1.

1b The five basic corporate finance functions

VOCAB
Corporate finance is mainly concerned with the decisions of companies and their management
- Capital budgeting – what investments to make
- Capital structure – how to finance these investments
- Payout policy – what to payout to shareholders
Equity shares: long-term financing sources for any company. These shares are issued to the general
public and are non-redeemable in nature.
Equity is generally not freely tradable in the market as it directly affects the holding of the
business entity. At the same time, shares are easily tradable through the recognized stock
exchange.
Venture capitalists (风险投资人): Professional investors who specialise in making high-risk, high-return
investments in rapidly growing entrepreneurial businesses.
Initial public offering (IPO): Companies offering shares for sale to the public for the first time by selling
shares to outside investors and listing them for trade on a stock exchange.
Shareholders/stockholder/equity holder: owner of company’s shares, created when a company issues
shares via an IPO
- Shareholders are entitled to (discretionary) dividend (红利，股息；好处) payments

When companies are young and small:

- Raise equity capital privately, from friends and family
- From professional investors → Venture capitalists

After companies reach a certain size

- Go public → IPO
- Companies can raise funds by selling additional shares

Financial management
- Key responsibility: have enough funds on hand to support day to day operations
- Require technical, analytical, people skills

Week 1 Lecture

Market value maximisation concepts:

1. The time value of money and interest rates
2. Riskless arbitrage and the law of one price
- The idea that the same asset (for example, gold) trading in two different markets must trade at
the same price
3. The role of information and capital market efficiency

The time value of money and interest rates

The basic valuation principle states that if the value of benefits exceed the value of costs, then the
decision will increase the value of the firm
Time value of money: The difference between the value of money today and money in the future
- By depositing money in a bank account (that is, lending money to the bank) you can convert
money today into money in the future
- By borrowing money from a bank you can exchange money in the future for money today

Simple vs compound Interest

Simple interest is the value of a cash flow calculated without including any accrued (that is, earned)
interest to the amount you invest (that is, the principal)
- Future value using simple interest, FVn = PV0(1 + n x r)

Compounded interest
- Interest accrued (that is, earned) is added back to the principal and is reinvested
- The (future) value of a cash flow is calculated based on the principal and interest accrued
- This compounding of interest over time is referred to as interest on interest
- FVn = PV0(1 + r)n
- Interest on interest = FVn – PV0 – simple interest

Factors Future value (FVn) Present value (PVn)

Interest rate (r) increase increase decrease

Time period (n) increase increase decrease

Compounding frequency increase increase decrease

Four rules:
Rule 1: You can only compare or combine cash flows at the same point in time
Rule 2: To move cash flows forward in time you must compound them
Rule 3: To move cash flows back in time you must discount them
Rule 4: The interest rate used to compound or discount cash flows must match the periodicity of those
cash flows
 Week 2 Lecture

Future and present values of a series of cash flows

NPV = cash inflow – cash outflow

Unknown cash flow

PV(Benefits or cash inflows) = PV(Costs or cash outflows)
FV(Benefits or cash inflows) = FV(Costs or cash outflows)

Perpetuity: an equal, periodic cash flow that goes on forever and ever and ever
- 1st cashflow occurs at the end of period 1
- present value of a perpetuity, 𝑃𝑉0 = C/r

Deferred perpetuity: equal, periodic cash flow that starts at some future date and
then goes on forever
- the present value of a perpetuity deferred to the end of time n+1 is

Example 2: A prize guarantees you $10,000 per year forever with the first payment to be made at the end
of year 1. How much would you sell the prize for today if the interest rate is 10% p.a.? What would the
prize’s value be if it were deferred to the end of year 4? That is, the first cash flow occurs at the end of
year 4.
❖ Present value of the perpetuity, PV0 = 10000/0.10 = $100,000
❖ Present value of the deferred perpetuity…
❖ PV3 = 10000/0.10 = $100,000
❖ PV0 = 100000/(1.10)3 = $75,131.48
Ordinary annuity: a series of equal, periodic cash flows occurring at the end of each period and lasting
for n periods
- The first cash flow occurs at the end of period 1 and the last cash flow occurs at the end of
period n
- The present value of an ordinary annuity equals the difference between an ordinary
perpetuity (starting at the end of period 1) and a deferred perpetuity (starting at the end of n+1)

- The future value of an ordinary annuity can be obtained by compounding the present value
above to the end of time period n using (1 + r)n

Example: Your friend, who now owes $58,126 on her credit card, has decided to start paying off the debt
on a monthly basis, starting next month. If she can only afford to repay $400 every month how much
would she still owe on her credit card by the end of one year, that is, 12 months from now?

1. The future value of the current balance in 12 months is…

𝐹𝑉12 = 58126 (1 + 0.015)12 = $69,497

2. The future value of the $400 repaid every month in 12 months is…
𝐹𝑉12 =(−400/0.015) (1 + 0.015)12 − 1 = −$5,216

3. The net amount still owed at the end of the 12-month period is…
Amount still owed = 69497 – 5216 = $64,281

Annuities Due: series of equal, periodic cash flows occurring at the beginning of each period
- beginning of period n = the end of period n – 1.
- The present value & future value of an annuity due at r% p.a. is equivalent to the present value &
future value of an ordinary annuity compounded one additional period

Growing perpetuities
- Present value of growing perpetuity:
- r > g, g can be negative
- Growing deferred perpetuity = compound interest: Cn+1 = C1(1 + g)n
Growing annuity
- cash flows grow at a constant rate
- The present value of a growing ordinary annuity over n time = growing ordinary perpetuity – a
growing deferred perpetuity
- Present value of Growing ordinary annuity:
- Future value of Growing ordinary annuity = compound by (1+r)n

Example: A prize guarantees you $10,000 per year forever, growing at 5% p.a., with the first payment to
be made at the end of year 1. How much would you sell the prize for today if the interest rate is 10% p.a.?
What would the prize’s value be if this growing cash flow were deferred until the end of year 4? What
does the difference between the present values of these two cash flows represent?

Present value of the first prize…

❖ PV0 = 10000/(0.10 – 0.05) = $200,000
Present value of the second prize…
❖ We first get the cash flow deferred until the end of year 4 as…
❖ C4 = C1(1 + g)3 = 10000(1 + 0.05)3 = $11,576.25
❖ The present value of this deferred growing perpetuity is…
❖ PV3 = 11576.25/(0.10 – 0.05) = $231,525 (Note: End of year 3, not 0!)
❖ PV0 = 231525/(1.10)3= $173,948.16
❖ Difference in present values = 200000 – 173948.16 = $26,051.84

Week 3 Lecture – Debt Markets and Securities

Bank loan: The typical bank loan involves borrowing a sum of money with the promise to make
regular payments to pay off the loan over a pre-determined time horizon. The interest rate payable can be
fixed or variable.
- Focus: fixed rate loans

Amortization – Ordinary annuity

- In an amortizing loan, the periodic amount the borrower pays includes the interest on the
outstanding loan balance and a part of the amount borrowed

The loan amortization schedule shows the interest paid, principal repaid and principal remaining over
the loan’s duration, as follows…
- Interest paid = Previous period’s principal x Interest rate
- Principal repaid = Loan payment – Interest paid
- Principal balance remaining = Previous period’s principal – Principal repaid

Example: Loan payment C = $6,309.42

- In year 1, we have…
- Interest paid = 20000 x 0.10 = $2,000.00
- Principal repaid = 6309.42 – 2000.00 = $4,309.42
 - Principal balance remaining = 20000.00 – 4309.42 = $15,690.58 (i)
- Iteratively, in year 2, we have…
- Interest paid = 15690.58 x 0.10 = $1,569.06 (ii)
- Principal repaid = 6309.42 – 1596.06 = $4,740.36 (iii)
- Principal balance remaining = 15690.58 – 4740.36 = $10,950.22

Loan amount outstanding n years after:

1. Entire time horizon – n = remaining term of the loan
2. Entire time horizon’s FVn becomes remaining time’s PV0
3. Solve PV0 using ordinary annuity formula

The Effective Annual Interest Rate

- When interest is compounded more often than once a year, we need to calculate the effective
annual interest rate in order to make a like-for-like comparison
- Re is the annualised rate that takes account of compounding within the year.
re = (1 + r/m)m – 1
- r is the annual percentage rate (APR) or the stated interest rate
- m is the compounding frequency: 1 for annual, 2 for semi-annual, 12 for monthly, and so on
- r/m is the per period interest rate taking into account the compounding frequency

Properties of re
- r = re only when the compounding frequency is one year (m = 1), otherwise re will always exceed
r
- re increases as the compounding frequency increases

Continuous compounding: compounding frequency becoming larger with m approaching infinity

- As m becomes larger, in the limit (1 + r/m) m approaches er
- The effective annual rate with continuous compounding: re = er – 1

Matching Cash Flows With Interest Rates

Rule 4 from week 1: The interest rate used to compound or discount cash flows must match the cash
flows
- Annual cash flows; interest compounded annually, use 12%
- Quarterly cash flows; interest compounded quarterly, use 12/4 = 3%
- Monthly cash flows; interest compounded monthly, use 12/12 = 1%
 - Annual cash flows; interest compounded semi annually requires calculating the effective annual
interest rate as: re = (1 + 0.12/2)2 – 1 = 12.36%
- Annual cash flows; interest compounded quarterly requires calculating the effective annual
interest rate as: re = (1 + 0.12/4)4 – 1 = 12.551%
- Annual cash flows; interest compounded monthly requires calculating the effective annual
interest rate as: re = (1 + 0.12/12)12 – 1 = 12.6825%

- Semi annual cash flows; interest compounded monthly requires calculating the effective semi
annual interest rate as…
- Monthly rate = 0.12/12 = 1%
- Effective semi-annual rate = (1 + 0.01)6 – 1 = 6.152%

Example:
Semi annual cash flows; interest compounded monthly requires calculating the effective semi annual
interest rate as…
❖ Monthly rate = 0.12/12 = 1%
❖ Effective semi-annual rate = (1 + 0.01)6 – 1 = 6.152%

Cash flows every two years; interest compounded quarterly requires first calculating the effective
annual interest rate and then the effective two-year interest rate as…
❖ Effective annual rate = (1 + 0.12/4)4 – 1 = 12.551%
❖ Effective two-year rate = (1 + 0.12551)2 – 1 = 26.677%

PV of annually compounding > PV of monthly compounding

The Valuation Principle: The price of a security today is the present value of all future expected cash
flows discounted at the “appropriate” required rate of return (or discount rate)
- P0 = PV(Future expected cash flows)

Short term debt securities

- They mature within the year – typically in 90 and 180 days
- The issuer has contractual obligation to make the promised payment (Fn) at maturity
- Examples: Treasury Bills, Bank Bills, etc
Long term debt securities
- Matures after several years
- Investors bear a much higher interest rate and reinvestment risk with longer maturity bonds
than with shorter maturity ones.
- They may or may not promise a regular interest (or coupon) payment
- The issuer has a contractual obligation to make all promised payments
- Examples: Semi-government securities issued by states and territories

Characteristic of debt securities

- Face (or par) value is the dollar amount paid at maturity Fn
- Assumed face value = 100
- Coupon (or interest) rate is the interest rate promised by the issuer, expressed as a
percentage of the face value
- Coupon rate = Coupon payment/Face value
 - Coupon (or interest) payment (C) the periodic (annual or semi-annual) payment made to
bondholders
- Coupon payment, C = Coupon rate x Face value
- Current yield is the coupon (or interest) promised by the issuer divided by the current price of the
bond
- Current yield = Coupon payment/Price

The yield to maturity(rD) is the rate of return earned by an investor who buys and holds the security
until it matures assuming no default occurs on the security
- Given: P0 = $700, Fn = $1,000 and n = 3 years
- The bond’s yield to maturity (rD) can be calculated using: P0 = Fn /(1+rD)n
- If including coupons (1 year) P0 = (Fn + Cn) /(1+rD)1
- The interest rate factor for securities maturing in less than a year is…
- Interest rate factor = (Time to maturity/365) x rD = (n/365) x rD
- Price of discount security: P0 = Fn/[1 + (n/365) x rD]

Bonds: 是筹集资金的社会经济主体向投资者出具的，承诺按约定条件支付利息、 偿还本金的一种债权债务凭

证。

Price of coupon paying bond: C = Fn x coupon rate

- As rD decrease, P0 increases
- As n decreases, P0 increases (interest rate has a larger effect for longer maturity bonds)
- Interest rate increase, rD increase

When Price = Face value; the bond is selling at par

- YTM = Coupon rate
When Price > Face value; the bond is selling at a premium
- YTM < Coupon rate
When Price < Face value; the bond is selling at a discount
- YTM > Coupon rate

HPL Ltd has recently issued bonds paying a fixed annual coupon of 8% p.a. and maturing in 10
years’ time. The yield to maturity on these bonds is 10% p.a. If market interest rates rise
unexpectedly, what is most likely to happen to the price of the bonds?
YTM > Coupon rate → trading at discount
When market interest rates rise unexpectedly the price of the bonds will fall. So, following the rise in
interest rates the bonds would continue trading at a discount

If interest rates on all maturities rise by one percent what will happen to the price of these bonds?
The price of the shorter maturity bond will fall by a lower percentage than the fall in price of the longer
maturity bond. The intuitive reason is that investors bear a much higher interest rate and reinvestment
risk with longer maturity bonds than with shorter maturity ones.
 Week 4 Lecture – Equity Markets and Securities

Equity: represents an ownership claim on a company

- Ordinary shares (common stock): represent ownership in the issuing company’s cash flows
(earnings and dividends)
- Ordinary shareholders have a residual claim to a return on (equity) capital
- Unlike debt securities which are contractual obligations to pay interest and repay the
amount borrowed, ordinary shares have no such obligations associated with them
- preference shares (preferred stock): shares which give their holders preference over ordinary
shareholders when it comes to the payment of dividends (and repayment of capital in case of
liquidation)
- Dividends are fixed over the life of the preference shares

Characteristics of Equity Markets

- Private (Pty Ltd) or public (Ltd)
- Primary markets: where funds are raised by the company and a market is created
- for its shares to trade
- Once listed, shares are trade (bought and sold) among market participants on
- secondary markets
- Makes buying and selling shares much easier
- A venue that provides current market valuations of company shares
- Reporting obligations on company management (more regulation)
- Market value (or market cap) = Share price × Number of shares outstanding
- Value of trading = Share price × Number of shares traded

Characteristics and Pricing of Ordinary Shares

- Ordinary shares typically provide investors with an infinite stream of uncertain earnings and
dividends
- Relevant cash flows: dividends
- Only cash can be saved, spent or reinvested not earnings
- Dividends are cash flows so it makes sense to value a firm based on the cash flows
- received by shareholders
- Note that earnings and dividends are linked because typically dividends are paid out
- of earnings

Pricing Ordinary Shares

- Over any one year, the share price is equal to the sum of the expected dividend and price
next year discounted at the appropriate required return on equity (rE)

- Return on equity (rE) = Expected dividend yield + Expected percent price change

- Unequal cash flows

Note that the current dividend (D0) is not relevant to our estimate of the current price as the estimated
price is assumed to be the ex-dividend price

General dividend discount model

- 𝐴𝑠 𝑛 → ∞, 𝑃𝑉(𝑃n) → 0

Constant dividend growth model

- Analysts typically assume that dividends grow at a constant growth rate (g) forever
- Growing perpetuity: rE > g

- the expected percent change in price equals the growth in dividends, g

Under price = actual < estimated

Over price = actual > estimated

The Variable Dividend Growth Model

- The variable growth assumptions can be simple or complex…
- High growth initially, followed by normal growth forever
- High growth, followed by lower growth, followed by normal growth forever
- No growth, followed by low growth, followed by high growth, followed by normal growth
forever
- Initial high, but declining growth, followed by normal growth forever, and so on

Characteristics of Preference Shares

- Cumulative preference shares give the holder the right to receive any missed (or reduced)
dividend payments first. Non-cumulative preference shares don’t have the right to claim missed
or reduced dividends
- Participating preference shares give the holder the right to the preference share dividend and to
participate in the firm’s profitability by receiving additional dividends based on prespecified
conditions
- Convertible preference shares give the holder a right to convert their shares to a fixed
- number of ordinary shares at some future date
- Price = present value of a perpetuity of dividends
Preference Shares VS Ordinary Shares

Earnings, Dividends and Prices

- The P/E ratio (or P/E multiple) of ordinary shares is the ratio of the current market price to
expected (or current) earnings per share
- Expected (or forward) P/E ratio: P0/E1
- Current (or trailing) P/E ratio: P0/E0
- The expected P/E ratio is defined as the amount investors are willing to pay now for $1.00 of
future expected earnings
- A P/E ratio of 10 means that investors are willing to pay a price of $10 for $1.00 of future
expected earnings

- The expected P/E ratio rises as…

- The payout ratio (alpha) rises
- The growth rate of dividends (g) rises
- The required return on equity (rE) falls
 Week 5 Lecture – PortTheory I

Ordinary shares: rates of return =

Bonds:

p =price not probability

Arithmetic average return measures the return earned from a single, one period investment
over a specific time horizon

Geometric average return measure the return earned per period from an investment over an
investor’s entire time horizon (compounding)

- only the geometric average can be used to link the starting and ending values of an
investment

The observed (or actual) risk of a security (or portfolio) is measured by the variability in its
actual returns around the (arithmetic) average return
The Probability Distribution Approach

Expected return: expected outcome measured as the weighted average of the individual
outcomes

Expected return for treasury bill = yield to maturity rD

2 securities:
- wj = Amount invested in security j / Total amount invested
- w1 + w2 = 1

The variance or standard deviation of returns is the measure of dispersion around the
expected return
- Greater the dispersion, higher the uncertainty and risk
- Investors are typically concerned with returns below the expected return (that is,
downside risk)

2 securities:

When minimum variance portfolio (0 risk → sd=0, correlation = -1)

σp2 = w12σ12 + w22σ22 + 2w1w2σ1σ2ρ12
σp2 = w12σ12 + w22σ22 + 2w1w2σ1σ2(-1)
σp2 = w12σ12 + w22σ22 – 2w1w2σ1σ2
σp2 = (w1σ1 – w2σ2)2
σp(sd) = w1σ1 – w2σ2

Portfolios and Risk Diversification

A risk averse investor’s objective is to...
- Minimise the risk of portfolio of investments, given a desired level of expected return
- Maximise the expected return of portfolio of investments, given a desired level of risk

- 1 combination of w1 and w2 will make portfolio completely risk free (0 return

correlation=-1 → var=0)

The simplest (and naïve) way to minimise risk is to diversify across different securities by
forming a portfolio of securities
- Portfolio risk falls as the number of securities in the portfolio increases
- But portfolio risk cannot be eliminated completely using this method
 - The risk that cannot be eliminated is called systematic risk

Covariance of returns

- rAn = Return on security A (n terms) rBn = Return on security B (n terms)

- σ12 > 0 Above (below) average returns on security 1 tend to coincide with above
- (below) average returns on security 2
- σ12 < 0 Above (below) average returns on security 1 tend to coincide with below
- (above) average returns on security 2
- σ12 = 0 Security 1’s return tends to move independently of security 2’s return
- Can be written as

Correlation of returns

- Lower the correlation; higher the diversification benefits

- Smaller correlation, smaller portfolio sd
- Positive correlation (0<ρ12<1): returns of the two companies tend to move in the
same direction → low diversification benefit
- Negative correlation (ρ12 close to 1): high diversification benefit → spread the risk
across different assets and reduce the overall volatility of your portfolio.

Short selling: borrowing (typically via a broker) shares, selling them now with a contractual
obligation to buy them back later at (an expected) lower price
- Sell then buy back (sell at high price buy at low price)
- Note that being long a security means you have purchased it and being short a
security means you have sold it
- Short selling is like risky borrowing to leverage a portfolio
- This leveraging increases portfolio risk
- Borrowing and short selling a security A and investing proceeds in security B implies wA
< 0% and wB > 100% such that wA + wB = 1

Portfolio leveraging: borrowing funds at a risk free rate of return and investing these funds in a
risky security.
 Week 6 Lecture – PortTheory II

In large portfolios, return covariances determine portfolio risk

- As a portfolio becomes large in size its total risk (standard deviation) falls, but at a
declining rate

Efficient frontier

Plots all efficient portfolios: X Z Y W

The CAPM (capital asset pricing model) can be written as…
- The CAPM is a theoretical model that can be used to “price” individual securities
- Pricing: estimating its required rate of return, and then obtaining a price estimate
based on the security’s future expected cash flows
- Market portfolio only consists of systematic risk, whereas security has both
systematic (beta) and unsystematic risks.
- The amount of risk (systematic risk) is measured by the covariance of the security
with the market portfolio (the beta of the security, Betaj)
- Higher the market price of risk and/or higher the amount of risk, greater the risk
premium
- The security market line (SML) equation
- E(rj) = equilibrium required return
- E(rm) is the expected return on market portfolio
- The market price of risk (market risk premium) is measured as E(rm) – rf
- Total risk premium = Amount of risk(beta) x Market price of risk
- Beta = systematic risk ≠ sd

- Beta = 1: Security (portfolio) has the same systematic risk as the market portfolio
- Beta = 0: Security (portfolio) has zero risk – risk free asset
- Beta < 1: Security (portfolio) has lower risk than the market portfolio
- Beta > 1: Security (portfolio) has higher risk than the market portfolio

Is CAPM a good model? – assumptions

- Investors are risk averse individuals – reasonable
- Investors have homogeneous (same) expectations about the volatilities, correlation,
and expected returns of securities – insane
- The returns on these securities are jointly normally distributed – not true
 - Investors only hold efficient portfolios of securities that are all traded in financial
markets

Underprice:
- Current expected return > CAPM E(r)
- Return will be expected to fall to
equilibrium price CAPM E(r), price
rises
Overprice:
- Current expected return < CAPM E(r)
- Return will be expected to rise to
equilibrium price CAPM E(r), price
fell

Portfolio evaluation
- The Sharpe ratio, S = [E(rp ) – rf ]/σp
- The portfolio with the highest Sharpe ratio has the best performance
- Main limitation: The ratio uses total risk as a measure of risk when only
systematic risk is priced in the market
- The Treynor ratio, T = [E(rp ) – rf ]/βp
- The portfolio with the highest Treynor ratio has the best performance
- A simple extension of the Sharpe ratio and addresses the Sharpe ratio’s main
limitation by substituting beta (or systematic) risk for total risk
- Jensen’s alpha, A = rp – [rf + (E(rm) – rf)βp]
- rp = the portfolio’s observed return
- Note: By definition, Jensen’s alpha for the market is 0
- Example: If portfolio 1’s alpha is 2% and portfolio 2’s alpha is 5%, then portfolio 2
has outperformed portfolio 1 by 3% and the market by 5%
 Week 8 Lecture – Capital Budgeting I

The main methods used by managers to evaluate projects are…

- Net present value
- Internal rate of return

The Net Present Value Method

- I0 = Initial investment
- Ct = Net after-tax cash flow at the end of year t
- r = Project’s required rate of return (or discount rate)
- N = Economic life of the project in years
- Accept project if NPV > 0, reject if NPV < 0
- Point of indifference when NPV = 0

The Net Present Value Profile

Eg. ASL Enterprises has 10 million shares outstanding with a current market price of $10
per share

Total firm value before investment = 10 × 10 = $100 million

Case 1
- Total firm value = 100 + 5.163 = $105.163 million
- Share price = (100 + 5.163)/10 = $10.52 > $10.00
Case 2
- Total firm value = 100 – 1.986 = $98.014 million
- Share price = (100 – 1.986)/10 = $9.80 < $10.00
Conclusions
- Negative NPV → share price drops
- Positive NPV → share price rise
Internal Rate of Return (IRR)
- the rate of return that is earned by the project over its economic life
- Accept project if IRR > r, reject if IRR < r
- Point of indifference when IRR = r
- The IRR does not change with the scale of the project
- When NPV is 0: x -int of NPV profile

Problems with the IRR Method

IRR contradicts NPV

The IRR is 23.4% and is greater than the required rate of return of 10% → accept the book deal
However, the book deal’s net present value is negative → not accept the book deal

IRR doesn’t exist when NPV never cross x axis

NPV is positive → accept NPV is negative → not accept

Multiple IRRs
R between 7.2% and 28.6% R between 7.2% and 28.6%
NPV positive → accept NPV negative → not accept

Independent projects are projects where the decision to accept one project does not affect
the decision to accept or reject other projects
- Invest in all positive NPV projects

Mutually exclusive projects are projects where the acceptance of one project rules out the
acceptance of other (competing) project
- Assume all are positive NPV → Invest in the highest NPV project
Incremental project (A-B B-A) – mutually exclusive

The IRR of the incremental project can be calculated using…

NPVB-A = 0 = –90000/(1 + IRRB-A) + 10000/(1 + IRRB-A)2 +105000/(1 + IRRB-A)3
IRRB-A = 13.7% > 10.0%

Problems with the Incremental IRR

- The incremental IRR may not exist
- Multiple incremental IRRs can exist
- The fact that the IRR exceeds the required rate of return for both projects does not
necessarily imply that either project has a positive NPV
- The individual projects may have different required rates of return
- Not clear which required rate of return should be used to compare with the incremental
IRR
Payback period: the time it takes for the initial cash outlay on a project to be recovered from
the net (after-tax) cash flows
- n + (I0 - Cn) / Cn+1
- Between years n and n+1, cumulative cash flows will reach the initial investment.
- Cn = cumulative cashflow at the end of year n
- Cn+1 = net cash flow per year
- Accept if : payback period is less than a prespecified maximum payback period
- Mutually exclusive projects: shortest payback period is preferred

Problems with Payback Period

- The payback period method fails to take account of the cash flows that occur after the
payback period cutoff date
- It is biased against projects that have longer development periods eg. Mining and
exploration projects
- It ignores the time value of money

Accounting rate of return (ARR): the average earnings generated by the project, after
deducting depreciation and taxes, expressed as a percentage of the investment outlay

- Average Earning = total earning / time

- Accept of: ARR exceeds a prespecified minimum rate of return
- Mutually exclusive projects: highest ARR is preferred

Problems with the Accounting Rate of Return

- Earnings are not net cash flows
- Earnings numbers are subject to the vagaries of the accounting choices made by
managers
- Time value of money is ignored
- A dollar of earnings tomorrow is regarded as equivalent to a dollar of earnings
today
- ARR tends to be biased towards projects with shorter lives
- Earnings received in earlier years would increase the numerator and hence the
ARR
 Week 9 Lecture – Capital Budgeting II

Incremental cash flows

- Only cash flows that change if the project is accepted are relevant in evaluating a project
- Excludes sunk costs
- Considers opportunity cost and tax implications

Fixed overhead costs

- Overhead costs are typically allocated by management to firm’s divisions. For example,
administrative costs incurred by the head office and allocated to divisions
- If the costs do not vary with the decision to take the project they should be ignored

Net working capital (NWC)

- NWC = Current assets – Current liabilities
- NWC = Cash + Inventory + Account receivables – Account payables
- The change in net working capital is defined as ΔNWC = NWCt – NWCt-1
- An increase in net working capital is a cash outflow and is an incremental cost
- associated with the project
- A decrease in net working capital is a cash inflow associated with the project

Taxes have three main effects on net cash flows

- Corporate income taxes
- cash outflow
- After-tax cash flow = Before-tax cash flow × (1 – tc)
- tc = The effective corporate tax rate
- Depreciation tax shield
- Depreciation itself is not an operating expense and is excluded from the net
cash flows
- However, depreciation affects net cash flows as it decreases the taxes payable
due to the depreciation tax shield
- Depreciation tax savings (or shield) = tc × Depreciation expense
- Taxes on disposal of assets

Salvage (or scrap) value of assets SVt

- taken into account after taxes
- Book value = Acquisition cost – Accumulated depreciation
- SVt = before tax sale price – tax payable/saving
- Taxes are payable when an asset is sold for more than its book value
- There is a tax saving when an asset is sold for less than its book value as the loss
can be offset against the firm’s taxable income
- Capital Gain (or loss) = Salvage/disposal value – Book value
- Taxes payable of gain = tc × Gain on sale → company pay, Ct – tax payable
- Tax saving on loss = tc × Loss on sale → company claim this tax credit, Ct + credit
Net Cashflows
- The periodic cash flows are the incremental net after-tax cash flows (or free cash
flows)
- Ct = Rt – OCt – (Rt – OCt – Dt)tc
- Rt: Operating revenues in time t
- OCt: Operating costs in time t
- Rt – OCt: operating cashflows
- (Rt – OCt – Dt)tc: Taxes paid in time t
- tc = tax rate %
- (Rt – OCt – Dt )(1 – t c ) = earnings after tax EAT
- Rt – OCt – Dt = earnings before interest tax EBIT
- Depreciation per year Dt = Initial investment/ time
- Depreciation tax shield: tcDt
- + SVt at the end
- The typical non-periodic cash flows are…
- – The initial and future investment / capital expenditure, I0 and It
- Changes in net working capital, ΔNWC0
- + if ΔNWC<0 – if ΔNWC>0
- + After-tax salvage (or scrap) value, SVt

Fisher relationship

- r = Nominal rate of return (or nominal interest rate) per annum

- rr = Real rate of return (or real interest rate) per annum
- i = Expected inflation rate per annum
- For nominal cash flows use the nominal discount rate
- For real cash flows use the real discount rate
- Cn (nomial) = Cn(real) x (1 + tc)n x (1 - tc)

Projects With Different Lives

- Constant chain of replacement assumption: We assume that both projects can be
invested in with identical projects until they achieve a common duration (or life)
- The lowest common multiple method
- A 2-year versus a 3-year project: invest in the 2-year project 3 times and in the
3- year project 2 times (common life = 6 years)
- A 2-year versus a 4-year project: invest in the 2-year project 2 times and in the
4-year project one time (common life = 4 years)
- The perpetuity method
- assumes that both projects are invested in forever
The Weighted Average Cost of Capital (WACC)
- benchmark required rate of return (or hurdle rate) used by a firm to evaluate its
investment opportunities
- Before tax

- rD = Cost of debt (bonds) – yield to maturity

- rE = Cost of equity (ordinary shares) – required rate of return
- rP = Cost of preference shares – required rate of return = Divide nt rate x Fn) / p
- D = Market value of debt
- E = Market value of equity (ordinary shares)
- P = Market value of preference shares
- V = Market/asset value of the firm (= D + E + P)
- Weights = D/V E/V…

- After tax
- rE > rP > rD > rD (1 – tc)

The weighted average cost of capital is the discount rate that is used to evaluate projects of
similar risk to the firm

The WACC cannot be used in the following situations…

- If the project alters the operational (or business) risk of the firm
- If the project alters the financial risk of the firm by dramatically altering its capital
structure
 Week 10 Lecture – Capital Structure and Payout Policy I

Business (or operational) risk

- The variability of future net cash flows attributed to the nature of the firm’s operations
- It is the risk faced by shareholders if the firm were financed only by equity
Financial risk
- The risk attributed to the use of debt as a source of financing a firm’s operations
- Surveys of managers indicate that they spend a lot of time quantifying and managing
financial risk

Financial leverage
- Issuing debt (borrowing money from bank) → financial risk exists
- With no debt the company only faces business risk. With debt, the company now faces
financial risk in addition to business risk
- This financial risk results in increased variability in the EPS and ROE
- Leverage amplifies the financial risk for equity holders because debt must be serviced
before any earnings are available to equity holders.
- The higher shareholder profitability comes at the cost of increased risk that shareholders
face when the company takes on leverage
- In perfect capital markets with no corporate taxes, leverage increase the risk
variability of a firm’s earnings and its systematic risk
- Financial leverage is measured as the debt-to-equity ratio (D/E) or the debt-to-total
assets or debt-to-value ratio [D/(D + E)] ratios
- Effects
- Expected rate of return on equity increases
- The variability of returns to shareholders also increases (financial risk
increases)
- Borrow at lower cost of capital (debt) and generate higher returns on equity.
- Higher leverage → higher returns
- Reality
- Cost of debt increases with leverage → raise more equity to service debt →
return on equity falls (as net profit decreases and amount of equity increases.)
- Increasing leverage involves a trade-off between risk and return
- Risk averse investors will demand a higher expected return for a higher level of
risk
Calculations
- Net income = EBIT – interest on debt (rate x total debt)
- Earnings per share = Net income / shares outstanding
- Return on equity = EPS/price per share = Net income / total equity value
- Return of assets = EBIT / total asset value ( total shares + total equity)

- Annual interest expense = Debt issued x Interest rate on debt per year
- Annual Interest tax shield = Annual interest expense x Tax rate
- Tax shield is perpetual: PV of tax shield = Annual Interest tax shield / tax shield risk
- Tax savings on debt = Amount of debt × Interest rate on debt × Tax rate

Modigliani and Miller assumptions

- Capital markets are perfect
- There are no corporate or personal taxes, transaction costs or issuance costs
- We also assume perpetual cash flows (earnings) to simplify the analysis

The overall effects of borrowing funds and taking on financial leverage are…
- Adding financial risk on top of business risk via increased variability in both earnings
per share and return on equity
- Magnifying the effects on shareholder profitability (EPS and ROE) in good and bad
economic circumstances
- The higher shareholder profitability comes at the cost of increased risk that shareholders
face when the company takes on leverage!

Capital structure theory

In perfect capital markets, with no corporate taxes → capital structure decisions are
irrelevant to firm value
- WACC stays the same → not affected by leverage ratio/capital structure
- Higher leverage ratio (more debt – borrow more money from bank) → high cost of debt
(kd) and equity (ke)
- High proportion of debt and low proportion of equity → decreases WACC
- high cost of debt (kd) and equity (ke) → offset decrease in WACC
- Change in capital structure does not affect a firm's value and share price.

In perfect capital markets, with corporate taxes we concluded that capital structure decisions
are completely relevant to firm value
- Wants to pay as much debt
- Maximise Interest tax shield: increase in interest expense → decrease in taxable income
 Week 10 Lecture – Capital Structure and Payout Policy II

Summary of Payout Policies

Regular dividend: Dividends paid out to the shareholders every period (usually quarter,
half-year or full year)
Special dividend: A one-time dividend payment made by a firm, which is usually much larger
than its regular dividend
Share split and bonus shares: A dividend paid in ordinary shares rather than as cash to
shareholders
Share repurchase (or share buyback): A return of cash to shareholders via either an
on-market or off-market repurchase of shares
Liquidating dividend (not covered): A return of capital to shareholders from a business
operation that is being terminated

Features of Dividends
- Dividend declaration (or announcement) date
- Ex-dividend date
- Typically, 1 – 2 business days before the record date so there is enough time for
company records to be updated
- If you purchase the shares before this date, you receive the announced dividend
- On, or after, this date you do not receive the announced dividend
- Shares trade without the dividend (“ex dividend”) from this date onwards
- Shares trade with the dividend (“cum dividend”) before this date
- Record date
- The date on which shareholders of record receive the announced dividend
- Payment date
- Date dividend is paid electronically (or mailed)

Payout ratio = dividend per share / earnings per share

Dividend Payout Policies
Pure residual dividend policy
- Pay out any earnings that the firm does not need to reinvest
- Dividends and dividend payout ratios tend to be unstable
- Total dividend = Net income – Capital expenditure (if positive)
- External financing required when NI < CE
Smoothed (or fixed) dividend policy
- Target a proportion of earnings to be paid out as dividends
- Objective here is for the dividends to equal the (long run) difference between expected
earnings and expected capital expenditures – Stable dividends over time
Constant payout dividend policy
- Pay a constant proportion of earnings as dividends
- Stable dividend payout ratio but unstable dividend amounts
Low regular dividend and special (or extra) dividend policy
- Paying a low regular dividend, supplemented by special (or extra) cash dividends as
warranted by earnings

Calculations
- Dividend per share = Total dividend value / total shares outstanding
- Net income = Taxable earnings – corporate tax (rate x taxable earnings)
- External financing required when NI after div < CE
- = Capital expenditure – Net income after dividend

The Classical Tax system

- 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 = Taxable earnings x Shareholder rate of earnings x (1 – tc) x (1 –
tP) x Payout ratio
= 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 × (1 − 𝑡𝑐) × (1 − 𝑡𝑝) x payout ratio
= Dividend received x (1 – tP)
- Earnings = Shareholder rate of earnings x Taxable earnings
= EPS x no of shares owned
Shareholder rate of earnings = no of shares shareholders own / no of shares
- 𝑡𝑐 = corporate tax rate 𝑡𝑝 = personal tax rate
- The net effect of a classical tax system is that earnings are double-taxed: corporate
level → personal level

Imputation/franking Tax System

- 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 = Taxable earnings x Shareholder rate of earnings x (1 – tP) x
payout ratio
= 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 × (1 − 𝑡𝑝) x payout ratio
= Dividends received – Personal tax liability + Franking credit
= grossed up dividend – Personal tax liability
- Net income = dividend paid = taxable earnings x (1 – tc) x payout ratio
- Dividends received = dividend paid x shareholder rate of return
 - Personal tax liability = (DivGrossed-up) × tp
- Franking / imputation credit = Earnings × tc = difference between div
grossed up and actual div paid
- The net effect of an imputation tax system is that earnings paid out as dividends are
taxed only once at the shareholder’s marginal tax rate
- Shareholders receive higher dividends compared to classical tax system

Bonus Shares
- Payments made to existing shareholders where the dividend takes the form of new
shares issued
- Example: A company has 10 million shares outstanding trading at $10 per share, If it
pays a 20% share dividend
- The number of shares outstanding increases by 20%: 10 × 1.20 = 12 million
- The price per share changes by a factor of 1/1.20 = 0.833 (Not a 20% fall!)
- Price after share dividend = 10.00 × 0.833 = $8.33
- The market value of shares does not change…
- Before payment: 10 × 10.00 = $100 million
- After payment: 12 × 8.33 = $100 million
Share Split
- Share splits affect a company’s shares in a similar way to share dividends. When a
company conducts a share split, its share price declines because the number of
outstanding shares increases
- A 5-for-1 share split means that for every 1 share owned you receive 5 shares
after the split
- The number of shares outstanding increases: no of shares × 5 = 50 million
- The price per share decreases = price x ⅕
- n 5-for-1 share split → no of shares x 5n price / 5n
- The market value of shares does not change
- When their share price is high, it appears expensive for retail investors,
companies use this to decrease share price, making them more affordable and
potentially increasing liquidity.
- Reverse share splits: the number of shares outstanding decreases, and the share
price rises as a result of a consolidation of shares
- a 1-for-100 reverse share split
- The number of shares outstanding decreases: no. of shares/100
- price per share increases = price × 100
- The market value of shares does not change
- When their share price is low, Companies use this to increase shareprice,
enhance their brand image and maintain exchange listing
Why are companies using share split?
- Affordability
- Liquidity: increase no of shares → increase demand for stock
- Signaling: signal shareholders that they will grow rapidly
- In the long run it creates wealth
- Example: 2-for-1 split 6 times
- Adjusted share price = original price per share / 26 = 0.2656
- Unadjusted (no spilt) share price = last share price x 26 = 4,795
- Total return = (last share price – price per share)/price per share
- Adjusted = = (74.93 – 0.2656)/0.2656 = approx. 28,100%!
- Unadjusted = (4795 – 17.00)/17.00 = approx. 28,100%

Share repurchase
- Share repurchases / share buybacks have become a significant mechanism for
returning cash to shareholders
- Advantage of share buybacks is that they increase the company’s earnings per share
as the number of shares on issue declines
- Share repurchase vs dividends
- Repurchases can be discretionary → do not place strong constraints on firm
- Firms think their stock price is low, so repurchases at a higher price
- Firms have extra cash and no other source of investment, so they choose to
repurchase.
- Increase Earnings per share (EPS) and return on equity (ROE)

Modigliani and Miller proposition

- Capital markets are perfect
- The firm can issue and sell new shares as and when needed
- There are no personal taxes
- The firm is all-equity financed (capital structure decisions are ignored)
- The firm has a given investment plan which is not affected by changes in its dividends
(capital investment decisions are ignored)

Does Payout Policy Affect Firm Value?

- Pay dividends with excess cash
- Firms value today V0 = Cash on hand + [PV(Expected cash flows)=expected
cashflow/cost of capital
- PCum-Div (include dividend)= D0 + PV(Future dividends)
- 𝑃𝐸𝑥−𝐷𝑖𝑣 (dividend paid out)= 𝑃𝑉(Future dividends) = dividend per share / ROE
- Ex-dividend price = Current share price - Dividend per share
- shareholders will be indifferent because their pre and post-dividend wealth
remains unchanged
- Repurchase shares and pay no dividend
- No of shares repurchased = cash / price per share
 - No of shares outstanding = original no of shares – no shares repurchased
- Value of shares = original value – allocated repurchase value
- no of shares x price per share
- Dividend per share increases = expected cash flow / no of shares outstanding
- P0 (share price) = Dividend per share / cost of equity
- In perfect capital markets, an open market share repurchase has no effect on
the share price, and the share price is the same as the cum-dividend price if a
dividend were paid instead
- What if investors have different preferences?
- Firm pay dividend, investor wants shares: use dividend paid to
purchase additional shares
- Firm repurchases, investor wants dividend: raise cash by selling
shares
- Pay a higher dividend and issue new equity
- The firm wants to pay $48m dividend instead of 20m, need an additional $28
million to pay the larger dividend. To do this, the firm decides to raise the cash
by selling new shares.
- Example: Given a current share price of $42.00, the firm could raise $28 million
by selling 666,667 shares
- 28000000/42.00 = 666,667 shares
- Total number of shares outstanding after the share issue = 10,666,667
shares
- new dividend per share = 48000000/10,666,667 = $4.50
- PCum-Div = 4.50 + 4.50/0.12 = $42.00
- Share price does not change, only dividend per share changes
- There is a trade-off between current and future dividends…
- A higher dividend now implies lower dividends in the future
- A lower dividend now implies higher dividends in the future

Market imperfection – The differential tax treatment: can result in shareholders preferring
other payout alternatives over dividend payments, or vice versa
- Classical tax system
- Optimal dividend policy: pay no dividends
- Shareholders who pay high taxes will tend to prefer low (or no)
dividend-paying firms
- Shareholders who do not pay taxes (or pay low taxes) will prefer high
dividend-paying firms
- Imputation Tax System
- Optimal dividend policy: pay dividends
- If all of the firm’s shares were held by resident shareholders with marginal tax
rates less than the corporate tax rate → optimal dividend policy: pay as
much dividends as would exhaust all the available franking credits
The non-tax related explanations of why dividend policy may matter relate to various factors,
including
- Cash retention to cover potential future cash shortfalls
- Cash retention to help fund future growth opportunities
- Firms change dividends infrequently and dividends tend to be much less volatile than
earnings
- Firms raise their dividends only when they perceive a long-term sustainable increase
in the expected level of future earnings, and cut dividends only as a last resort.
- When a firm increases its dividend, it typically sends a positive signal to
investors that management expects to be able to afford the higher dividend for
the foreseeable future
- When a firm decreases its dividend, it may signal that management has given up
hope that earnings will rebound in the near term and so need to reduce the
dividend to save cash