shockso Firm specific (diversifiable) risk – eg) new CEO, new project

Weeks 10 and 11:Slide 9 as guide for test… Risk premium for market risk:

o Rational diversified shareholder will only expect a risk premium to compensate for market risk

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o Market (portfolio) risk < standalone risk diversified shareholder will accept ↓ return (pay ↑ price therefore setter of market price and return) than undiversified shareholder

No risk premium for diversifiable risk:o Only can be one expected return which will be set by diversified shareholders in regard to market

risk cannot obtain full return for standalone risk The measure of market risk – beta:

o Standalone risk = market risk + diversifiable risko Beta is market risk – contribution of a stock to the market risk of a portfolio o This depends on total volatility (standalone risk) and the correlation with market changeso Mathematically: σ²tot = ßσ²mkt + σ²div

o Beta is also the slope of the regression line (line of best fit) of return of asset vs return of marketo Beta = correlation coefficient x standalone risk

risk of marketo Values for beta:

Market return has ß = 1 ‘Average’ stock has ß = 1 ß > 1 – stock more risky than average ß < 1 – stock less risky than average Most real stock 0.5 < ß < 1.5 ß negative if stock had negative correlation with market very rare

Market risk premium:o Risk premium – expect extra return required to hold a risky asset (vs risk-free)o Market risk premium – expected extra return on the average risky asset also the expected extra

return on a value weighted index of the whole market o Depends on investor’s risk aversion and expectation of variability of market returno Risk premium = expected extra market return – expected risk free returno RPm = km – krf expected k

Capital Asset Pricing Model (CAPM):o Formal theory for relationship between ß and k (expected return of an asset)o Useful part of CAPM is the Security Market Line relationship o Postulates: Risk premium for an asset = ß x Market risk premiumo ie. SML equation: k = krf + ß(km – krf) or k = krf + ß(RPm)

o Return calculated from SML – The Required Return Terms:

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

o Realised return – past return received by investors in the asset mean of actual previous returnso Required return – return calculated from theory based on asset’s market risk o Rational expectations – market is in equilibrium when expect returns = required returns rational

because: if expected > required, can ↑ risk/reward or portfolio by buying more of that asset Undervalued if k(^) > k expected return > required return Overvalued if k(^) < k Fairly valued if k(^) = k

SML Graph k (%)[required return]

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undervalued

km overvalued

krf

Risk (ß) ß = 1

Beta for a portfolio:o Portfolio ß = weighted average of asset ßso ie. ßp = Σ wi ßi o kp = weighted average k or kp = krf + ßp(km – krf)

Effect of macro factors:o If some macro factor caused r to ↑ ↑ risk free rate ↑ whole SML by ↑

Changing risk aversion:o Slope of SML is mark risk premiumo If investors become ↑ risk averse market risk premium ↑ ↑ SML slope

check graphs for these changes CAPM and SML in practice:

o Formidable obstacles to testing: Theory is about expected returns can only measure realised returns, and estimate ß using

real returns Theory requires that market portfolio used to calculate ßs include all risky assets, including

intangibles eg) human capital Impossible to get data on such a portfolio

o Empirical results: Using stock market to test conformance of stocks to SML Results depend on methods used Some researchers pursed more complex models, adding more factors lack theoretical

justification Others argue CAPM correct, and that results of testing are due to use of stock market indexes

instead of correct index using all assetso CAPM to estimate costs of capital:

CAPM is better than no risk adjustment Should ignore diversifiable risk if aim to max shareholder value Can usefully distinguish between ↑ and ↓ market risk projects Must recognise that CAPM estimates of cost of capital are imprecise

o Examples: ↑ ß and ↑ market risk if outcome is sensitive to economic conditions eg) capital goods

manufacture, property development ↓ ß and ↓ market risk if outcome is insensitive to economic conditions eg) food retailing,

water and power utilitieso Conclusion:

Distinction between standalone and portfolio risk leads to theory of ‘required return’ for a given level of market risk

Can still yield imprecise estimates of cost of capital Still useful to estimate appropriate discount rates for DCF techniques

Motivations for estimating cost of capital:

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o To provide required rate of return (hurdle rate) to use in DCF evaluationo To provide cost of capital for accounting calculations of Economic Value Added (EVA)o Regulators setting prices for monopoly --> aim for zero EVA

Components of capital:o Debt:

Money raised from investors in return for contractual payments Long term (bonds or debentures), Short term (bank bills, overdraft) Debt may be secured --> ↓ default therefore ↓ cost of secured debt --> hence ↑ risk and cost

of other unsecured debt Cost of debt = kd

o Preferred shares: Receive fixed dividends Preferred because no dividend can be paid on ordinary shares until preferred shareholders

have been fully paid Equity because no legal right to dividend, can only be paid from profit Companies will pay preferred dividends of they can Cost of preferred stock = kp

o Ordinary equity: Owners of company Entitled to all remaining funds after other have all been paid Vote at general meetings, appoint/remove directors All limited companies must have shareholders Cost of ordinary equity = ks

o Watchpoints: Balance sheets prepared using accrual accounting --> finance techniques such as DFC uses

cash accounting – therefore components of capital ≠ balance sheet headings Equity shares, retained profits, reserves only distinguished for tax purposes --> in finance all

are ordinary equity Trade creditors, accruals are all cash flow timing issues --> in finance, cash flow is explicit –

only interested in point where it becomes cash flows and hence not part of cost of capital Tax considerations rationale:

o Usually calculate costs of capital after allowing for company tax because: Maximizing shareholder value is maximizing after tax value To capture investment decisions on tax related cash flows

o Tax allowable debt: Market return is after tax cost of capital for equity Interest is tax deductible for the company If company is paying tax, after tax cost of debt =

(1-t) x (Market cost of debt) Historic vs current market costs:

o Should we use market cost of capital, or cost of the capital to us eg) from retained profits?o Opportunity costs issue --> must use current market costso Rationale – could also use this money to repurchase securities --> this would save the company the

market cost of capital = opportunity cost. Alternatively, the investors could reinvest their capital at market rate – must use as hurdle

Estimating component costs of capital:o Debt:

Pretax cost of debt = market yield to maturity of issued debt After tax cost of debt = pretax cost of debt x (1-t) ie. kdAT = kdBT(1-t)

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To calculate yield when not given: Set up in bond (or other) calculation formula If x% coupon and x% market rate – will trade at FV…so if P > FV, yield < x% Estimate yield…if value > P, yield must be ↓ etc

o Preferred shares: Assume companies will always pay preferred dividend when calculating cost of capital --> as

failure to pay often results in vote entitlement which dilutes ordinary shareholder control Perpetual preferred shares are a perpetuity Cost = dividend / price Pp = Dp / kp --> kp = Dp / Pp

Dividends of preferred stock not tax deductible Do not adjust for tax or floatation cost

o Equity: CAPM:

Uses SML relationship ks = krf + ßs(km – krf) For:

o Backed by theoryo Consistent – uses market data to estimate market cost of equity

Against:o Only useful for listed companieso Estimation problems for ßo Assumes shareholder diversified

Discounted cash flow from dividend growth model: Current price = discounted PV of future dividend cash flows ks = k(^)s = (D1 / Po) + g(^) Estimating growth rate:

o From analysts’ estimateso Expected growth = retention rate x ROE, where:

ROE is the expected future return on equity Retention rate is the % of equity earning retained ie. (1 – payout ratio)

For:o Only requires single current share price and dividendo May be used for unlisted company (price derived from private transactions)o No assumption that shareholders are diversified

Against:o Very hard to estimate growth rateo Using retention ratio x ROE is using accounting data to estimate market cost

of equity Own bond yield plus risk premium:

Assumes relative bond yields reflect relative equity risk ks = bond yield + risk premium Risk premium – judgement --> 3-5% For:

o Simple to implement --> used by those who don’t understand other methods Against:

o No theoretical basiso Bond yields are assumed to reflect difference in equity risk between

companies:

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Bond determinants – maturity, coupon, r, default risk Equity risk determinants – earning variability, market correlation,

leverage Only leverage and default risk are somewhat related

Should you average? – averaging does not imply better answer --> judgement call Floatation costs (of equity):

o Cost of raising new capital eg) brokers, underwriterso Negative signal that raising new equity may sendo Approaches:

Add to initial investment cost Allow for in calculation via DCF model:

ks = D1 / Po(1-F) + g(^)o Depends on type of capital and markets perception (re company riskiness and

negative signal)o Mainly issue with equity, but equity raising infrequent --> cost per project

smallo Often ignored or treated outside the evaluation of other decisions

Notes: Can use any one of above, or combination --> judgement needed No correct answer --> estimates are imprecise

WACC (Weighted average cost of capital):o Cost to company of securities sold to raise funds = return to investor of holder that portfolioo WACC = k = wdkd(1-t) + wpkp + wsks

o Factors influencing WACC: Investment policy of firm --> riskiness of its assets - ↑ risk = ↑ WACC Market conditions eg) r, average risk premium Firm’s capital structure and dividend policy

o Tax imputation and WACC: Effective company tax rate and tax subsidy for debt will be ↓ depending on amount of

company tax which is claimed as personal tax Dividends must be grossed up by the attached franking credits eg) for cost of equity with

DFC, market/company return for CAPM regressiono WACC as hurdle rate:

Projects should be evaluated with cost of capital appropriate to the risk WACC is average cost for all companies activities --> need some adjustment for individual

projects Results of not adjusting for risk: (graph)

↓ risk but positive NPV projects will be rejected ↑ risk but negative NPV project will be accepted average company risk will ↑ returns to shareholder will be ↓ than they should be

o Types of project risk: Standalone risk – cash flow variability Corporate risk – effect of project on total firm cash flow Market risk – effect on firms market / beta risk

Market risk is theoretically correct for maximizing wealth of diversified shareholder Corporate risk relevant to undiversified shareholder, creditors and employees Balance these considerations using judgements

o Project risk adjustment procedures: Subjective adjustment of WACC for projects of different risk

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Evaluate project as if standalone company and estimate ß for market risk adjustment Use one of above to establish cost of capital for each division and use that for the division’s

projects: Pure play – find companies that operate only in the same areas as the division,

estimate and average ßs --> difficult Accounting beta – regress divisions ROA against ROA of companies in similar

markets --> these ßs are somewhat correlates, but difficult to get ROAs for projects that don’t exist

Week 11 onwards… Capital Structure:

o Financial leverage – use of debt and preferred stocko Financial risk – additional risk resulting from financial leverageo Example re financial leverage…

Ratios: BEP – Basic Earning Power = EBIT / assets ROE – Return on Equity = NI after tax / OE TIE – times Interest Earned = EBIT / interest

Conclusions: To ↑ expected ROE, must have BEP > kd because if not, then interest expense >

operating income produced by debt-financed assets; therefore leverage ↓ income As debt ↑, TIE ↓ because EBIT is unaffected by debt and interest expense ↑ (Int Exp

= kdD) BEP is unaffected by financial leverage

The effects of taxes on capital structure:o Classical tax system:

Company income is taxed, then shareholders pay tax on dividendso Imputation taxation systems:

Company tax is paid, shareholders get a franking credit on dividends Capital gains tax – tax paid on real capital profits (1/2 personal rate)

o Effect on value of the firm: VL = VU + [ tcI / kd ]

VL = VU + PV of annual tax savings Effectively get govt paying some of your interest repayment as it is tax deductible why

not borrow everything Costs of financial distress:

↑ firm borrows, ↑ probability it will default Direct costs – liquidation costs (legal, accounting fees) Indirect costs – lost sales, ↓ value for assets in illiquid markets, managerial time, firm

specific human capital etc Thus, Value = Value if all equity financed + PV of tax savings – PV of expected

bankruptcy costs Company taxes and personal taxes:

o VL = VU + [ 1 – (1 – t c )(1 – t s ) ] D (1 – td)

where tc – corporate tax rate , ts – shareholder tax rate (average div + cap gains rates), td – debt tax rate

o Provide [ ] > 0, VL > VU

o But with imputation, no advantage for un/levered firmo Imputation removes any tax advantage for debt, other reasons for debt – if

return > cost

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Business risk:o Uncertainty about future operating income (EBIT) how well can we predict operating income?o Business risk does not include financing effectso Determinants of business risk:

Uncertainty about demand (sales) ↑ variability, ↑ risk Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage:

Use of fixed costs rather than variable costs If more costs are fixed (ie. do not ↓ when demand falls) ↑ operating leverage Effect of operating leverage:

o ↑ operating leverage ↑ business risk (because small sales ↓ causes big profit ↓ ↑ break even point ↑ area to make a loss, but past break even point ↑ profit region ie. ↑

region of profit and losses Profits can by ↑ by ↑ FC mechanise production process ↑ variable costs may work, may not Operating leverage can ↑ E(EBIT), but also ↑ risk ↑ in mean but at

cost of dispersion ie risk Business risk vs financial risk:

o Business risk depends on business factors – competition, product liability, operating leverage shared between shareholders and debt holders

o Financial risk depends only on the types of securities issued ↑ debt = ↑ financial risk shareholders only

Operating leverage and financial leverage combined:o Degree of operating leverage: DOL = 1 + (FC / NI)o Degree of financial leverage: DFL = 1 + [ I / (FC + NI) ]o Degree of total leverage: DTL = DOL x DFLo Questions…

Optimal capital structure:o Capital structure (mix of debt, preferred and common equity) at which P0 is maximisedo Trades off ↑ E(ROE) and EPS against ↑ risk the tax benefits of leverage are exactly offset by the

debt’s risk costso Target capital structure is mix with which firm intends to raise capitalo If debt levels ↑, riskiness of firm ↑o This ↑ riskiness = ↑ cost of debt, but also equity (ks)o The Hamada Equation:

Quantifies the ↑ cost of equity due to financial leverage ie. if D ↑, tell us the new cost of equity

Uses the unlevered beta – business risk of a firm if it had no debt ßL = ßU [ 1 + (1 – T)( D/E ) ] Note: ß in CAPM is ßL

o Other factors re target capital structure: Industry average debt ratio TIE ratios under different scenarios ↓ TIE, ↑ rate lender will charge Lender / rating agency attitudes Reserve borrowing capacity Effects of financing on control

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Asset structure ↑ intangible assets able to borrow ↓ Expected tax rate

Modigliani-Miller Irrelevance Theory:o Capital structure of a firm is irrelevant to firm’s valueo Uses many assumptions eg) shareholders have same info as managers, no bankruptcy costs, no taxes

(MM vs reality graph)o Incorporating signaling effects:

Signaling theory suggests firms should use ↓ debt than MM suggests This unused debt capacity helps avoid stock sales, which ↓ stock price because of signaling

effects If we assume:

Managers have better info than outsiders and that managers cat in best interest of stockholders, then management would:

Issue stock if they think it is overvalued Issue debt if they think stock is undervalued Hence, investors view stock offering as a negative signal empirically cause share

price to ↓ Conclusions on capital structure:

o Need to make calculations but only estimateso ↑ judgmental component o capital structures therefore differ widely, even within industries

Welsh: (level of detail?)o Empirically found that external stock market influences capital structure mostly (specifically, lagged

stock returns)o Concluded that managers are essentially inert ie. capital structure is imposed by external forces and

not management intervention Dividend policy:

o Decision to pay out earning vs retain and reinvesto Theories:

Dividend irrelevance: Investors don’t care about payout any OK Investors are indifferent between dividends and capital gains create their own

dividend policy ie. want cash – sell stock; no cash – use div to buy more stock Proposed by MM but on unrealistic assumptions eg) no taxes, brokerage costs

difficult to test empirically Bird-in-the-hand:

Investors prefer a high payout Investors think dividends are ↓ risky than potential capital gains like dividends ↑ payout = ↑ price

Tax preference: Investors prefer a low payout Retained earnings lead to long-term capital gains, which are taxed at ↓ rate to

dividends capital gains also deferred (therefore still preferred even if taxed equally)

↓ payout = ↑ price Note: reverse implication for cost of equity eg) tax preference > irrelevance > bird-in-the-

hand Don’t know which theory is correct manager use judgment (must apply analysis with

judgment)

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o Information content or signaling hypothesis: Managers won’t ↑ dividends unless they think it is sustainable so investors view dividend

↑ as management’s view of the future Therefore price ↑ could reflect ↑ E(EPS) not desire for ↑ dividends

o Clientele effect: Different groups of investors prefer different dividend policies Firm’s past dividend policy determines its current clientele Therefore clientele effect impedes changing dividend policy (tax, brokerage costs) change

unfavourable to existing clienteleo Residual dividend model:

Payout as dividends residual of earnings after taking out retained earnings needed for the capital budget

This minimises floatation and equity signaling costs, hence minimises WACC Dividends = Net Income – (Target equity ratio x Total capital budget) Then divide this by Net Income for ratio Implies that dividend will change every year empirically wrong Change in investment opportunities:

↓ good investment = ↓ capital budget = ↑ dividend payout ↑ good investment = ↓ payout

Advantage – minimises frequency of new stock issues and floatation costs Disadvantages – results in variable dividends, sends conflicting signals, ↑ risk, doesn’t appeal

to any clientele Conclusion – consider residual model when setting target payout, but don’t follow rigidly

adjust slowly only if circumstances allowo Dividend reinvestment plan (DRIP):

Shareholders can reinvest dividends in shares of the company’s common stock get more stock instead of cash

Types of plans: Open market:

o Dollars to be invested are turned over to a trustee, who buys shares on the open market

o ↓ brokerage costs due to volume, convenient o Equity capital ie. no of shares, doesn’t change

New stock:o Firms issue new stock (usually at a discount), keeps money and uses it to buy

assetso Convenient way for company to expand capital base

Firms that need new equity use new stock plans Firms with no need for new equity use open market plans

o Setting dividend policy: Forecast capital needs over a planning horizons eg) 5 years Set a target capital structure Estimate annual equity needs Set target payout based on residual model Generally, some dividend growth rate emerges try to maintain this growth rate, varying

capital structure somewhat if necessaryo Stock repurchases:

Buying own stock back from shareholders Reasons:

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Alternative to distributing cash as dividends allows investors to realise capital gains as opposed to dividends

To dispose of one-time cash from an asset sale To make a large capital structure change

Advantages: Stockholder can tender or not Helps avoid setting ↑ dividends that can’t be maintained Repurchased stock can be used in takeovers or resold to raise cash as needed

greenmail – reacquisition of shares from hostile bidder at a premium Income received is capital gains rather than ↑ taxed dividends Stockholders may take as positive signal – management thinks stock is undervalued

Disadvantages: May be viewed as a negative signal poor investment opportunities. Repurchase is

a zero NPV project (Σdiv = price) can signal that this is the best option available to firm (assumes however that market is efficient)

Penalties if purpose was to avoid taxes on dividends Selling stockholders may be ill-informed, hence treated harshly Firm may have to bid up prices to complete purchase, thus paying too much for its

own stock Reasons for undertaking share buybacks (Lamba and Ramsay 2001):

Leverage ↑ D/E ratio Information signaling might signal undervaluation Anti-takeover mechanism buyout hostile shareholders Wealth transfer more wealth to shareholders if undervalued Free cash flow cash left after all + NPV projects. Managers reluctant to give up

FCF b/c of possible wage ↑ may invest in – NPV projects instead therefore buy back positive

Earnings per share (magic?) false: assets would ↓ therefore expect earning to ↓, PE ratio would likely change more risky as ↑ D/E (can’t work, otherwise would do it to max)

Conclusions (of the article):o Share buy backs are good newso Share markets are efficient at pricing with buybacks o Buybacks signal stock is undervalued wealth transfer to those who stay

with the companyo Stock dividends and stock splits:

Stock dividend – firm issues new shares instead of cash dividend price ↑ as + signal Stock split – firm increases the number of shares outstanding no change in price Both ↑ number of shares All things remaining constant, both will cause price to ↓ to keep each investor’s wealth

unchanged Both may get stock to an ‘optimal price range’ Stock splits generally occur when management is confident, so are interpreted as positive

signals Note cum-dividend (declared but not paid) vs ex-dividend (after paid)

o Australian Tax System: Before imputation – capital gains taxed at full income rates after indexation for CPI Now (since 1999) – no indexation but tax rate is half that of income

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