FINANCIAL MANAGEMENT CLASSES/TUTORIALS

Time Value of Money and DCF Technique

Exercise A1. Calculating Future Values
Assume you deposit $10,000 today in an account that pays 6 percent interest. How much
will you have in five years?

Solution. We need to calculate the future value of $10,000 at 6 percent for five years. The
future value factor is:
1.06^5 = 1.3382
The future value is thus
$10,000 x 1.3382 = $13,382.26

Exercise A2. Calculating Present Values

Suppose you have just celebrated your 19th birthday. Your uncle in USA has set up a trust
fund for you that will pay you $150,000 when you turn 30. If the relevant discount rate is 9
percent, how much is this fund worth today?

Solution. We need the present value of $150,000 to be paid in 11 years at 9 percent. The
discount factor is:
1/1.09^11 = 1/2.5804 = 0.3875
The present value is thus about
$150,000 x 0.3875 = $58,130

Exercise A3. Calculating Rates of Return

You’ve been offered an investment that will double your money in 10 years. What rate of
return are you being offered?

Solution. Basic future value equation is:

𝑭�𝑽�=𝑷�𝑽�×[(𝟏�+𝒓�)]^𝒏�
Future value is expected to be twice as big as present value in ten years:
FV=2xPV
so we have 2xPV=𝑷�𝑽�×[(𝟏�+𝒓�)]^10
and 2= [(𝟏�+𝒓�)]^10
From here, you need to solve for r, the unknown rate:
𝟏
𝟐 ⁄𝟏𝟎 = 𝟏 + 𝒓
r = 7,18%

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Exercise A4. Calculating the Number of Periods
You’ve been offered an investment that will pay you 9 percent per year. If you invest
$15,000, how long until you have $30,000? How long until you have $45,000?

Solution. The basic equation is:

$30,000 = $15,000 x (1 + 0.09)^n
that is
2 = (1 + 0.09)^n
so
n = 8.04 years
In a similar way, to get $45,000
n = 12.75 years

Exercise B1. Present Values with Multiple Cash Flows

A three-year, $25 million contract has been signed with a football player. The details provide
for an immediate cash bonus of $2 million. The player is to receive $5 million in salary at the
end of the first year, $8 million the next, and $10 million at the end of the last year.
Assuming a 15 percent discount rate, is this package worth $25 million? How much is it
worth?

Solution. Obviously, the package is not worth $25 million because the payments are spread
out over three years.
The bonus is paid today, so it’s worth $2 million.
The present values for the three subsequent salary payments are:
($5/1.15) + (8/1.15^2) + (10/1.15^3)
= ($5/1.15) + (8/1.32) + (10/1.52)
= $16.9721 million
The package is worth a total of $18.9721 million.

Exercise B2. Future Value with Multiple Cash Flows You plan to make a series of deposits in
an individual retirement account. You will deposit $1,000 today, $2,000 in two years, and
$2,000 in five years. If you withdraw $1,500 in three years and $1,000 in seven years,
assuming no withdrawal penalties, how much will you have after eight years if the interest
rate is 7 percent? What is the present value of these cash flows?

Solution We will calculate the future values for each of the cash flows separately and then
add them up. Notice that we treat the withdrawals as negative cash flows:
$1,000 x 1.07^8 = $1,000 x 1.7812 = $ 1,718.19
$2,000 x 1.07^6 = $2,000 x 1.5007 = 3,001.46

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 -$1,500 x 1.07^5=-$1,500 x 1.4026 = -2,103.83
$2,000 x 1.07^3 = $2,000 x 1.2250 = 2,450.09
-$1,000 x 1.07^1=-$1,000 x 1.0700 = - 1,070.00
Total future value = $ 3,995.91

To calculate the present value, we could discount each cash flow back to the present or we
could discount back a single year at a time.
However, because we already know that the future value in eight years is $3,995.91, the easy
way to get the PV is just to discount this amount back eight years:
Present value = $3,995.91/1.07^8
= $3,995.91/1.7182
= $2,325.64

Exercise B3. Annuity Present Value

You are looking into an investment that will pay you $12,000 per year for the next 10 years.
If you require a 15 percent return, what is the most you would pay for this investment?
Solution The most you would be willing to pay is the present value of $12,000 per year for 10
years at a 15 percent discount rate. The cash flows here are in ordinary annuity form, so
relevant value factor is:
Annuity present value factor = (1 - Present value factor)/r

= [1 - (1/1.15^10)]/0.15
= (1 - .2472)/0.15
= 5.0188
The present value of the 10 cash flows is thus:
Present value = $12,000 x 5.0188

= $60,225
This is the most you would pay.
Exercise B4. APR versus EAR
The going rate on student loans is quoted as 8 percent APR. The terms of the loans call for
monthly payments. What is the effective annual rate (EAR) on such a student loan?
Solution. A rate of 8 percent APR with monthly payments is actually 8%/12 = .67% per
month. The EAR is thus:
EAR = [1 + (0.08/12)]^12 - 1 = 8.30%
Exercise B5. It’s the Principal That Matters
Suppose you borrow $10,000. You are going to repay the loan by making equal annual
payments for five years. The interest rate on the loan is 14 percent per year. Prepare an
amortization schedule for the loan. How much interest will you pay over the life of the loan?

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Solution. We first need to calculate the annual payment. With a present value of $10,000, an
interest rate of 14 percent, and a term of five years, the payment can be determined from:
$10,000 = Payment x {[1 - (1/1.14^5)]/0.14}
= Payment x 3.4331
Therefore, the payment is $10,000/3.4331 =$2,912.84 (actually, it’s $2,912.8355; this will
create some small rounding errors in the following schedule). We can now prepare the
amortization schedule as follows:

You will pay $4,564.17 over the life of the loan as interest.
Task 1 Prepare an amortization schedule for the loan from Exercise B5 assuming decreasing
annual payments (equal principal payments) for five years.
Task 2 You’ve recently finished your MBA at the Wroclaw University of Science and
Technology Business School. Naturally, you must purchase a new BMW immediately. The car
costs about $21,000. The bank quotes an interest rate of 15 percent APR for a 72-month
loan with a 10 percent down payment. What will your monthly payment be? What is the
effective interest rate on the loan?
Task 3 A bank is offering 12 percent compounded quarterly. If you put $100 in an account,
how much will you have at the end of one year? What’s the EAR? How much will you have at
the end of two years?
Task 4 Three banks quote the following rates:
Bank A: 15% compounded daily,
Bank B: 15.5% compounded quarterly,
Bank C: 16% compounded annually.
Which is the best for opening a savings account? Which is the best for taking a loan?

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 Capital Budgeting Criteria
Problems with the IRR
The problems with the IRR come about when the cash flows are not conventional or when
we are trying to compare two or more investments to see which is best.
Nonconventional Cash Flows Suppose we have a strip-mining project that requires a $60
investment. Our cash flow in the first year will be $155. In the second year, the mine will be
depleted, but we will have to spend $100 to restore the terrain. As figure below illustrates,
both the first and third cash flows are negative. To find IRR, we can calculate the NPV at
various rates:

As may be noticed, for discount rate = 0% (actually – no discounting), the NPV is negative
(-$5). In conventional investments, when discount rate increase, NPV decreases, but here is
just opposite situation – when discount rate rises to 10%, 20%, 30%, the NPV rises as well. It
becomes positive for discount rate = 30%, and then becomes negative again. You may try to
find its value for discount rate between 20% and 30% - there is somewhere an IRR, and
somewhere in between 30% and 40% - there is another IRR. Actually NPV is zero for discount
rate = 25% and for 33.33%. This is shown on the graph below:
This is the multiple rates of return problem.
Suppose our required return is 10%. Should
we take this investment? Both IRRs are
greater than 10%, so, by the IRR rule, maybe
we should. However, as the graph shows, the
NPV is negative at any discount rate less than
25%, so this is not a good investment.
When should we take it? Looking at the graph
again, we see that the NPV is positive only if
our required return is between 25% and
33.33%.
In some industrial investments there may
exist such nonconventional cash flows, when at the end of the life of the project there are
some negative cash flows, often linked with the costs of liquidation of the investment. In
such cases it is recommended to apply NPV criterion.
Mutually Exclusive Investment decisions
This is a situation in which taking one investment prevents the taking of another. If two
investments, X and Y, are mutually exclusive, then taking one of them means that we cannot
take the other. Two projects that are not mutually exclusive are said to be independent. For

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example, if we own one corner lot, then we can build a gas station or an apartment building,
but not both. These are mutually exclusive alternatives. Thus far, the problem was, whether
or not a given investment is worth undertaking. There is a related question, however, that
comes up very often: Given two or more mutually exclusive investments, which one is the
best? The answer is simple enough: the best one is the one with the largest NPV. Can it be
also said that the best one has the highest return? As it will be shown, the answer is no.
To illustrate the problem with the IRR rule and mutually exclusive investments, consider the
following cash flows from two mutually exclusive investments:
The IRR for A is 24%, and the IRR for B is 21%.
Because these investments are mutually exclusive, we
can only take one of them. IRR rule says that
Investment A is better because of its higher return.
However, for zero discount rate NPV (A) = 60, and
NPV(B) = 70, so in such a case B would be better. To
evaluate these investments the NPV of both
investments for different levels of a discount rate has been computed:
We see from this table that which investment has
higher NPV depends on discount rate. Investment B
has higher NPV for discount rates lower than 10% (or
11% approximately). It pays more at later years, so low
discount rate does not decrease these payments
much. At higher discount rates Investment A is better.
At later years it pays less, so these higher discount
rates do not have high impact on total NPV. So, in this
example, at relatively low discount rates (up to 10 or 11%) the rules of NPV and IRR are in
conflict. At higher discount rates (required return rates) there is no conflict. The situation is
illustrated on next graph that shows NPV profiles of both investments:
This example illustrates that when we have
mutually exclusive projects, we shouldn’t rank
them based on their returns. More generally,
anytime we are comparing investments to
determine which is best, looking at IRRs can
be misleading. Instead, we need to look at the
relative NPVs to avoid the possibility of
choosing incorrectly. Remember, we’re
ultimately interested in creating value for the
shareholders, so the option with the higher
NPV is preferred, regardless of the relative
returns. Notice also the importance of the
discount rate (required return) here. This rate
depends on general economic conditions
prevailing in the period of investment and on

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the rates the company earns on other/similar projects in this period. So, the
estimation/calculation of a proper rate is a crucial point in investment analysis and decisions.
Calculating the Crossover Rate
In previous example the NPV profiles cross at about 11%. How can we determine just what
this crossover point is? The crossover rate, by definition, is the discount rate that makes the
NPVs of two projects equal. To illustrate, suppose we have two mutually exclusive
investments with the following cash flows in subsequent years:
Investment A: -$400, 250, 280 and Investment B: -$500, 320, 340.
What’s the crossover rate?
To find the crossover, first consider moving out of Investment A and into Investment B. If
you make the move, you’ll have to invest an extra $100 ($500 - 400). For this $100
investment, you’ll get an extra $70 ($320 - 250) in the first year and an extra $60 ($340 -
280) in the second year. Is this a good move? In other words, is it worth investing the extra
$100? Based on our discussion, the NPV of the switch, NVP(B -A), is:
NPV(B - A) = - $100 + [70/(1 + R )] + [60/(1 + R)^2]
We can calculate the return on this investment by setting the NPV equal to zero and solving
for the IRR:
NPV(B - A) = 0 = - $100 + [70/(1 + R )] + [60/(1 + R )^2]
If you go through this calculation, you will find the IRR is exactly 20%. What this tells us is
that at a 20% discount rate, we are indifferent between the two investments because the
NPV of the difference in their cash flows is zero. As a consequence, the two investments
have the same value, so this 20 percent is the crossover rate. Check to see that the NPV at
20% is $2.78 for both investments.
In general, you can find the crossover rate by taking the difference in the cash flows and
calculating the IRR using the difference. It doesn’t make any difference which one you
subtract from which. To see this, find the IRR for (A - B); you’ll see it’s the same number.
Task 1 Investment Criteria
A proposed expansion project has the following cash flows: -$200, 50, 60, 70, 200. Calculate
the payback, the discounted payback, and the NPV at a required return of 10%.
Task 2 Mutually Exclusive Investments
Consider the following two mutually exclusive investments. Calculate the IRR for each and
the crossover rate. Under what circumstances will the IRR and NPV criteria rank the two
projects differently? Investment A: -$75, 20, 40, 70; Investment B: -$75, 60, 50, 15.
Task 3 Average Accounting Return
You are looking at a three-year project with a projected net income of $2,000 in Year 1,
$4,000 in Year 2, and $6,000 in Year 3. The cost is $12,000, which will be depreciated
straight-line to zero over the three-year life of the project. What is the average accounting
return (AAR)?

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 Capital Investment Decisions
Special Cases of Discounted Cash Flow Analysis and Tasks
Case 1. Evaluating Cost-Cutting Proposals
One decision frequently faced is whether or not to upgrade existing facilities to make them
more cost-effective. The issue is whether or not the cost savings are large enough to justify
the necessary capital expenditure.
For example, suppose we are considering automating some part of an existing production
process. The necessary equipment costs $80,000 to buy and install. The automation will save
$22,000 per year (before taxes) by reducing labor and material costs [remark: savings
decrease expenses, so make income tax bigger by tax rate x savings]. For simplicity, assume
that the equipment has a five-year life and is depreciated to zero on a straight-line basis over
that period. It will actually be worth $20,000 in five years. The tax rate is 34 percent, and the
discount rate is 10 percent. Should we automate?
As always, the first step in making such a decision is to identify the relevant incremental cash
flows. First, determining the relevant capital spending is easy enough. The initial cost is
$80,000. The after tax salvage value is $20,000 x (1- 0.34) = $13,200 because the book value
will be zero in five years. Second, there are no working capital consequences here, so we
don’t need to worry about changes in net working capital. Operating cash flows are the third
component to consider. Buying the new equipment affects our operating cash flows in two
ways. First, we save $22,000 before taxes every year. In other words, the firm’s operating
income increases by $22,000, so this is the relevant incremental project operating income.
Second, and it’s easy to overlook this, we have an additional depreciation deduction. In this
case, the depreciation is $80,000/5 = $16,000 per year. Because the project has an operating
income of $22,000 (the annual pretax cost saving) and a depreciation deduction of $16,000,
taking the project will increase the firm’s EBIT by $22,000 - 16,000 = $6,000, so this is the
projects EBIT. Finally, because EBIT is rising for the firm, taxes will increase. This increase in
taxes will be $6,000 x 0.34 = $2,040. With this information, we can compute operating cash
flow in the usual way:
OCF = EBIT + Depreciation – Tax = 6,000 + 16,000 – 2,040 = 19,960
So our after tax operating cash flow is $19,960. It might be somewhat more enlightening to
calculate operating cash flow using a different approach. What is actually going on here is
very simple. First, the cost savings increase our pretax income by $22,000. We have to pay
taxes on this amount, so our tax bill increases by 0.34 x $22,000 = $7,480. In other words,
the $22,000 pretax saving amounts to $22,000 x (1 - 0.34) = $14,520 after taxes.
Second, the extra $16,000 in depreciation isn’t really a cash outflow, but it does reduce our
taxes by $16,000 x 0.34 = $5,440. The sum of these two components is $14,520 + 5,440 =
$19,960, just as we had before. Notice that the $5,440 is the depreciation tax shield we
discussed earlier, and we have effectively used the tax shield approach here.
We can now finish off our analysis. Based on our discussion, the relevant cash flows are:

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At 10 percent, it’s straightforward to verify that the NPV here is $3,860, so we should go
ahead and automate.
Case 2. Evaluating Equipment Options with Different Lives
The problem involves choosing among different possible systems, equipment setups,
machines, devices or procedures. The goal is to choose the most cost-effective. The
approach considered here is only necessary when two special circumstances exist. First, the
possibilities under evaluation have different economic lives. Second, and just as important, it
is needed whatever is bought more or less indefinitely. As a result, when it wears out,
another one will be bought.
For example, imagine we are in the business of manufacturing stamped metal
subassemblies. Whenever a stamping mechanism wears out, we have to replace it with a
new one to stay in business. We are considering which of two stamping mechanisms to buy.
Machine A costs $100 to buy and $10 per year to operate.
It wears out and must be replaced every two years.
Machine B costs $140 to buy and $8 per year to operate.
It lasts for three years and must then be replaced.
Ignoring taxes, which one should we go with if we use a 10% discount rate?
In comparing the two machines, we notice that the first is cheaper to buy, but it costs more
to operate and it wears out more quickly.

How can we evaluate these trade-offs?

We can start by computing the present value of the costs for each:
Machine A: PV(A costs) = -$100 + -10/1.1 + -10/1.1^2 = -$117.36
Machine B: PV(B costs) = -$140 + -8/1.1 + -8/1.1^2 + -8/1.1^3 = -$159.89
Notice that all the numbers here are costs, so they all have negative signs. If we stopped
here, it might appear that A is the more attractive because the PV of the costs is less.
However, all we have really discovered so far is that A effectively provides two years’ worth
of stamping service for $117.36, whereas B effectively provides three years’ worth for
$159.89. These costs are not directly comparable because of the difference in service
periods.

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We need to somehow work out a cost per year for these two alternatives. To do this, we ask
the question:
– What amount, paid each year over the life of the machine, has the same PV as PV of the
machine?
This amount is called the equivalent annual cost (EAC).
Calculating the EAC involves finding an unknown payment amount. For example, for
Machine A, we need to find a two-year ordinary annuity with a PV of -$117.36 at 10%. We
know that the two-year annuity factor is:
Annuity factor = (1 - 1/1.10^2)/0.10 = 1.7355
For Machine A, then, we have:
PV(A costs) = -$117.36 = EAC(A) x 1.7355
EAC(A) =-$117.36/1.7355 =-$67.62

For Machine B, the life is three years, so we first need the three-year annuity factor:
Annuity factor = (1 - 1/1.10^3)/0.10 = 2.4869
We calculate the EAC for B just as we did for A:
PV(B costs) =-$159.89 = EAC(B) x 2.4869
EAC(B) = -$159.89/2.4869 =-$64.29
Based on this analysis, we should purchase B because it effectively costs $64.29 per year
versus $67.62 for A. In other words, all things considered, B is cheaper. In this case, the
longer life and lower operating cost are more than enough to offset the higher initial
purchase price.
Task 1
Company X has projected a sales volume of $1,650 for the second year of a proposed
expansion project. Costs normally run 60% of sales, or about $990 in this case. The
depreciation expense will be $100, and the tax rate is 35%. What is the operating cash flow?
Calculate your answer using all of the approaches (including the top-down, bottom-up, and
tax shield approaches).
Task 2
Project Y involves a new type of graphite composite skate wheel. We think we can sell 6,000
units per year at a price of $1,000 each. Variable costs will run about $400 per unit, and the
product should have a four-year life. Fixed costs for the project will run $450,000 per year.
Further, we will need to invest a total of $1,250,000 in manufacturing equipment. This
equipment is straight-line depreciated for seven years for tax purposes. In four years, the
equipment will be worth about half of what we paid for it. We will have to invest $1,150,000
in net working capital at the start. After that, net working capital requirements will be 25%
of sales.

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Should we undertake the venture? To answer, first prepare a pro forma income statement
for each year. Next, calculate operating cash flow. Finish the problem by determining total
cash flow and then calculating NPV assuming a 20% required return. Use a 30% tax rate
throughout.
Task 3
We’re contemplating a new automatic surveillance system to replace our current contract
security system to save money on it. It will cost $450,000 to get the new system. The cost
will be depreciated straight-line to zero over the system’s four-year expected life. The
system is expected to be worth $250,000 at the end of four years after removal costs. We
think the new system will save us $125,000, before taxes, per year in contract security costs.
The tax rate is 30%. What are the NPV and IRR on buying the new system? The required
return is 15%.

Task 4
You are evaluating two different pollution control options. A filtration system will cost $1.1
million to install and $60,000 annually, before taxes, to operate. It will have to be completely
replaced every five years. A precipitation system will cost $1.9 million to install, but only
$10,000 per year to operate. The precipitation equipment has an effective operating life of
eight years. Straight-line depreciation is used throughout, and neither system has any
salvage value. Which option should we select if we use a 12 percent discount rate? The tax
rate is 34 percent.

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 Risk and Return
Based on capital market history, there is a reward for bearing risk. This reward is the risk
premium on an asset.
The total risk associated with an asset has two parts: systematic risk and unsystematic risk.
Unsystematic risk can be freely eliminated by diversification (this is the principle of
diversification), so only systematic risk is rewarded. As a result, the risk premium on an asset
is determined by its systematic risk. This is systematic risk principle.
An asset’s systematic risk, relative to the average, can be measured by its beta coefficient, β.
The risk premium on an asset A is then given by its beta coefficient multiplied by the market
risk premium, 𝛽𝐴 × [𝐸(𝑅𝑀 ) − 𝑅𝑓 ].

The expected return on an asset A is equal to the risk-free rate 𝑅𝑓 plus the risk premium of
asset A:
𝐸 (𝑅𝐴 ) = 𝑅𝑓 + 𝛽𝐴 × [𝐸 (𝑅𝑀 ) − 𝑅𝑓 ]

This is the equation of the Security Market Line (SML), and it is often called the Capital Asset
Pricing Model (CAPM).
Example
Suppose the risk-free rate is 4%, the market risk premium is 8.6%, and a particular stock has
a beta of 1.3. Based on CAPM, what is the expected return on this stock? What would the
expected return be if the beta were to double?
With a beta of 1.3, the risk premium for this stock is 1.3 × 8.6% = 11.18%. The risk-free rate is
4%, so the expected return of this stock is 4% + 11.18% = 15.18%. If the beta were to double
to 2.6, the risk premium for this stock would double to 2 × 11.18 = 22.36%, so the expected
return on this stock would be 4% + 22.36% = 26.36%.
Task 1 (Yield and return)
Suppose you bought some stock at the beginning of the year for $25 per share. At the end of
the year, the price is $35 per share. During the year, you got a $2 dividend per share. What is
the dividend yield? The capital gains yield? The percentage return? If your total investment
was $1,000, how much do you have at the end of the year?
Solution
Dividend yield = dividend / initial investment = $2 / $25 = 8%
Capital gains yield = capital gain / initial investment = ($35 - $25) / $25 = 40%
The percentage return = (dividend + capital gain) / initial investment = ($2 + $10) / $25 = 48%

For the $1,000 investment, at the end of the year you have $1,480 (148% of $1,000).
You may check that for $1,000 you have purchased $1,000 /$25 = 40 shares. On each share
you earned $2 dividend and $10 capital gain, so it made 40 × ($2 + $10) = $480.

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Task 2 (Portfolio)
Compute the expected return of stock A , of stock B, and expected return of a portfolio P of
30% of stock A and 70% of stock B for the following data:

Probability of state State of Economy Rates of return in a given state of economy

of economy Stock A Stock B
60% Recession -20% 30%
40% Boom 70% 10%

Solution
𝐸 (𝑅𝐴 ) = 0.6 × (−20%) + 0.4 × 70% = −12% + 28% = 16%
𝐸 (𝑅𝐵 ) = 0.6 × 30% + 0.4 × 10% = 18% + 4% = 22%
𝐸 (𝑅𝑃 ) = 30% × 𝐸 (𝑅𝐴 ) + 70% × 𝐸 (𝑅𝐵 )
𝐸 (𝑅𝑃 ) = 0.3 × 16% + 0.7 × 22% = 4.8% + 15.4% = 𝟐𝟎. 𝟐%
In the other way you can compute 𝐸 (𝑅𝑃 ) as:
In case of recession: 𝑅𝑃,𝑟𝑒𝑐𝑒𝑠𝑠𝑖𝑜𝑛 = 0.3 × (−20%) + 0.7 × 30% = −6% + 21% = 15%

In case of boom: 𝑅𝑃,𝑏𝑜𝑜𝑚 = 0.3 × 70% + 0.7 × 10% = 21% + 7% = 28% , so

𝐸 (𝑅𝑃 ) = 60% × 𝑅𝑃,𝑟𝑒𝑐𝑒𝑠𝑖𝑜𝑛 + 40% × 𝑅𝑃,𝑏𝑜𝑜𝑚

𝐸(𝑅𝑃 ) = 0.6 × 15% + 0.4 × 28% = 9% + 11.2% = 𝟐𝟎. 𝟐%

Task 3 (Risk and Return)

Suppose you observe on efficient market the following situation:

Security Beta Expected return

A 1.6 19%
B 1.2 16%

Question 1 If the risk-free rate is 8%, are these securities correctly priced?
𝐸(𝑅𝑖 )−𝑅𝑓
Answer 1 On efficient market the reward-to-risk ratio should be the same for each
𝛽𝑖
security i (correctly priced securities offer the same reward-to-risk ratio).
Computing reward-to-risk ratio for security A and for security B gives:
𝐸(𝑅𝐴 )−𝑅𝑓 19%−8%
For A: = = 6.875%
𝛽𝐴 1.6

𝐸(𝑅𝐵 )−𝑅𝑓 16%−8%

For B: = = 6.67%
𝛽𝐵 1.2

13
Security B return, relative to security A return, is too low, so its price is too high (prices and
returns move in opposite directions). Alternatively – security A return is too high, so its price
is too low. Final answer is then: “No, they are not correctly priced.”
Question 2 What would the risk-free rate have to be if they are correctly priced?
Answer 2 They should offer the same reward-to-risk ratio, so it should hold:
𝐸 (𝑅𝐴 ) − 𝑅𝑓 𝐸 (𝑅𝐵 ) − 𝑅𝑓
=
𝛽𝐴 𝛽𝐵
19% − 𝑅𝑓 16% − 𝑅𝑓
=
1.6 1.2
From the above: 𝑅𝑓 = 7%

Task 4 (CAPM)
Suppose the risk-free rate is 8% and expected market return is 14%.
Question 1 If a particular stock C has beta = 0.60, what is its expected return (based on
CAPM)?

Answer 1 Market risk premium is (𝑅𝑀 − 𝑅𝑓 ) = (14% − 8%) = 6%

𝐸 (𝑅𝐶 ) = 𝑅𝑓 + 𝛽𝐶 × [𝐸(𝑅𝑀 ) − 𝑅𝑓 ]

𝐸 (𝑅𝐶 ) = 8% + 0.60 × 6% = 11.60%

Question 2. If another stock D has an expected return = 20%, what must be its beta?

Answer 2 According to CAPM it holds:

𝐸 (𝑅𝐷 ) = 𝑅𝑓 + 𝛽𝐷 × [𝐸 (𝑅𝑀 ) − 𝑅𝑓 ], so
𝐸(𝑅𝐷 ) − 𝑅𝑓 20% − 8% 12%
𝛽𝐷 = = = =2
𝐸 (𝑅𝑀 ) − 𝑅𝑓 14% − 8% 6%

Stock D risk premium is twice as big as market risk premium.

14
 Bond Valuation
Task 1 Semiannual Coupons Case
Assume a bond of $1,000 face value that has a 14% coupon rate and pays coupons twice a
year, so the owner of a bond gets $70 each half a year. Current market yield is 8% every 6
months, so it is quoted as 16% (bond yields are quoted as APRs – Annual Percentage Rates).
Assume the bond matures in 7 years.
Question 1. What is the effective annual yield on this bond?
Effective Annual Rate (EAR) = (1 + 0.08)^2 – 1 = 16.64%
Question 2. What should be the bond value (price)?
Present value of the bond’s face value of $1,000 paid in 7 years is:
PV (face value) = $1,000/1.08^14 = $1,000/2.9372 = $340.46
because 7-year period has 14 periods of six months each at 8 % per period.
The payments of coupons is a 14-period annuity of $70 per period. The present value of such
annuity, at 8% discount rate is:
PV(annuity) = $70 × (1 – 1/1.08^14)/0.08 = $70 × (1 – 0.3405)/0.08 = $70 × 8.2442 = $577.10
Total PV = $340.46 + $577.10 = $917.56
The value (price) is below its face value (the bond sells at a discount) because it has a coupon
rate of 7% every 6 months, but the market requires 8% every 6 months. To give investors
demanded 8%, the price of this bond must be lower than $1,000.
Task 2
A company’s bond has a 10% coupon rate and a $1,000 face value. Interest is paid
semiannually, and the bond has 20 years to maturity. If investors require a 12% yield, what is
the bond’s value? What is the effective yield on the bond?
Because the bond pays interest semiannually, the coupons are (10% × $1,000) / 2 = $50 paid
every 6 months. The required yield (yearly, stated in APR form) is 12%, so for a six-months
period it is 12%/2 = 6% every 6 months. The bond matures in 20 years, so there are 40 six-
months periods.
The bond’s value is the present value of $50 paid every 6 months for 40 six-months periods
plus the present value of the $1,000 face amount:
Bond value = $50 × [(1 – 1/1.06^40)/0.06] + $1,000/1.06^40
= $50 × 15.04630 + 1,000/10.2857
= $849.54
This bond has to sell at a discount because investors require a 12% return, but the bond has
a 10% coupon yield.
The effective annual yield on the bond is (1 + 0.06)^2 – 1 = 12.36%.

15
Task 3
A corporation’s bond has an 8% coupon, paid semiannually. The par value is $1,000, and the
bond matures in six years. The bond currently sells for $911.37. What is its yield to maturity?
What is the effective annual yield?
It is assumed that the market is efficient, so the current price of $911.37 is the present value
of the bond’s future cash flows. The face value is $1,000, and the coupon is $40 every 6
months for 12 periods. So the bond’s yield to maturity is the unknown “r” in the formula for
the price of the bond (the present value of future cash flows):
$911.37 = $40 × [1 – 1/(1 + r)^12]/r + 1,000/(1 + r)^12
Because the price is lower than the face value (the bond sells at a discount), it means the 6-
month yield must be bigger than the 6-month coupon rate of 4%. Solving this by trial and
error and computing the value for r = 6% one gets:
Bond value = $40 × (1 – 1/1.06^12)/0.06 + 1,000/1.0.06^12 = $832.32
This is less than the actual value of $911.37, so the applied discount rate of 6% is too high.
The next step is to try r = 5%, and it is the right choice.
By convention the bond’s yield to maturity is quoted as being 2 × 5% = 10%.
However the effective yield is (1 + 0.05)^2 – 1 = 10.25%.
Task 4
Suppose a company issues bonds with par value of $1,000, a maturity of five years, and a
coupon rate of 8% paid annually. The company decided to sell the bonds below par at $995.
Although the bond is issued at less than par, it still provides the buyer with the same cash
flow stream as if it were issued at par. The bondholder will receive $80 each year for the
following 4 years and will receive $1,080 the fifth year if the bond is kept until maturity.
Thus, the expected return is higher than the 8% coupon rate because when the bond is
redeemed in 5 years, the holder will realize a capital gain of $45 ($1,000 less $955). It also
means that the company is actually borrowing at a cost higher than the 8% coupon rate, and
even higher than the current yield of 8,38% (the $80 coupon payment of the bond divided by
its $955 price). What is this expected return? Why the company issues its bonds at a
discount? Why not issue them at par and thus borrow at the 8% coupon rate?
Task 5
Suppose that you bought a bond from Task 4 for $955 a year ago and that you wish to sell it
today. You cannot sell it to the issuer. You will have to sell it to another investor through the
corporate bond market. What price can you expect to receive for your bond? The answer
depends on the yield at which new corporate bonds, similar to yours, are currently being
issued. Similar bonds are those with a four-year maturity and with the same risk as your
bond. Assume they are now being issued at par ($1,000) with a 7% coupon rate.

16
 Stock Valuation
Task 1
The Corporation has just paid a dividend of $3 per share. The dividend of this company
grows at a steady rate of 8% per year. What will the dividend be in 5 years?

The future dividend is:

$3 × (1 + 0.08)^5 = $3 × 1.4693 = $4.41
Task 2
Assume you know the next dividend of a company will be $4 per share and this company
dividends increase by 6% every year. Investors require a 16% return on these type of
companies. What is the value of the company stock today? What is the value in four years?
Based on the dividend growth model, the price per share is given by:
𝑃0 = 𝐷1 /(𝑅 − 𝑔)
The dividend next year 𝐷1 is already given as $4, so
𝑃0 = $4 / (0.16 – 0.06) = $4 / 0.10 = $40.
The price in four years is given by:
𝑃4 = 𝐷4 × (1 + 𝑔)/(𝑅 − 𝑔)
Dividend in four years can be computed based on the known dividend in one year 𝐷1 :
𝐷4 = 𝐷1 × (1 + 𝑔)3 = $4 × (1+0.06)^3 = $4.764

Finally: 𝑃4 = $4.764 × (1 + 0.06) / (0.16 – 0.06) = $5.05 / 0.10 = $50.50

The price in four years can also be computed directly based on price today as follows:
𝑃4 = 𝑃0 × (1 + 𝑔)4 = $40 × (1 + 0.06)^4 = $50.50

Task 3
Consider a company that currently is not paying dividends and the first dividend of $0.50 will
be paid in 5 years, then it is going to grow at a rate of 10% per year. Assume the required
return on companies such as this one is 20%. What is the price of the stock today?
Using the dividend growth model, it is possible to compute the price in 4 years:
𝑃4 = 𝐷5 /(𝑅 − 𝑔) = $0.50 / (0.20 – 0.10) = $5
To get the price today it is enough to discount the price of $5 back four years at 20%:

𝑃0 = $5 / (1 + 0.20)^4 = $5 / 2.0736 = $2.41

The stock is worth $2.41 today.
Task 4

17
Suppose a company is expected to pay a $2 cash dividend in a year from now and that this
dividend is anticipated to grow at a constant annual growth rate of 3% forever. Investors
require a return of 12% on their investment in the company’s stock. What is the present
value of one share of this company common stock?
Task 5
Suppose a company is expected to pay a $2 cash dividend at the end of the year and that
one share of its stock will be worth $30 at the same date. What is the estimated value of
one share now (at beginning of the year) if investors require a return of 12% to hold the
company’s common stock?
Task 6
Consider the fast growing company that just paid $5 million total dividends, and that
announced to increase dividend payments by 30% for 3 subsequent years. You estimate
however that after 3 years the company is going to reduce this growth to 10% yearly for
several years (assume – indefinitely). Required return is 20%. What is the total value of the
stock of this company now?
Task 7
Consider a company that just paid a cash dividend of $2 per share and it is expected the
steady 8% growth of the dividend. Investors require a 16% return from investments such as
this. What is the current value of the stock? What will the stock be worth in 5 years?
(Find the answer for the second question in both ways:
a) computing the dividend in 5 years and applying the dividend growth model, and
b) computing the price in 5 years directly, based on the current price of the stock;
compare the results).
Task 8
Assume the company just paid a $2 dividend per share. It is expected that the dividend will
grow at 20% per year for the next three years and then the growth is going to drop to 8% per
year indefinitely. Investors require 16% return from this investment. What is the stock
selling for today?

18
 Cost of Capital

From capital budgeting discussion it is known that the critical data (assumption) in
analysis of investment projects is the discount rate (required rate). Till now it was not
discussed how to come up with that number. Now it’s time to do so. The topic – cost of
capital – brings together the topics of bonds, stocks, capital budgeting, and risk and return.
Understanding required returns is important to everyone because all proposed projects (in
marketing, management, operations or accounting) must offer returns in excess of their
required returns to be acceptable.
If we assume, for example, that required return (discount rate) for a project is 8%,
that means that if actual return will be higher, only then NPV > 0. That 8% is necessary just
to compensate investors for the use of their capital for the investment and for the risk of
their investment. Thus, the cost of capital for a risk-free investment is the risk-free rate.
However, if a project is risky, then (ceteris paribus), the required return is higher than the
risk-free rate, and that higher rate is used as a discount rate in calculation of NVP of the
project, and this higher rate is the „cost of capital” of the project. So the following terms will
be used equivalently here:

„required return” = „discount rate” = „cost of capital”

It is important to notice that cost of capital associated with an investment depends on the
risk of that investment. So it may be said that:

„The cost of capital depends primarily on the use of funds, not the source”

(In other words, it’s the use of the money, not the source that matters.)

The assets of the firm are financed by the mixture of debt and equity, measured by
debt-to-equity (D/E) ratio. A firm’s overall cost of capital reflects the required return on the
firm’s assets as a whole. This overall cost of capital is a mixture of the returns needed to
compensate its creditors and its stockholders, so the mixture of costs of debt capital and
equity capital. The weights in the mixture are proportions of debt and equity in their sum
(E+D)=V (the combined market value of equity and debt). This overall costs of capital is
called „weighted average cost of capital” (WAAC). Denoting required return on equity capital
by 𝑅𝐸 and required return on debt capital by 𝑅𝐸 , and assuming no income tax, it is:

𝐸 𝐷
𝑊𝐴𝐶𝐶 = × 𝑅𝐸 + × 𝑅𝐷
𝑉 𝑉
The WACC is the overall return the firm must earn on its assets.

The Cost of Equity

The cost of equity capital is the return that equity investors require on their
investment in the firm. The problem is that it is not possible to directly observe that return,
so it has to be somehow estimated. Two approaches to this estimation are presented:
- the dividend growth model, and
- the security market line (SML) approach.

19
The dividend growth model

It determines the current price of a stock. Value of common stock depends on

expected cash flows from future dividends, future price of stock when it will be sold and the
required return in the market on the investment in this stock.
Assuming:
P0 - current price of stock (to be found)
D1 - the cash dividend paid at the end of the period (a year)
P1 - the price in one year (not known)
R - required market return on this stock, it holds that:
D1 P
P0   1 , so
1 R 1 R
D  P2
D1  2
D1  P1 1  R  D1  D2  P2
(*) P0    
1 R 1 R 1  R (1  R) 2 (1  R) 2

D1 D2 D3 D4
P0     
1  R (1  R) 2 (1  R) 3 (1  R) 4
The price of the stock today is equal to the present value of all the future dividends.

→ Case of zero growth and constant dividend D1  D2  D3    D  const

D D D
P0       
1  R (1  R) 2
(1  R) n

This is the perpetuity, so:

D
P0  ; e.g. paying constant dividend ( $10 / year ) ”forever”,
R
$10
for R  ( 20 ) % gives P0   $ 50.
0,2
→ Case of constant growth of dividend:
D0 - dividend just paid, D1  D0 (1  g ) - dividend in a year

where g is the rate of growth, g  R - required return

We have the following cash flows:

D1 D1 (1  g ) D1 (1  g ) 2 

0 1 2 3  t

20
 D1
This is a growing perpetuity, and its PV 
Rg
D1 1 g
(**) so P0   D0  ;
Rg Rg

e.g.: If next year dividend D1  $10 , dividend will grow 10% / year , R  20% , so:
D1 $10 $10
P0     $100 .
R  g 20%  10% 0,1

From equations denoted by (*) and (**) we have that

D1  P1 D1
P0   and from this may be derived that P1  P0 (1  g ) and Pn  Pn1 (1  g )
1 R Rg
(In dividend growth model stock price grows with the same rate g as dividends grow)

→ The return on equity capital may be obtained from the dividend growth model, assuming
R  RE in equation (**)

D1 D1
P0  , so RE  g
RE  g P0

where D1 is expected dividend in one year, P0 is the current price per share of the stock,
g is the growth of dividend; 𝐷1 = 𝐷0 �× (1 + 𝑔)
D
RE  0 (1  g )  g
P0
D0 and P0 can be observed directly, and g should be estimated based on historical growth
rates. The model is simple, but there are problems with practical applications (some
companies don’t pay dividends, other pay but the growth is not constant etc.)
The estimated cost of equity R E is very sensitive to g . The model does not take
explicitly risk into account. Risk is included implicitly to the model: the higher the risk- the
lower the price P0 .

The SML approach in estimating the cost of equity capital R E

In SML the expected or required return on a risky investment (risky security) i, E ( Ri ) ,

depends on risk-free rate R f in the market, the expected market risk premium
( E ( RM )  R f ) , and the systematic risk of this investment relative to average risk,  , as
follows:

E ( Ri )  R f  [ E ( RM )  R f ]   i

21
Applying this we can write:

E ( R E )  R f  [ E ( RM )  R f ]   E

where E ( RE ) is expected return on the company's equity 𝐸�and  E is the estimated  for
the equity 𝐸.

To make this model consistent with the dividend growth model it will be written as:

R E  R f  ( RM  R f )   E

The SML approach has two advantages – it explicitly adjusts for risk and it is
applicable not only to companies with steady dividend growth. The drawbacks are – the
market risk premium requires estimation and the estimate may depend on period
considered and stocks selected;  estimation also may be different. Additionally these
estimates base on historical data and the past may not be a good guide to the future. Some
data may be found on web pages of financial institutions and agencies.

Example
Assume that stock of company A has a beta of 1.2, its market risk premium is 8%, and
risk-free rate is 6%. Last dividend was $2 per share and dividend is expected to grow at 8%
indefinitely. The stock currently sells for $30. What is company's cost of equity capital?

According to SML expected (required) return on the common stock of A is

R E  R f   E  ( RM  R f )
 6%  1,2  8%  15,6%

According to dividend growth model, the projected dividend next year is

D1  D0  (1  g )  $2  (1  0,08)  $2,16 ,

so expected (required) return is:

D1
RE  g
P0
$2,16
  8%  7,2%  8%  15,2%
$30
Finally these two estimates may be averaged and give expected (required) cost of A's equity
equal approximately 15,4%.

The Cost of Debt

The cost of debt of the firm is the return that the firm's creditors demand on new
borrowing, so it's simply the interest rate that the firm must pay on new borrowing, and this
can be observed on the financial markets. For example, if the firm already has bonds
22
outstanding, than the yield to maturity on those bonds is the market-required rate on the
firm's debt.
Alternatively, if we know that the firm's bonds were rated, for example AA, then we
could simply find out what the interest rate on newly issued AA-rated bonds was.
(Other approach would be by determining the  for the firm's debt and then use the SML to
estimate the required return on debt just as it was estimated the required return on equity.
There is no need to do it since this rate can be directly observed.)
Important remark – the coupon rate on the firm's outstanding debt is irrelevant here.
It tells what the firm’s cost of debt was back when the bonds were issued, not the cost of
debt is today. That's why it's necessary to look at the yield on the debt in today's
marketplace. The cost of debt is denoted by R D .

Example
Assume the X Company issued a 30-year, 7% bond eight years ago. The bond is
currently selling for 96% of its face value, that is for $960. What is the X's cost of debt?
Because bond is selling below its face value ($1,000), it is said that it is selling at a discount,
the yield must be greater than 7% (not much greater because the discount is small). Annual
coupons are 7% of $1000, so are of $70.
The yield to maturity (YTM), denoted here by r , can be found from formula for price of the
bond, for given coupon C , face value F , and number of periods to maturity n :
1
1
(1  r ) n F
P C 
r (1  r ) n
Assuming annual coupons, there are 22 years to maturity, so n = 22.

C  $70 , F  $100 , P  $960

By trial-and-error it can be found that the yield to maturity is about 7,37%, so the X’s cost of
debt R D = 7,37%.

The Cost of Preferred Stock

Preferred stock has fixed dividend, so it is equivalent to the case of common stock of
zero growth and constant dividend discussed earlier (infinite sequence of constant dividend),
so it is a perpetuity. The cost of preferred stock, R P , is thus:

𝐷
𝑅𝑝 = �
𝑃0

where D is the fixed dividend and 𝑃0 is the current price per share of preferred stock.
(The cost of preferred stock (required return on preferred stock) is the dividend yield on
preferred stock.) Alternatively, preferred stocks are rated (as bonds), so this cost can be
estimated by observing the required returns on other rated shares of preferred stock.

Example

23
 In 2002, Citigroup had several issues of preferred stock that traded on NYSE. One
issue paid $ 1,78 annually per share, so its R p = D / P0 = $1,78/$25,35 = 7,02% (share price
was traded as $25,35) The other issue paid $1,72 annually per share and sold for $24,90 per
share, so its R P =6,91%. So, Citigroup's cost of preferred stock was that time in the range of
(6,9% - 7,0%).

The Weighted Average Cost of Capital

As already stated on p.1, the following notation is used:

E - equity, it should be a market value, so (number of shares)  (price per share) = E ,
D – debt, market value (total of all issues of bonds (their number)  (prices of bonds) = D .
If there is a debt that is not publicly traded, than the yield on similar, publicly traded
debt should be observed and using this yield as the discount rate, the market value of such
not publicly traded debt (privately held debt) should be estimated. For short-term debt, the
book values (accounting values) may be used, because accounting values and market values
are rather similar. Finally V (standing for “value”) is used for the combined market value of
debt and equity:
V ED
Dividing both sides by V we get
𝐸 𝐷
1= +
𝑉 𝑉
or in percentage form
E D
100%  %  %
V V

These percentages can be interpreted just like portfolio weights, and they are often called
“capital structure weights”.

Example
Total market value of company's stock were calculated as $200 million, and total
market value of a company's debt were calculated as $50 million, so these are 80% equity
and 20% debt.
For the privately owned companies, the market values may not be possible to get, so
the accounting value can be used (that are better than nothing), but the result is only a
rough estimate.
The above cost of debt R D and consequently WACC were calculated assuming no
income tax. Now, assuming income tax rate for corporations is TC  0 , the pretax cost of
debt R D should be substituted by aftertax cost of debt R D (1  TC ) , and

WACC  ( E / V )  RE  ( D / V )  RD  (1  Tc )

The WACC is the overall return the firm must earn on its existing assets to maintain the value
of its stock.

24
 If a firm uses preferred stock in its capital structure, then if P is the value of
preferred stock, so V  E  P  D and R P is the cost of preferred stock, so

WACC  ( E / V )  RE  ( P / V )  RP  ( D / V )  RD  (1  TC )

The WACC is also the required return on any investments by the firm that have essentially
the same risks as existing operations (for example expansion of existing operations).

Example of WAAC calculation

The corporation has 1,4 million shares of stock outstanding. The stock currently sells
for $20 per share. The firm's debt is publicly traded and was recently quoted as 93% of the
face value of $5 million. It is currently priced to yield 11%. The risk-free rate is 8%, and the
market risk premium is 7%. It has been estimated that beta is 0.74. Corporation pays 34%
corporate tax. What is WACC of this corporation?

E = 1,4 million  $20 = $28 million, D = 0,93  $5 million = $4,65 million;

V = E + D = $32,65 million.

From SML the cost of equity

RE  R f    ( RM  R f )  8%  0,74  7%  13,18 %

The pretax RD  11% , so

E D 28 4,65
WACC   RE   RD  (1  TC )   13,18%   11%  (1  0,34)  12,34%
V V 32,65 32,65

Task1 Cost of Equity

Suppose stock of B. Corporation has a beta of 0,90. The market risk premium is 7%, and the
risk-free rate is 8%. B's last dividend was $1,80 per share, and the dividend is expected to
grow at 7% indefinitely. The stock currently sells for $25. What is B's cost of equity capital?
(Apply SML approach and dividend growth model approach)

Solution:

SML approach

Expected (required) return on B.’s common stock is:

𝑅𝐸 = 𝑅𝑓 + 𝛽𝐸 ∙ (𝑅𝑀 − 𝑅𝑓 )
𝑅𝐸 = 8% + 0,90 ∙ 7% = 14,3%

Dividend growth model approach

25
The projected dividend 𝐷1 = 𝐷0 ∙ (1 + 𝑔) = $1,80 ∙ 1,07 = $1,926
Expected (required) return on B.’s common stock is:
𝐷1 $1,926
𝑅𝐸 = +𝑔= + 7% = 7,704% + 7% = 14,704%
𝑃0 $25
These two estimates are fairly close, so averaging them gives B.’s cost of equity (required
return) 𝑅𝐸 = 𝟏𝟒, 𝟓%.

Task 2 WACC

In addition to B's cost of equity from Task 1, suppose B has a debt-equity ratio of 50%. Its
cost of debt is 8%, before taxes. If the tax rate is 34%, what is the WACC?

Solution:

𝐷 1 𝐷 1 𝐸 2
Since = , so = and = , where V = E + D.
𝐸 2 𝑉 3 𝑉 3

B.’s capital structure is 1/3 debt and 2/3 equity.

𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∙ 𝑅𝐸 + ∙ 𝑅𝐷 ∙ (1 − 𝑇𝐶 )
𝑉 𝑉
2 1
𝑊𝐴𝐶𝐶 = ∙ 14,5% + ∙ 8% ∙ (1 − 0,34) = 𝟏𝟏, 𝟒𝟐𝟕%
3 3
Task 3 WACC

The cost of debt for Company C. is 8% and because its cost of equity is twice as this, it
selected its capital structure to be 1/3 equity and 2/3 debt. If the tax rate is 30%, what is its
WACC?

Solution:
𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∙ 𝑅𝐸 + ∙ 𝑅𝐷 ∙ (1 − 𝑇𝐶 )
𝑉 𝑉
1 2
𝑊𝐴𝐶𝐶 = ∙ 16% + ∙ 8% = 𝟏𝟎, 𝟔𝟕%
3 3

Task 4 Cost of Equity, WACC

Suppose you know from the financial statements of the G. Corporation, that its debt-to
equity ratio is 1/3, that it pays a 20% income tax, and that company’s debt consists of bonds
that are traded publicly and yielding 5% return. You’ve got the inside information about the
WACC the company’s management applies in valuation of their expansion projects: it is 8%.
Could you estimate what the expected (required) return on G.’s equity capital is?

Solution:

Since D/E = 1/3, then V/E = (E+D)/E = 1 + D/E = 1 + 1/3 = 4/3, and then E/V = 3/4.
Consequently D/V = 1/4, because E + D = V.

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Substituting the values to general formula for WACC, we have:
3 1
8% = ∙ 𝑅𝐸 + ∙ 5% ∙ (1 − 0,2)
4 4
𝟏
And finally 𝑅𝐸 = 𝟗 𝟑 %.

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 Capital Structure

A primary reason for studying WACC is that the value of the firm is maximized when
the WACC is minimized. To see this, notice that the WACC is the discount rate for the
firm’s cash flows. Since values and discount rates move in opposite directions, minimizing
the WACC will maximize the value of the firm’s cash flows. WACC depends on capital
structure (measured by debt-equity ratio), so the problem of choosing optimal capital
structure (with the lowest possible WACC ) is discussed. Management may change capital
structure increasing or decreasing the amount of debt in financing the assets:
- by issuing bounds and using obtained cash to buy back some stock, the debt-equity ratio
will increase, or
- by issuing stock and using obtained money to pay off some debt, the debt-equity ratio will
decrease.
The above activities are called capital restructurings.
Application of debt in financing the assets is called application of financial leverage.
Application of financial leverage increases or decreases return on equity ( ROE ) and
earnings per share ( EPS ) depending on expected EBIT obtained (expected future business
situation: recession and small EBIT or expansion and big EBIT )
The impact (the effect) of financial leverage can be analyzed by comparing firm
without debt to the firm with debt (theirs ROE or EPS ).

Assume no Tax.
→ For firm without debt (index NoD) the Interest on debt, denoted by “Int” is of course
zero, so

NI EBIT  Int EBIT 1

E  A , so ROENoD      EBIT
E E A A
→ For firm with D  0 (index D)

NI EBIT  Int 1 Int

ROED     EBIT  ;
E E E E
E  A , so 1  1 , so slope of ROED > slope of ROE NoD
E A

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For EBIT  Interest, ROED  0 ROED
and ROENoD  0 . ROE
ROE NoD

EFL
EBITO is break-even point, for which:

ROED EBITO   ROENoD EBITO 

EBIT  EBITO
1 Int 1
EBITO   EBITO  E
E E A
EBIT  Int EBIT
E
EBITO  Int  EBITO EBITO
A
 Int
 E A
EBITO 1    Int  E
 A D
Int
EBITO  A   A  i D where i D is interest rate on D
D
For EBIT  EBITO ROED  ROENoD ,
so the EFL  ( ROED  ROENoD ) is positive.
We say that the effect of financial leverage (EFL) is positive. In this case the return on equity
is greater for the firm with debt than for the firm without debt.

EBIT  Int EBIT A  EBIT  A  Int E  EBIT D  EBIT  A  Int

EFL  ROED  ROENoD      
E A EA EA EA
D EBIT Int D  EBIT Int  D  EBIT 
         iD 
E A E E A D E  A 

It may be written also:

EBIT D  EBIT 
ROED  ROENoD  EFL     iD 
A E A 
EBIT
and denoting by OpROA  Operating ROA
A

we have: ROED  OpROA 

D
OpROA  iD  .
E

EBIT Interest
If EBIT is big enough that OpROA   iD  , than EFL is positive,
A Debt
increasing ROE of the firm with debt. However, there is a risk of not earning such EBIT ,
and in such situation the effect of financial leverage will be negative, decreasing ROE .
Shareholders can adjust the amount of financial leverage by borrowing and lending
on their own - this is called „homemade leverage”. If an investor wants to increase financial
leverage for him/her, they may borrow personally on fixed interest rate and buy extra shares
of stock. In such case the total capital invested in stock will consist of more debt than before
borrowing, so D / E increases.

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 In the opposite case it is possible to decrease the financial leverage existed in
company by selling part of shares and loaning out (lending) the money obtained from this
sales, earning the interest on the loan. (Only the ”personal” amount of financial leverage is
going to decrease of course, not the company’s; we assume that interest rate for borrowing
and lending is the same in both cases).
Assuming above simplifications and based on above reasoning the M&M Proposition
I was formulated by two Nobel laureates, Franco Modigliani and Merton Miller. It states
that:
„The value of the firm is independent of its capital structure”

M&M Proposition I: The Pie Model of the Firm’s Value

“The size of the pie doesn’t depend

on how it is sliced”

Imagine two identical firms in the sense that they have the same assets and the same
operations, only structure of capital financing assets is different. According to Proposition I
of M&M their value (so, their prices of stock) will be the same.
According to M&M Proposition I:
The value of the firm levered (VL ) is equal to the value of the firm unlevered (VU )
VL  VU
The implications of Proposition I:
- a firm’s capital structure is irrelevant,
- a firm’s WACC is the same, no matter what mixture of debt and equity is used to finance
the firm.

M&M Proposition II
E D
Ignoring income tax, we have WACC  RE  RD , V  E  D
V V
WACC was also interpreted as the required return on the firm’s overall assets, so the symbol
R A will now be used for WACC .
𝐸 𝐷
𝑅𝐴 = 𝑅𝐸 + 𝑅𝐷
𝑉 𝑉
The equation can be solved for 𝑅𝐸 :
𝑉 𝐷
𝑅𝐸 = 𝑅𝐴 − 𝑅𝐷
𝐸 𝐸

𝐷 𝐷
𝑅𝐸 = (1 + ) × 𝑅𝐴 − 𝑅𝐷
𝐸 𝐸
𝐷
𝑅𝐸 = 𝑅𝐴 + × (𝑅𝐴 − 𝑅𝐷 )
𝐸

30
This is the famous M&M Proposition II , that says that the cost of equity R E depends on
required return on firm’s assets, R A , the firm’s cost of debt R D , and the firm’s debt-equity
ratio, D . For D  0 , RE  RA . The figure below shows that, as D/E grows, the increase in
E
leverage increases the risk of equity and therefore increases the required return on equity R E
(cost of Equity). In the figure the WACC doesn’t depend on D / E ratio.
This is another way of stating M&M Proposition I:
- „The firm’s overall cost of capital (required return on assets) does not depend on capital
structure.”

The fact that the cost of debt is lower than the cost of equity is exactly offset by the increase
in the cost of equity (required return on equity) that comes when borrowing ( D / E )
increases. In other words: the change in capital structure weights ( E / V and D / V ) is
exactly offset by the change in required return on equity (cost of equity) R E , so the WACC
stays the same.

Business Risk and Financial Risk

𝐷
The M&M Proposition II is: 𝑅𝐸 = 𝑅𝐴 + 𝐸 × (𝑅𝐴 − 𝑅𝐷 )
The total systematic risk of the firm’s equity has two parts: business risk and financial risk.
Business risk is the equity risk that comes from the nature of the firm’s operating
activities (it depends on the systematic risk of firm’s assets) The greater the business risk,
the greater R A will be, and consequently (ceteris paribus) the RE will be.
Financial risk is the equity risk that arises from the use of debt. If there is no debt the
second component in R E is zero. As debt increases, required return on equity rises (as is
seen in the formula and in the figure) because debt increases the risks borne by
stockholders. The required return on equity (cost of equity) rises when the firm increases its
use of financial leverage because the financial risk of the equity increases while the business
risk remains the same.

Capital Structure and Corporate Tax

For corporations, interest paid on debt is tax deductible (is subtracted from revenue
(from EBIT ) before calculation of income tax), so it’s an advantage of firms compared to
persons. However, big debt may cause bankruptcy of a firm, and this aspect of debt
financing is a disadvantage of debt. How corporate income tax influences capital structure?
Consider two firms: Firm U (unlevered) and Firm L (levered) that are identical on the left-
hand side of the balance sheet, and having the same operations. Assume EBIT is $1,000
every year for both firms. Firm L assets are partially financed by perpetual bonds of the
issuing value of $1,000 on which Firm L pays 8% interest (in the form of coupons) each year,

31
 that is $80 every year. Let corporate tax is 30%. Let’s compare part of Income statement of
each firm, starting from EBIT :
Firm U Firm L Now consider financial Cash Flow of both
firms assuming (simplification) that
EBIT $1000 $1000
Depreciation = 0, Capital spending = 0,
- Interest 0 80 and  NWC = 0. Generally it holds that CF
EBT $1000 $920 from Assets = CF to creditors + CF to
stockholders. Also CF from Assets =
- Tax (30%) 300 276
Operating CF +Capital spending +  NWC
EAT (Net Income) $700 $644 spending, so here CF from Assets =
Operating CF, and Operating CF = EBIT + Depreciation – Tax = EBIT - Tax.
CF from Assets = CF to creditors + CF to stockholders (  )

CF from Assets = Operating CF + Capital Spending +  NWC spending,

=0 =0
so:
CF from Assets = Operating CF
Operating CF = EBIT + Depreciation – Tax, so:
=0

CF from Assets = EBIT – Tax

So: CF from Assets Firm U Firm L CF from Assets of both firms are not
EBIT $1000 $1000 the same, in spite of the fact that they
- Tax 300 276 have the same type of assets and
Total $700 $724 perform identical operations! We see
that capital structure has an impact on
cash flow the assets generate!

Since ( 
CF from Assets = CF to creditors + CF to stockholders, so it holds that for:
)
Firm U : $700 = $0 + $700
Firm L : $724 = $80 + $644
Total CF from Assets of firm L is bigger by $24, because it paid lower Tax bill by $24,
because it subtracted Interest before calculating Tax bill, so it didn’t pay Tax on $80 of
Interest, so it didn’t pay Interest × Tax rate = $80 × 30% = $24.
The amount saved, Interest × Tax rate = $24, is called interest tax shield.
Since the debt is perpetual, the same $24 shield will be generated every year, so each year
L ’s cash flow will be greater than U ’s cash flow by $24, so firm L is worth more than U by
the value of this $24 perpetuity (perpetuity of cash C = $24). The discount rate for this
perpetuity is the same as the cost of debt (8%), because the tax shield is generated by paying
interest on debt, so it has the same risk as debt (8%). So the present value of the tax shield
perpetuity is:

C  $24 30%  Interest 30%  ( Debt  Interest rate)

   PV     30%  Debt  30%  $1000  $300.
r 8% Interest rate Interest rate

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Denoting Debt by D , Tax rate for corporations by TC , and because Interest rate is
equivalent to risk of debt RD , we have:

TC  D  RD
PV of perpetual interest tax shield   TC  D
RD

So, value of firm L , V L , exceeds the value of firm U , VU , by the present value of interest
tax shield TC  D .This is another famous result, M&M Proposition I with taxes, that states
that:

VL  VU  TC  D

The value of the firm levered VL  is equal to the value of the firm unlevered VU  plus
the present value of the interest tax shield, where TC is the corporate income tax rate
and D is the amount of debt.

M&M Proposition I with taxes is shown below:

The slope of the V L line is TC , and the value of V L
VL
V L  VU  TC  D increases as the amount of debt D (independent
variable here) increases. So, the conclusion could be
TC  D
drawn that
firms should increase their financing with debt, and
VU optimal capital structure is 100% debt.
VU The above conclusion does not take into account the
impact of potential bankruptcy, so this issue should
D be considered now.

Bankruptcy

In principle (in ideal world) a firm becomes bankrupt when the value of its assets equals the
value of its debt. The value of equity becomes zero, and stockholders transfer the control
over the firm to bondholders. Ideally this transfer is costless.
In practice it is expensive to go bankrupt. This transfer is a legal process (bankruptcies are to
lawyers what blood is to sharks). These legal and administrative expenses are called direct
bankruptcy costs.
It is said, that firms having significant problems in meeting debt obligations, are experiencing
financial distress. The cost of avoiding bankruptcy are called indirect bankruptcy costs. Direct
and indirect bankruptcy costs are called financial distress costs. The interests of stockholders
and bondholders are opposite, and their fighting decreases the value of the firm. This
possibility of loss of value limits the amount of debt that a firm chooses to use.
At low debt levels, the probability of bankruptcy and financial distress is low, and the benefit
from interest tax shield is higher than the cost.
At very high debt levels the financial distress costs outweigh the benefits from interest tax
shield. From the above follows that there may exist an optimal capital structure, somewhere
in between these extremes.

33
Static Theory of Capital Structure

This theory states that a firm borrows up to the point when the tax benefit from an
extra dollar in debt is exactly equal to the cost that comes from the increased probability of
financial distress. This is called the static theory because it assumes that the firm’s assets are
not changed (their structure and value) and changes in operations are not considered, and
only changes in the debt-equity ratio are possible.

The static theory of capital structure is illustrated below:

Value of the firm Value of the firm with debt The gain from the tax
VL and no bankruptcy cost shield on debt is
Present value of V L  VU  TC  D offset by financial
tax shield distress costs.
Financial
VL distress
costs At optimal capital
VU Value of the firm structure the gain
with no debt
from financial
D is not an easy leverage is balanced
D D identifiable point. with the financial
Optimal amount of debt distress costs.

D  D 
The optimal capital structure is composed of 1    in equity.
in debt and
VL  VL 
When actual capital structures were examined it was found that:
- firms in the United States typically do not use great amounts of debt, in spite of the fact
that they pay substantial taxes (this suggests that there is a limit to the use of debt financing
to generate tax shields);
- there is a wide variation in the use of debt across industries, suggesting that the nature of
the firm’s assets and operations is an important determinant of its capital structure.
Task1 - Capital restructuring, EPS , ROE
The ” G ” Corporation decided to restructure its capital by increasing its current $5million in
debt to $25million. Interest rate on debt is 12% and will be the same after capital
restructuring. Now G has 1 million shares outstanding and price per share is $40.
Management expects to increase EPS and ROE , planning to increase EBIT . What is the
minimal EBIT that management expects to earn? Ignore taxes.

Task 2 - M&M Proposition II, no taxes

The Pro Bono Corporation has a WACC of 20%. Its cost of debt is 12%, and D / E =2.
What is its cost of equity? Ignore taxes.

Task 3 - M&M Proposition I with corporate tax

The TG Corporation has equity of value $20,000 and no debt. Corporate tax rate is 30%.
What will be the value of the firm if it borrows $6,000 and used this money to buy up its
stock?

34
Task 1 solution
The purpose is to apply financial leverage and have EBIT > EBIT-0 the break-even value at
which EPS before restructuring (EPS-1) is the same as EPS after restructuring (EPS-2).
Price of 1 share is $40, so with $20 million of new debt it is possible to buy back
($20,000,000 / $40) = 500,000 shares, so Shares-2 = 1,000,000 – 500,000 = 500,000 shares
At EBIT-0 it holds that: EPS-1 = EPS-2
(EBIT-0 – Interest-1) / Shares-1 = (EBIT-0 – Interest-2) / Shares-2
(EBIT-0 – 12% x $5million)/1million = (EBIT-0 – 12% x 25million)/0.5million
EBIT-0 – $0.6million = 2 x EBIT-0 - $6million
EBIT-0 = $5.4million
Another solution is based directly on the formula
EBIT-0 = Assets x Interest on Debt.
In both cases the Assets = $45million, so
EBIT-0 = $45million x 12% = $5.4million.

Task 2 solution
WACC = 20% = 𝑅𝐴 , 𝑅𝐷 = 12%, D/E = 2
𝑅𝐸 = 𝑅𝐴 + (𝑅𝐴 − 𝑅𝐷 ) × 𝐷/𝐸
= 20% + (20% - 12%) x 2 = 36%

Task 3 solution
After restructuring TG will be worth the original $20,000 (before financed with equity only,
and now by $14,000 equity and $6,000 debt) plus the present value of the tax shield.
According to M&M Proposition I with taxes, the present value of the tax shield is
𝑇𝐶 × 𝐷 = 30% x $6,000 = $1,800,
So the firm is worth original $20,000 + $1,800 = $21,800.
Equivalently: 𝑉𝐿 = 𝑉𝑈 + 𝑇𝐶 × 𝐷 = $20,000 + 30% x $6,000 = $21,000.

35