Transcript Slide 1

Final Lecture
C. L. Mattoli
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Forward
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In the course we have discussed many aspects
of finance, focusing on financial management of
corporations.
Finance is very different from economics and
accounting.
The differences are embodied in the use of cash
flows versus earnings, time values of cash flows,
and the inclusion of risk.
Like economics, finance, these days, also looks
at psychological factor of human transactions
This lecture reviews the course materials.
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What is Finance
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What is Finance?
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The modern definition of finance is the
allocation of financial resources over
time under conditions of risk
At the macro level, finance encompasses
the study of the operations of financial
institutions and markets within the
economy in the allocation of funds
(money) to various uses.
At the micro level, finance essentially
involves the processes of investment
decision making and funding (financing)
of investments, by firms, financial
institutions and individuals.
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The 4 Basic Branches of Finance
Traditional finance is broken into 4
basic topics:
1. Corporate Finance, which is the
main topic of this course.
2. Investments
3. The study of financial institutions.
4. International finance.
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Corporate and Business Finance
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Corporate (or business) finance studies
all of the financial ideas, operations, jobs
and decisions that go into running a
business.
Moreover, business finance includes topics
from the other major areas because they
cover topics that are relevant to business
finance.
On the other hand, the ideas contained in
this topic apply also to the others.
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Business Finance
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Starting a business cannot be done,
thoughtlessly.
Many people believe that starting a business is
the key to getting rich, but they rarely
understand what it takes to start and run a
business, successfully.
The first step in starting a business is
investment. You decide what your business
will be, e.g., selling eggs or making candles.
You will have to find a place to run the
business.
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Business Finance
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You might have to invest in equipment or just
display counters.
You will have to have extra money to pay
expense, while you are in the start up phase.
(Capital Budgeting)
You will need money for all of this initial
investment. Where will you get it? Thus, the
second step is financing your business.
Will you risk your own money? Will you borrow
money? Or will you find others to invest in your
business as partners or part owners. (Capital
Structure)
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Business Finance
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Then, once you start the business, you will
have to manage your day-to-day financial
affairs, like collecting money from customers
and paying suppliers, employees, and your
landlord.
This third step of business finance will be
important for keeping you in business.
(Working Capital Management)
These are the 3 basic topics that we will
study in business finance.
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Accounting for decisions
Working
Capital
Current Assets
Cash
A/R
Inventory
Current Liabilities
Accrued Expenses
A/P
SR Debt
Long term debt
Equity
Long term assets
Capital Budgeting
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Capital Structure
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How businesses are organized
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2.
3.
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Businesses can be set up in several
different forms:
Sole proprietor
Partnership
Corporation
Trust
We shall concentrate on the first three, in this
course.
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Financing business operations
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Sources of financing are direct or indirect
In direct finance the supplier of funds (called
surplus units) and the user of funds (called
deficit units) deal with one another, directly.
This happens when a company issues stock
or debt securities directly to investors. It
could be a private placement to a small group
(even as small as 1) investors or a public
offering to the general public.
In Intermediated finance, a financial
intermediary collect funds from suppliers and,
then, dole them out to fund users. Banks, for
example, take deposits and then make loans
from the pooled deposits.
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Debt and Equity Defined
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Debt is a contractual arrangement to
borrow money that will be repaid in the
future.
Equity represents an ownership interest,
so there is no expectation that it will be
‘repaid’ in the future. Equity holders can get
their money back by selling their ownership
interest. For corporations, that ownership
interest is represented by shares of stock.
In accounting terms, A – L = E, Assets less
liabilities = Book equity.
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What you Get
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Debt holders receive interest payments
from the borrower (and eventually, at maturity,
the principal amount of the loan)
Interest payments provide a tax deduction
for the borrower.
Interest income is taxable income for the
holders of bonds and other debt.
Equity holders may receive dividends,
periodically, or not. They own shares of stock.
Dividends are not tax deductible, but give
the shareholder imputation credits if they
are franked
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Features of companies
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The thing that distinguishes
corporations, either private or public, is
that they issue ownership certificates
called shares of stock.
In a private company, shares are held by
a small number of people and cannot be
readily sold.
The term public company means that the
stock is held by the general public and can
be sold to anyone else.
Stock shareholders (the owners of
companies) have limited liability. They
can only lose their investment in the stock.
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How the Corporation is Run
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The stockholder owners usually elect
directors of the corporation. These are their
direct agents. The election is by vote
according to the number of shares each
owner holds.
Then, directors hire managers, who become
secondary agents of the stockholders and
who are paid to manage the company for the
owners’ benefit.
People, in general, are self-interested. There
is potential for conflict of interest in all
agency relationships. This is known as the
agency problem.
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Ownership Transfer
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One of the downsides of buying any type of
investment is that you might lose some or
all of your money.
Sole proprietorships, some partnership
shares, and large business investment
projects, like investment in PP&E, might be
difficult to divest.
Moreover, sole traders have no source of
equity capital but their own money, and
partnerships might have difficulty finding new
partners to contribute equity.
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Ownership Transfer
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If you can easily resell (transfer ownership of)
an investment, you will feel better about making
the investment, in the first place.
Ease of transfer is one of the greatest benefits
of the corporate organizational form of
business.
As a result of ease of transfer, corporations will
have an easier time raising capital.
As we will discover, shortly, it will be even easier
to raise more equity capital, if the corporation is
a public company. It will also help them raise
debt.
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Financial markets
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The financial markets are not a
specific place.
Financial markets include all of the
means of making financial contracts,
which is what securities and other types
of financial instruments are.
The other important function is providing
a means of buying and selling of those
contracts, initially or in an after-market.
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Corporate market value
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The value of a publicly-traded corporation is
the market capitalisation of the company
Market capitalisation is the total value of a
corporation as measured by the price of each
issued share multiplied by the number of issued
shares. For example, if XYZ Corp. has 1 million
shares, which are priced at $50/share, in the
stock market, the total market capitalization is
$50/share x 1 million shares = $50 million.
Market value of a debt or any security is
calculated as the value of each security times
the number outstanding.
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Financial Statement Analysis
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Intro
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To begin financial analysis, we need financial
information.
One of the most common forms of financial
information is the financial statements of
companies or other businesses.
Remember, again, that finance is not
accounting, so we will need to use financial
information in the proper manner.
In particular, you should understand the
difference between income and cash flow
and accounting value versus market value
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Abstract Basic Balance Sheet
Net WC = CA - CL
Current Assets
Cash
A/R
Inventory
Current Liabilities
Accrued Expenses
A/P
SR Debt
Non-current
liabilities, including
Long term debt
Long term assets
Tang. fixed assets
Intangibles
E=A-L
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Equity
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Market value vs. book (acctg) value
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The true value of something is what you
could sell it for (in, e.g., a market): market
value.
The numbers shown in a BS are the book
values of the firms assets and liabilities.
Book value may not be representative of
market value, which is what we want.
In addition, many of the firms true assets
are not even listed on the BS. These are
things, like band name, management and
employee skill, and reputation.
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Textbook Table 2.2
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Non-cash Items
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A major reason that accounting income
differs from actual cash flows is that
accounting income statements include
non-cash items.
Depreciation is one of the most common.
Financial managers is critically interested
in the actual timing of cash flows (time
value), in order to come up with proper
values of things.
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Corporate Taxes
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The current corporate tax rate is a flatrate of 30% on all income.
In a flat-rate tax, there is only one tax rate,
a percentage of income that is owed as
taxes.
Thus, if income before tax is $1 mil., then,
taxes =30%x$1 mil.=$300,000, and net
income AT=$700,000=$1 mil.-$300,000 =
$1 mil. x(1– tax rate)=$1 mil.x70%=
$700,000.
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Personal Marginal Tax Rates
Taxable income $ Marginal tax rate
%
0 – 6 000
nil
6 001 – 25,000
15
25,001 – 75,000
30
75,001 – 150,000
40
over 150,000
45
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Dividend taxation in Australia
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In the so-called classical taxation system,
corporate profits are taxed; some of the ATI is
paid out to shareholders, who are taxed again
on their dividend income.
Thus, in a classical system, corporate profits
are double taxed.
In the imputation system, the company tells
the shareholder how much tax it paid on the
income that made the dividend.
The shareholder, then, adds that tax imputation
franking credit to his cash dividend income.
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Effect of a $700 dividend fully franked at 30% tax rate
Percentage
150/700 =
-21.4%
0/700 =
0%
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100/700 =
+14.3%
150/700 =
+ 21.4%
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The flow of cash
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What we care about, in finance, is the actual
cash that flows into and out of a business
venture and when.
The accounting statement of cash flows of a
company is helpful, but it is not the exact
information that we need, in finance.
Since the BS is broken up into liabilities and
equity equals assets, cash flows will, similarly,
go from assets to pay creditors and owners.
CF from assets = CF to creditors + CF to
owners.
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Table 2.5 from text book: CF identity
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Ratio Analysis – fundamental analysis
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In module one, we first mentioned the
usefulness of ratios, when we looked at
income on investment, in a ratio with initial
investment, rate return on investment.
The percentages, in common-size balance
sheets are ratios: item/total assets or
item/revenues.
We use many different ratios as a means of
analyzing financial data to put things on an
equal footing. See below.
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Ratio classification
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1.
2.
3.
4.
5.
6.
7.
We will cover ratios that can be put into the
following general classifications:
Growth rates
Rates of return
Profitability ratios
Efficiency ratios - Turnovers
ST solvency - liquidity ratios
LT solvency
Market value ratios
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Textbook Table 3.5
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Valuation
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Time Value of Money
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A dollar, now, is worth more than a dollar,
later. Thus, money has a time value.
If you have money, now, you invest it and earn
more money (future value).
If you get money, later, you lost the opportunity
to invest (opportunity cost).
In investment, we invest money, now, to get
cash flows, in the future, whether we invest in
equipment or we buy the securities of
companies.
Therefore, finance asks the question: what is
money, received later, worth to us, right now
(present value).
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Future Value: Simple Interest
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In finance, we talk about (percentage) rates of
return, and usually, annual percentage rates
(APR) of return.
Interest on savings in a bank is an example of a
rate of return.
In that regard, if I put $100 in a bank account
that earns a 10%/year interest rate of return,
then, I will earn 10% of that $100, in a year, or
10%$100 = $10.
Therefore, at the end of a year, I will have $110,
in bank = $100, original principal, plus $10,
interest earned.
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Future Value: Simple Interest
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We can put this into a simple equation form as
FV1 = P + rP = P(1 + r), where r is the annual
rate of return = interest rate, in this case.
We have used the notation, FV1, to indicate that
this is the value of your savings account, in the
future, and we call it the future value.
If you earn interest on that principal for n years,
where n can be > 1 or n < 1, then, the simple
interest equation becomes FVn = P + nrP =
P(1 +nr).
In n years, you will have P(1+nr) dollars in
future value.
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Future Value: Compounded
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More common than simple interest is
compound interest.
If I put $100 (P) in bank for a year, at the end
of a year, I will have $110 [FV = P(1+nr)], in
the bank.
If I leave that money, in the bank, I will earn
interest on the whole thing
At the end of 2 years, I will have FV2 =
$110(1+10%) = $121 =
$100(1+10%)*(1+10%) = $100(1+10%)2 =
P(1+r)2.
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Future Value: Compounded
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What has happened is that we have
earned interest on the interest that we
earned in the previous year.
This is referred to as compounding, and
you earn compound interest on your
principal.
For any number of years, n, the future
value equation with compounding of
interest is given by FVn = P(1+r)n.
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FV for multiple CF’s
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We can make a general formula for cash
flows, CFm, invested in year m, and held in
the account til year n as:
The symbol, , is used to denote the sum of
the objects to its right, indexed by m, over the
specified range of m, in this case, m = 0, 1,2,
…,n.
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PV of any future payment
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Assuming that interest is compounded, the PV
of an amount of money, FVn, that will be
received n years into the future, is PV =
FVn/(1+r)n.
We usually refer to r as the discount rate or
the required rate of return (RRR), and the PV
is discounted future cash flow.
It just tells us what a future cash flow is
worth to us, today, given that we could
invest (opportunity) it, if we had it now, and
earn r rate of return compounded to that
future time.
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PV of MCF’s
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Since we can find PV for any future CF, and
PV is right now, time = n = 0, then, if we have
PV’s for a bunch of future CF’s, the PV of the
sum of the CF’s is the sum of all of the PV’s
of those CF’s.
The general formula for a stream of CF’s,
CFi, discounted at rate, k, is given by
n
n
CFi
i
PV  
  CFi (1 k)
i
i 0 (1 k)
i 0
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Annual Effective Rate
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When interest is compounded more than
once a year the earning rate is larger than
with annual compounding. Assume that k =
APR and m = # of periods in a year.
If we take PV and add compound interest for
one year (m periods), we will have FV =
PV(1+k/m)m at the end of a year.
We can find the effective rate of return
over the year from our basic equation for
return: reff ann rate of return = [PV(1+k/m)m –
PV]/PV = (1+k/m)m – 1 = reff.
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The real point: one time
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We usually talk about PV, the value
right now, or some FV.
The real point is that, in finance, we
realize that money has a time value.
Because of that, if we are to value
things and we want to compare their
values, then, they all have to be valued
at the same.
We could value them, now, t=0 or 3 years
from now.
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Securities, Markets
& Valuation
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Intrinsic Value
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The value of anything is its DFCF value.
The value of future cash flows must be
brought back to the present by discounting
at some opportunity cost RRR.
It is called the intrinsic value.
 It is the price that we should pay, if
we want to earn the RRR that we use
to discount the cash flows.
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Bond definitions
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Years to maturity will decrease as time
moves on.
All bonds have a Face Value (par value)
(FV), the amount paid at the end, usually
multiples of $1,000.
Most bonds will also pay interest in the
form of coupon interest payments,
usually paid semi-annually.
The coupon rate, %C is stated on the
bond.
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Zero-coupon bonds
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We should pay PV for the bond, based on
our own RRR = k. Thus, PV = FV/(1 + k)n
where FV is the face value of the bond and n
is the number of years to maturity (assuming
that you want to). earn a compound annual
return on investment =k
In that regard, if I invest PV, now, and I get
FV, in n years, I will earn an annual
compound rate of return on investment of k: k
= [FV/PV]1/n -1.
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Coupon Bonds
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Coupon bonds have regular coupon interest
payments, so they will pay multiple CF’s
over their lives, but they are only slightly
more complicated to value.
Our general equation for CF valuation is:
n
n
CFi
i
PV  

 CFi (1 k)
i
i 0 (1 k)
i 0
A coupon bond has coupon interest
payments, C, every year through maturity,
plus a final payment of FV at the maturity
time.
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Coupon Bonds
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In fact, sometimes, securities dealers, clip off the
strip of coupon payments, and sell the strip and
the ZCB face value portion, separately.
In that manner they create what is called a strip
and a ZCB from a coupon bond.
In any event we can value a coupon bond as:
M
PVBond
C
Coupons
=annuity
payments
FV
 [
]
t
M
(1  k )
t 1 (1  k )
Face value
=homemade
ZCB
= C[1 – (1+k)– M]/k + FV/(1+k)M
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Bond Yields: Investors’ RRR’s
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You can find bond yields in the market place,
these are market RRR’s.
Government bonds, representing a zerodefault rate, provide a floor on interest rates
on bonds.
There will be a risk-structure of rates, based
on a scale, like S&P’s, with riskier bonds
demanding a higher RRR than the less risky.
There are several other factors that go into
interest rates.
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The Fisher Effect
A person gives up current
consumption to save money.
 To lend his money he will want not to
lose his purchasing power.
 Thus, inflation should be a
component of all interest rates.
 The Fisher Effect says nominal rate
= real rate + inflation: R ≈ r + h
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Term Structure
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There will also be a component to rates that
depends on the term to maturity. This is
known as the term structure of rates.
Usually, the term structure is an upward
sloping line, a higher and higher rate as the
term to maturity increases.
The longer that you wait to get paid, the more
chance there is for something bad to happen,
including a change in inflation or interest
rates.
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Rates Summed Up
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All rate will include a real rate and inflation, as
components. However, expected inflation is
more important.
Usually, because interest rate increases with
increasing term to maturity, there is a larger and
larger risk premium as term gets larger.
On top of that structure is a default risk
structure, and premiums may also vary with the
term.
Final considerations in interest rates are
taxability (interest on some bonds or bonds
might be totally or partial tax free, e.g.) and
liquidity of the market for the bond.
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Equity
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Equity will, in general, be more difficult
to value than debt, using DFCF methods.
Equity has a potentially infinite life and it
has no promised cash flows.
Finally, there is no easy measure for
RRR’s, like in the bond markets.
For valuation using DFCF, we usually
focus on dividends, and the constant
dividend model is a compact equation
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Cash Flows
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If we buy a stock at P0, get D1 during the year
and sell the stock at the end for P1, the value
is P0 = (D1 + P1)/(1+k)
Other future price will come from a similar
equation: P1 = (D2+P2)/(1+k); Pn = (Dn+1 +
Pn+1)/(1+k).
That leads to further equations: P0 = D1/(1+k)
+ D2/(1+k)2 + … + P n/(1+k)n and, an infinite
dividend discount model:

Dt
P0  
t
t 1 (1  k )
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Special Cases
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A special case that results in a compact
reduced equation is constant dividend
growth.
Constant dividend growth model (CDGM),
the Gordon Model, dividends grow by g %
per year, so Dn+1 = Dn(1+g).
Then the value equation becomes P0 = D1/(k
– g).
Dividend growth is actually sometimes a
corporate goal.
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RRR for Equities
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Take the CDGM and turn it inside out to get k
= D1/P0 + g.
That says that the RRR for a stock is
composed of the dividend yield = D1/P0 plus
the dividend growth rate.
In general, rate of return = (income + cap.
gain)/Init. Invest. = inc/II + %ΔP.
Implicit CDGM is that share price will grow
at the growth rate, g.
Then, the first equation is k = dividend yield
+ cap gain yield.
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Preference (Preferred) Shares
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Preference shares (pfd) pay a fixed
dividend, which must be paid before
dividends can be paid on the common
shares.
In liquidation, the preferred shareholders
must be paid before the common
shareholders.
Voting rights for preferred shares will be
limited to votes involving the shares or there
might be no voting rights (see example in
table 7.2 in the text).
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Preference (Preferred) Shares
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For example, a 10% $100 par value pfd
would have an annual dividend of
10%x$100 = $10/year.
Dividends might be cumulative or noncumulative.
Cumulative, then, if payment cannot be
made in any one year, it will cumulate to
the next year. Non-cumulative, if it can’t
be paid, tough luck.
(C) C.L. Mattoli, 2008
62
Preference (Preferred) Shares




Limited life: it is redeemable preferred. There
might even be a sinking fund for retiring the
issue.
A non-redeemable preferred is valued as a
perpetuity; redeemable preferred would be
valued like a coupon bond.
That is why many people say that preferred
capital is like debt capital. It has fixed
payments and can have a liquidating final
payment.
The real difference is for legal and tax
purposes. Dividends non-payment does not
lead to default, and pfd dividends are treated as
dividend for tax purposes.
(C) C.L. Mattoli, 2008
63
Common Ordinary Shares




Common equity has the residual right to
assets and income.
Common shareholders have 1 vote per
share.
All companies hold an annual vote for
directors. In Australia, there is straight voting
whereby all directors are elected at one time.
Another possibility is staggered voting
wherein part, say 1/3 of the board, is elected
each year.
(C) C.L. Mattoli, 2008
64
Securities Markets.



Markets serve 2 important functions.
Primary markets are for issuing securities.
Secondary markets support the primary
markets by providing a means to sell
securities, rather than hold them til term or
for forever.
Markets are especially important for equity,
as there is really no alternative, except to
walk the streets to find investors. At least, for
debt, there are also banks and other financial
institutions as alternatives.
(C) C.L. Mattoli, 2008
65
Brokers and Dealers



A broker just gets paid commissions to
execute buy and sell orders.
Dealers maintain inventory of securities
and maintain a bid, the price they will buy
at, and an ask (offer), the price they will
sell at: they make money on the bid-ask
spread.
Markets comprised of dealer networks
are called OTC (over the counter) markets.
(C) C.L. Mattoli, 2008
66
The ASX




As opposed to OTC, the ASX is an exchange
market with 1 best bid and offer for each share,
as opposed to multiple bids and asks in a dealer
network.
Members of the exchange are the only ones to
execute orders for trading on the exchange.
Orders are executed by the Stock Exchange
Automated Trading System (SEATS), so there
is no trading floor, like the NYSE.
Shares of about 1700 companies are listed for
trading on the ASX.
(C) C.L. Mattoli, 2008
67
Capital Budgeting
(C) C.L. Mattoli, 2008
68
Intro



In the beginning of the course, we looked at
the 3 main decisions that financial managers
of a company need to make.
Capital budgeting (or allocation) is,
probably, the most important of the 3 since it
will determine the very character of the
business.
Also, since the capital budgeting decisions
result in what the business invests its money
in, we also call it the investment decision of
the firm.
(C) C.L. Mattoli, 2008
69
Value




We have learned that the proper way to value
things is using DFCF methods.
In the present context, then, we should value
potential projects for the firm by discounting
the expected cash flows of the project.
Projects will also have initial investment,
startup costs.
Thus, our method of valuing a project will be
to value it on DFCF, then, compare that
value to how much it will cost to do a project.
(C) C.L. Mattoli, 2008
70
Value


This is the essence of the Net present
value (NPV) method of valuing business
projects.
The NPV of a project is the difference
between the DFCF value and the initial
investment outlay (IO = II) , i.e.,
n
NPVi  
t 1
CFt
1  k a 
(C) C.L. Mattoli, 2008
t
 IO
71
Business investment value




As we said, previously, business
investment is: the output is worth more
than the input.
In the case of a business investment, there
is a long time frame for the investment
(project).
Thus, we expect multiple future cash flows,
and we must account for the time value
The future cash flows are estimates.
(C) C.L. Mattoli, 2008
72
Business investment value



Moreover, they are more complicated cash
flows, involving estimates of future costs of
inputs, like labor and materials, as well as
estimated sales prices and volumes, in
future years.
The original investment outlay will involve
purchase of PP&E as well as estimates of
other startup requirements for WC.
The final ingredient is a proper choice of the
RRR that will give investors enough of a
return.
(C) C.L. Mattoli, 2008
73
A first example




Assume Craig wants to add dress making to
his businesses.
He buys a sewing machine for $1,000, and
he assumes that it will last for 5 years.
Craig estimates his inflows (dress sales) and
outflows (costs) over the five years.
At the end of the 5 year project, Craig
believes that he can resell the used sewing
machine for $100 as scrap (or as a used
sewing machine).
(C) C.L. Mattoli, 2008
74
The cash flows

Assuming that the proper RRR for Craig is
15%, then, we have the situation displayed in
the table, below.
Time
line
IIO
Inflows
Outflows
Net inflow
Salvage
Net CF
Discounted
PV inflows
0
1
2
3
4
5
500
200
300
500
200
300
500
200
300
500
200
300
300
261
300 300 300
227 197 172
NPV = 55 >0
500
200
300
100
400
199
-1000
-1000
1055
(C) C.L. Mattoli, 2008
75
The outcome




In the above table, we assume RRR
=15%.
The DFCF value of the net inflows is
$1,055: NPV = $1,055 - $1,000 = $55.
That means that the project is estimated to
add $55 in value to Craig’s business
above his RRR over the period.
If NPV had turned out to be a negative
value, it would subtract from net worth
(C) C.L. Mattoli, 2008
76
The NPV Decision Rule



From the above example and discussion, we
can come up with a decision rule for using
NPV: accept positive NPV, negative NPV
Assume that the firm is in business, and they
already have a RRR demanded by their
investors.
Given our discussion in Mod 4 (Securities
valuation), shareholders will determine the
value of the company’s stock based on
DFCF valuation, using an appropriate RRR.
(C) C.L. Mattoli, 2008
77
NPV & Risk



An implicit assumption in the NPV
methodology is that the risk of a project must
be the same as the average risk of the firm.
We have chosen an “appropriate” discount
rate to use in NPV that is somehow
connected to the rate at which investors
discount the company’s CF’s to value its
shares.
We have also learned, in the preceding
module, that, in the marketplace for returns,
there is a risk component to rates of return, in
the market.
(C) C.L. Mattoli, 2008
78
NPV & Risk




Thus, the risk that investors perceive in the
firm has been incorporated into their RRR.
When we use RRR, determined by those
factors, to calculate NPV, the project must
have the same risk as the general risk of the
firm, or it will demand a different RRR.
A new product would be a riskier than
average venture.
A company that has a division that makes
military tanks and one that makes
chopsticks will have average risk, different
from the risks of each of its divisions.
(C) C.L. Mattoli, 2008
79
Payback Period: a non-DFCF rule




There are a number of other decision rules
for investment.
The first is the payback period, which
does not account for time value:
We pay out money to buy an investment:
our initial investment outlay. PBP is the
length of time it takes for CF’s to cover IO.
In the next slide, we show PBP
calculation.
(C) C.L. Mattoli, 2008
80
Payback Period Example

The payback period is over 3 years but under
4. It is 100/300 = 1/3 year over 3 years.
Time
0
line
IIO
1000
Inflows
Outflows
Net inflow
Salvage
Net CF
Payback paid
to go
payback period =
1
2
3
4
5
500
200
300
500
200
300
500
200
300
500
200
300
300
300
300
300
700
400
3 1/3
300
300
100
300
500
200
300
100
400
(C) C.L. Mattoli, 2008
100/300 = 1/3
81
Average Accounting Return



Another non-DFCF method is called the
average accounting return (AAR) of a
project or the accounting rate of return
(ARR).
There are a number of different definitions of
AAR of the general form: [average
accounting profits from investment]/[average
accounting value of investment].
We shall use the definition: average net
income/average book value.
(C) C.L. Mattoli, 2008
82
Internal Rate of Return




A second DFCF method that we shall
examine is internal rate of return (IRR).
We encountered the concept of IRR when we
looked at bonds: the IRR solves the coupon
bond equation for YTM.
The IRR method is also related to NPV.
With NPV we begin with a given value for
RRR, and we compare the DFCF from the
investment with the price, IIO, that we pay for
the investment.
(C) C.L. Mattoli, 2008
83
Internal Rate of Return


IRR finds the RRR that makes DFCF exactly
equal to IIO, i.e., the rate of return that
equates present value of the project’s cash
flows to the initial outlay.
Thus, we can write the equation form of IRR
as:
n
CFt
IO  
t
t 1 (1  IRR)

Then, the required rate of return that makes
NPV=0 is the IRR.
(C) C.L. Mattoli, 2008
84
RRR vs. NPV

In the chart below we show RRR vs. NPV for
a project, known as an NPV profile
RRR vs. NPV
600
500
400
300
200
100
0
-100
2%
4%
6%
8%
10% 12% 14% 16% 18% 20%
Series1
(C) C.L. Mattoli, 2008
85
Mutually Exclusive Projects




Projects can be mutually exclusive (ME).
That means choosing one but not both (or
all).
For example, you want to buy a new
computer for your business. You evaluate
the CF’s of using IBM, HP, or Lenovo.
In the end, you need only one computer
system, so, choosing one eliminates the
others.
(C) C.L. Mattoli, 2008
86
ME example



CF’s for two projects, B & C, are shown,
below.
The NPV of B is $147 and C is $106, using a
10% RRR.
IRR’s for the projects are 17.01% for B and
13.06% for C.
Time
0
1
Project B -1000
Project C -1000
2
450
100
3
380
125
(C) C.L. Mattoli, 2008
4
300
300
5
200
460
100
600
87
NPV Profiles for B & C
NPV Profiles for ME Projects
600
500
B
400
C
300
200
100
0
-100
2%
4%
6%
8%
10% 12% 14% 16% 18% 20%
-200
-300
(C) C.L. Mattoli, 2008
88
The lesson for ME, IRR, and NPV



It will always be more appropriate to use NPV
over IRR.
People care more about the money that they
make, NPV, versus their returns on
investment, especially when IRR might not be
a good rate for reinvestment, anyway.
Thus, if there are conflicting opinions from
IRR and NPV for ME, go with the choice
given by NPV.
(C) C.L. Mattoli, 2008
89
The Profitability Index



The profitability index (PI), also known as
the cost-benefit ratio, is similar to NPV, in
that it compares the DFCF from the project to
the cost, so it is.
PI = DFCF/IO, the discounted cash flow
value of the project divided by the initial
investment cost (outlay). Thus, if PI > 1,
accept; PI < 1, reject.
PI just gives a ratio, so there might be cases
for ME projects in which one has a higher PI
but a lower actual NPV. In such cases, the
choice lies in the decision given by NPV.
(C) C.L. Mattoli, 2008
90
More on CF’s




Since the focus, in finance is cash flows, we
must be careful to include the proper cash
flows and exclude improper ones in our
evaluation.
Two things should be noted, before hand.
First, companies may spend some money, in
the ordinary course of their business, looking
at and for new business ideas (projects).
What will be important is the net cash flows
that a project adds to the firm.
(C) C.L. Mattoli, 2008
91
Sunk Costs




There are some unusual costs that are part of
business project evaluation.
Sunk costs are costs that a business incurs
in looking at potential projects, in its regular
course of business.
They are liabilities that must be paid whether
or not the project is actually undertaken.
An example is a fee for a market analysis for
a potential new product.
(C) C.L. Mattoli, 2008
92
Opportunity Costs





The opportunity cost concept arises in
business project evaluation.
Basically, opportunity costs are in terms of what
you give up.
For example, suppose you own a building that
you paid $500,000 for, 10 years ago.
Due to new zoning laws, you are now allowed to
convert the building into apartments.
The opportunity cost that should be included in
evaluation of the apartment project is how much
you could sell it for, today, in the market.
(C) C.L. Mattoli, 2008
93
Incremental Cash Flow



To truly analyze the cost and benefits of
adding a new business to an existing
business, we consider all of the changes in
cash flow of the whole business associated
with the project.
In other words, we consider the total net
affect of the new business on cash flows.
The relevant project CF’s are, therefore,
incremental cash flows, the net additions or
subtractions of cash flow of the whole firm.
(C) C.L. Mattoli, 2008
94
Incremental Cash Flow



In that regard, we do not have to actually
calculate the whole of cash flows of the
firm with and without the project.
We only have to figure out the incremental
cash flows of the project.
That is known as the stand alone
principle. We evaluate the project
incremental cash flows, considering it as a
stand alone business.
(C) C.L. Mattoli, 2008
95
Incremental Example
Suppose we have the following comparison of cash
flows for some year in the life of a project.
Project
Implemented –
Project Not
Implemented
Increment
=
Sales
12000
9000
3000
Cash op. cost
(5000)
(4000)
(1000)
Depreciation
(2000)
(1000)
(1000)
5000
4000
1000
(1500)
(1200)
(300)
= Net oper. inc.
3500
2800
700
+ depreciation
2000
1000
1000
=Operating Cash
flow
5500
3800
1700
Pre-tax income
Taxes (30%)
(C) C.L. Mattoli, 2008
96
NWC and Projects



Startup costs for a business involve more
than just things like equipment purchase. It
will also involve working capital.
For example, if you start a clothing boutique,
you will have to buy some inventory for
startup.
Suppose, also, that your monthly sales will be
$100,000, and about 25%, credit sales. Then,
you will also need room, in the beginning, for
A/R of $25,000.
(C) C.L. Mattoli, 2008
97
WC recovery



WC initial investment is normally recovered at
the end of the project (unless otherwise
specifically stated in a problem).
For example, if we invest in inventory, in the
beginning, it will have been sold and included
in OCF’s, and there will be no inventory at the
end of the project.
Example, get $100,000 of dresses to sell.
Sell them for $100,000. At the end there are
none left.
(C) C.L. Mattoli, 2008
98
Depreciation



The value of depreciation, in finance, is the
tax savings, and we always use tax
depreciation.
For example, if an asset costs $100,000, can
be depreciated over 5 years, has a terminal
value of $20,000, and useful life of 8 years, D
= $100,000/5 = $20,000, straight line (prime
cost).
Alternatively, depreciation might be given in
%/year instead of years. The two ways are just
inverses of each other: D in years = 1/[D in
%/year].
(C) C.L. Mattoli, 2008
99
BV vs. MV: Taxes on Sale of P&E



Suppose that you sell the asset of the last
example, in year 4, for $25,000.
The BV = $100,000 – 4x$20,000 =
$20,000.
Then, the tax law says that you must pay
tax on the gain (or loss, which is a tax
savings) on sale price over BV: Taxable
Gain = 25,000 – 20,000 = $5,000.
(C) C.L. Mattoli, 2008
100
Multiple Futures: Scenarios

The next level of analysis involves creating
multiple scenarios and cash flows for the
future: average, good and bad.
Cash Flows & NPV
Year
NPV
IRR
Average
Good
Bad
0
-200000
-200000
-200000
1
59800
99730
24490
2
59800
99730
24490
3
59800
99730
24490
4
59800
99730
24490
5
59800
99730
24490
$15,565.62 $159,504.33 ($111,719.03)
15.10%
40.88%
(C) C.L. Mattoli, 2008
-14.40%
101
Sensitivity Analysis





In scenario analysis, we vary all of the variables.
In sensitivity analysis, we vary one variable at
a time to see what happens to the results. For
example, we could vary unit sales, fixed costs,
or prices.
In the end we will be able to construct a graph of
NPV vs. the variable.
The higher the slope of the line, the more
sensitive is the NPV to that variable.
We show an example of unit variation, below.
(C) C.L. Mattoli, 2008
102
Sensitivity Analysis

NPV vs. Units
$50,000.00
$40,000.00
$30,000.00
$20,000.00
$10,000.00
$0.00
5400
($10,000.00)
5600
5800
6000
6200
6400
6600
($20,000.00)
(C) C.L. Mattoli, 2008
103
Risk
(C) C.L. Mattoli, 2008
104
Intro




We have discussed the inputs of returns,
including, maturity, inflation, and risks.
We have been using RRR’s, but, so far,
we have said little about how they are
determined for a particular investment.
In order to explore this question, more
fully, we have to quantify risk.
Then, we can take a closer look at returns
and their relationship to risk.
(C) C.L. Mattoli, 2008
105
Detailed Returns


1.
2.
3.
4.
The authors of the textbook have compiled
quarter-to-quarter returns for classes of
Australian assets (over 20 years).
The portfolios are:
ASX All Ordinaries Index.
Government bonds with 10 years to
maturity
Cash as investment in 30-day BAB’s
The CPI, a broad measure of inflation.
(C) C.L. Mattoli, 2008
106
Real and Nominal Returns
Over the 20 year period, the average
return on cash was 8.4%, for 10-year
T-bonds 10.6%, for equities 14.4%,
and inflation averaged 3.9%.We
break these down, further.
 Real average return on cash was
4.5% (= 8.4% – 3.9%), on 10-year Tbonds 6.7%, on equities 10.5%.

(C) C.L. Mattoli, 2008
107
Risk Premiums



BAB’s are bank-guaranteed debt of large
corporations with good credit, and we have
limited maturity to 30 days, and are highly
liquid.
Thus, our cash rate is virtually default-risk
free, and we designate it as the riskless rate
We find that equities had an excess return of
5%, the price for bearing the risk of owning
equities, the risk premium, the reward for
bearing the risk, for holding equities.
(C) C.L. Mattoli, 2008
108
Summary of Returns
Average Returns 1982 -2002
Category
Average
Return
Risk
Premium
14.4%
Real
Return
10.5%
All
Ordinaries
10 Year TBonds
Cash
10.6%
6.7%
2.2%
8.4%
4.5%
0.0%
Inflation
3.9%
--
--
(C) C.L. Mattoli, 2008
6.0%
109
Variability & Risk




The risk premium for T-bonds was 2%, equities,
6%. Logically, if the risk premium is higher, then,
so must be the risk.
Risk is, basically, the chance that the future will
turn out differently than expected. We quantify it
as the variability of return.
The average return on equities was 14.4%, the
range was – 40% to + 30%, about 70%. The
average for T-bonds was 10.6% and the range
was only – 4% to 12%, or a range of 16%.
Thus, a correspondence between our
conception of risk and the market’s assignment
of a bigger premium for bearing the risk.
(C) C.L. Mattoli, 2008
110
Histogram of Returns: fig. 10.9
(C) C.L. Mattoli, 2008
111
Analysis of the Spread



The statistical/probability concept that
captures the spirit of what we want is the
variance of returns.
The variance measures the spread of a
distribution, while also accounting for the
height, the frequency or probability, of the
distribution, in the calculation.
The spread is measured from the central
(mean) return.
(C) C.L. Mattoli, 2008
112
Ex post variance

The ex post variance is the weighted
average of the deviations of observed
returns from the mean return
Variance( R)  Var (r )
T
 2 

 (R  R )
t 1
2
t
T 1
Where T is the number of past
observations and we use Mean(O) = Ō
(C) C.L. Mattoli, 2008
113
Markets in Action





A big topic in finance is market efficiency.
The most important thing in investing is
information.
Market prices change all the time as new
information arrives and is disseminated to
market participants who reassess their views.
The question of market efficiency becomes
how fast and accurately do markets adjust.
In an efficient market, prices should fully
reflect all of the available information so that
there is no reason to believe that prices are
either too high or too low.
(C) C.L. Mattoli, 2008
114
Possible Reactions & Adjustments




Suppose that a company announces a new
project that management has figured will
greatly increase the PV of its shares.
In a completely efficient market, the price will
adjust quickly to the news.
Other possibilities are delayed reaction,
taking several days to assimilate the
information, or overreaction and subsequent
adjustment.
We show the 3 possibilities in the next slide.
(C) C.L. Mattoli, 2008
115
Figure 10.12
(C) C.L. Mattoli, 2008
116
The Efficient Market Hypothesis



The gist of the EMH is that well-developed
financial markets, like the ASX, are
relatively efficient, although there are
“anomalies”.
In an efficient market, all investments are
zero NPV investments because DFCF=P.
In practice, competition among investors in
information gathering and processing will
move more and more prices to their proper
levels.
(C) C.L. Mattoli, 2008
117
The Efficient Market Hypothesis


As investors analyze the information, they
may conclude that a price is too high or
too low. Their action, their vote, in the
market, buying or selling shares will help
to move the price towards its true level.
The leftover, inefficient stocks will be just
enough to keep those people in business
whose specialty is finding, analyzing and
investing in undervalued investments.
(C) C.L. Mattoli, 2008
118
Forms of the EMH




EMH has been presented in 3 forms
Strong form = all information is reflected
in price. No such thing as inside
information. However, inside information
does exist.
Semi-strong = all publically-available
information is reflected in prices, so,
security analysis has no value.
Weak efficiency =present price reflects the
history of prices, so technical stock
analysis has no value.
(C) C.L. Mattoli, 2008
119
Expected & Unexpected Returns




Share prices and returns depend on
information.
Thus, the expected return, over the next
year, is based on known information. That is
the normal return. However, unexpected
things can happen during the year.
That will mean that the total return for a stock
will be its expected plus unexpected return,
Total return = E(R) + U.
Over time, the unexpected part will cancel
itself out, having negative surprises, some
years, and positive surprises, other years.
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120
Announcements & News




Since the market already has expectations
for a company’s outlook, some news is
already discounted by the market.
Unforeseen events could lead to a surprise
in an announcement. Thus news = expected
+ surprise = expected + unexpected.
We relate the expected parts to market
efficiency: current price represents all of the
known information, including expectations.
From here on, we will equate news with only
the real news, the surprise.
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121
Systematic & Unsystematic Risk



The real risk in owning an investment resides
in the surprises. If we always got what was
expected, there would be no risk.
Part of the risk of surprise will affect the
whole investment market. For example, if the
economy has unexpected slow growth, that
will affect the whole stock market.
Thus, we call this risk, systematic risk: the
risk to the whole system, in this case, the
stock market.
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122
Systematic & Unsystematic Risk



The other part of surprise will affect a
company or industry. For example, if oil
prices fall to $60/barrel when they had
been expected to remain at $100.
That risk is called unsystematic, unique or
asset-specific risk.
Then, also, we can rewrite return for an
individual asset as R = E(R) + systematic
part + unsystematic part = E(R)+m + .
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123
Diversification & Risk




As it turns out, if we diversify our
investment, i.e., spread it out over more
and more stocks, we will get lower and
lower portfolio risk, or variations of return.
There will, however, be a limit to the
amount of risk that we can eliminate: the
unsystematic risk: it is diversifiable risk.
What cannot be is the systematic risk.
We show the situation, in the next slide.
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124
Risk Diagram

Risk Diagram
p
2
Diversifiable risk
Risk associated with
market portfolio (systematic risk)
2
Number of securities in portfolio
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125
What type of risk matters?



A well diversified portfolio only contains
systematic risk because we can, by
intelligent diversification, get rid of
unsystematic risk
The unsystematic risk of each asset is offset
by the unsystematic risks of the other assets in
the portfolio, if constructed properly
Theoretically, investors cannot expect to
gain higher returns by increasing
unsystematic risk.
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126
Systematic Risk & Beta



The systematic risk principle says that reward
for bearing risk resides in systematic risk.
Then, expected return should also depend on
systematic risk. In reality, one asset might
react differently than another to the way
things turn out for the whole system.
 is the systematic risk of an asset. For the
entire market is 1;  > 1 is riskier than the
market;  < 1 is less risky than the market; 
< 0 is anti-correlated with the market.
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127
Portfolio Betas



Unlike portfolio variance which was
complicated to calculate, portfolio beta
is simple.
The beta for a portfolio is calculated
exactly like portfolio expected return.
We just do a weighted sum of betas for
the individual investments, weighted by
their portfolio weights, P = W1 1 +W2
2 + …
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128
Beta and the Risk Premium

Assume that you form portfolios from a risky
asset with risk, , and a riskless asset.

Then, portfolio expected return and risk
will be RP = W E(R) + (1 – W)RF and P =
W  + (1 – W) 0 = W .
That equation describes a line, varying W,
relating portfolio return to portfolio beta,
and the slope of the line is slope = [E(R)
- RF]/ , the reward-to-risk ratio, which
must be the same for all assets.

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129
The SML & the CAPM





The line in risk-return space is commonly
referred to as the security market lime (SML).
To find the line, recall that beta for the market is
1, so slope = [E(RM) – RF]/1.
Then for any asset in the market, slope = [E(R) RF]/  = E(RM) – RF, so, E(R) = RF + [E(RM) –
RF] .
This equation is the famous capital asset pricing
model (CAPM).
Since the model is usually applied to the stock
market, the risk premium, E(RM) – RF is usually
referred to as the equity risk premium, ERP.
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130
Graphical Meaning of the CAPM


CAPM-Security Market Line (SML)
Risk of the market is beta = 1.
E(R)
E(R(M))
R(0)
1

β
(contd)
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131
COC
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132
From Market to Business



CAPM theory says markets determine a
relationship between return and risk for
securities: the SML with slope reward per unit
risk.
Considering more general investments, like
business projects, the SML offers a
benchmark for reward-risk relationships.
Thus, any investment that a company makes
must offer expected return at least as good
as that offered, in the markets, for a particular
level of (systematic) risk.
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133
From Market to Business



If it did not, the firm’s shareholders
would be better off, investing on their
own.
Our job becomes: find investments with
returns superior to the markets. They
will have NPV > 0.
We compare the expected return on the
investment (IRR) to the return offered in
the market for the same beta.
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134
The Nature of COC




RRR for a business project means the project
must earn a return equal to the RRR to have
non-negative NPV.
A firm must earn RRR = COC to pay its
investors for the use of their capital in a
project.
To get the proper RRR/COC we turn to the
capital markets and use the rate for level of
risk to discount CF’s.
Thus, COC should be a function of the
investment, not the investors, i.e., COC
depends on the use, not the source of
funds.
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135
Financial Policy and COC




The firm will fund itself with both debt and
equity, so its COC will be a blended value.
Thus, we look at its cost of debt capital and
its cost of equity capital. Then, we can use
the capital weightings to find WACC.
Capital structure is a managerial
variable.
We assume, here, that cap structure is a
given target capital structure with a fixed
debt-equity ratio.
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136
Prologue



By beginning with COC equity, we are doing
the hard work, first.
As we have seen in our discussion of
applying DFCF methods to infinite-term
equity can only be done in idealized
circumstances.
Alternatively, the RRR of a firm’s
shareholders can not be computed directly
but must be approximated, in one way or
another.
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137
Table 12.1
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138
Capital Weightings




There are a number of ways that we could
approach the weighting.
For example, a firm with privately-placed
equity and debt will have only accounting
values for capital and weights.
Better than BV’s are market values, but
they fluctuate a lot.
The preferred weights are so-called target
capital weights: what the firm wants to be.
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139
No Risk Adjustment Project COC’s
SML
Accept
improperly
WACC
Reject
improperly
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140
Risk-adjusted Split RRR’s for Projects
SML
Reject
WACC
Accept
High Risk
Average
Risk
Low risk
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141
Capital Structure
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142
The Question




Our job is to choose capital structure that
will maximize firm value.
Value is DFCF value, and, for a company,
CF’s are discounted at the WACC, which
contains capital structure weights.
Value is inversely related to the RRR, so,
alternatively, the question becomes: what
capital structure will minimize WACC?
We say one capital structure is preferable to
another, if the WACC is smaller, and optimal
capital structure is that which will
absolutely minimize WACC, also called the
target capital structure of the firm.
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143
Consequences of Financial Leverage





Financial leverage refers to the use of debt.
Lower COC debt can enhance ROE.
However, debt has interest payments that
must be paid: they are fixed costs.
Thus, variability of income and ROE will also
increase with increasing debt, but will
shareholders reassess their risk in the firm?
The answer is no. Shareholders can create
their own, homemade leverage by splitting
their money between shares and
lending/borrowing, on their own.
144
Textbook Leverage Example

Figure 13.1
Disadvantage
Advantage
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145
Cap Structure & COC Equity



Our preceding arguments about the stock
price and leverage are just a special case of
the Miller-Modigliani (MM) Proposition I: a
firm’s capital structure is irrelevant.
MM Prop 1, the Pie Model, says if the asset
side of two companies’ balance sheets are
the same, then, the right hand side, the
capital does not matter.
Capital structure is the way the pie (pie chart)
is sliced, the size of the pie is the same.
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146
Cap Structure & COC Equity




According to MM I, cap structure has no affect
on firm value, but it does change, so we should
look at the WACC.
We write WACC = RA = (D/V)RD + (E/V)Re, or
RE = RA + (RA – RD)(D/E), which says RE is a
straight line with slope (RA – RD) versus (D/E).
This is MM Proposition II: COCE depends on:
(1) ROA, (2) the cost of debt, and (3) the D/E.
RE increases as D/E increases: the risk of
equity returns increases with increasing
leverage, which increases the RRR.
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147
Cap Structure & COC Equity



Some simple calculations will show that RA
= (D/V)RD + (E/V)RE = (D/V)RD + (E/V)[RA +
(RA – RD)(D/E)] = (E/V)RA + (D/V)RA =RA.
In other words, WACC is independent of
capital structure (MM I, restated).
The mechanism is that the increased
benefit of more and more lower cost debt is
exactly offset by the increasing COCE from
the addition of leverage.
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148
Figure 13.3
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149
The CAPM, the SML & Proposition II


How does financial leverage affect systematic
risk?
CAPM: RA = Rf + A(RM – Rf)


Where A is the firm’s asset beta and measures
the systematic risk of the firm’s assets
Proposition II


Replace RA with the CAPM and assume that the
debt is riskless (RD = Rf)
RE = Rf + A(1+D/E)(RM – Rf)
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150
Business & Financial Risk




MM II: firm has risk because of the business it is
in and how it operates it: the business risk of
the firm, represented by the first term in the MM
II equation.
Business risk depends on the systematic risk of
the firm’s assets.
The second term in the equation depends on
cap structure and is dependent on the firm’s
financial risk.
The financial risk of equity is increased by
addition of debt to the capital structure. Financial
risk increases even though the business risk is
constant, and that leads to increasing COCE.
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151
The Affect of Taxes



The preceding analysis was assuming no
corporate taxes. Taxes have a real affect since
interest is a tax deductible expense and gets a
tax shield, which is an added benefit of debt
financing.
On the negative side is the absolute obligation to
meet promises of debt service payments. Not
meeting them could result in bankruptcy.
Value of a levered firm = value of an unlevered
firm + PV of interest tax shield. Value of equity =
Value of the firm – Value of debt.
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152
Textbook Figure 13.4
(C) C.L. Mattoli, 2008
153
MM II with taxes
The WACC also decreases as D/E
increases due to the effective
government subsidy on interest
payments
 We have RA = (E/V)RE + (D/V)(RD)(1TC)
 So, RE = RU + (RU – RD)(D/E)(1-TC)

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154
Graphical MM II + T
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155
Default on Debt




The unrealistic conclusion of MM with taxes
is that we should lever the firm to almost
100% debt.
Realistically, the more debt, the more
obligated we are to make payments, and the
risk that we cannot increases.
When a debtor defaults on payments, the
lenders can take him to court and lay claim to
assets. A firm becomes bankrupt, in principle,
when A = L, so E = 0, and transfer of control
goes from owners to creditors.
Bankruptcy has its costs.
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156
Costs of Bankruptcy




The precursor to bankruptcy is financial
distress when the company is having difficulty
meeting its debt obligations but has not yet
tipped into default.
At that point the company will spend time and
energy in avoiding bankruptcy.
Moreover, as the firm fights for its life, customers
might beg off, good employees might quit, and
potentially lucrative projects might be shelved.
These indirect costs of bankruptcy are called
financial distress costs.
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157
Optimal Capital Structure.



Thus, the ever-increasing benefit of leverage a
la MM + T is moderated by the ever-increasing
probability of distress, default and bankruptcy.
The result is that instead of the increasing line,
in figure 13.4, it will be humped with a peak at
the optimal capital structure, thereafter
decreasing with increasing leverage.
We show this combined picture in the next
slide.
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158
Figure 13.6
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159
Dividends & Such
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160
Intro




Then, the cash flow is rolling in. What
should it do with that cash flow?
We can retain some or all of these cash
flows to invest in new projects or otherwise
We can also distribute some cash to
shareholders as cash dividends.
However, should not the corporation be
able to better invest the shareholder’s
money than the shareholders themselves?
(C) C.L. Mattoli, 2008
161
Intro



Cannot the shareholders create their own
cash flows by selling some shares?
The corporation can also do the same
thing in a share repurchase, buying shares
in the market, paying cash to those who
want to sell shares, instead of paying
dividends.
Just like in the case of capital structure,
there is no current comprehensive theory
of dividend decisions. There are only
simplified theories and some suggestions.
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162
Steps in cash dividends
1.
2.
3.
4.
First, a dividend must be declared by
the board of directors and then. The
announcement date is the date of
directors’ meeting.
The record date is used to identify all
shareholders-of-record.
The ex-dividend date is 4 days prior
to the record date in a system where
share transfer and settlement in the
secondary market, is 5 days.
Payment date is usually several
weeks after the date of record.
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163
Price on X




The day before an ex-date, the stock trades
with a right to receive a dividend.
The next day it will no longer contain that
right.
Thus, the price should drop from one day to
the next to reflect the loss of value of the
dividend.
So, if the stock was $50 on the day before
ex-D, and D = $2, then, the price on the exdate should be around $2 less, or $48.
(C) C.L. Mattoli, 2008
164
Irrelevance
MM showed that, under a number of
specific assumptions, dividend policy
affects neither the price of a firm’s shares
nor a firm’s cost of capital, i.e. dividend
policy is irrelevant.
 It is based on the assumptions that, if
there are no taxes, shareholders will be
focused on total return: capital gains
plus dividend yield

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165
Homemade dividends

Irrelevance relies on the basic premise
that the market value of a firm
 depends on the PV of future cash
flows from its assets
 which in turn depends on investment
decisions not on dividend decisions.
 Both investors and managers have the
same information regarding future
investment opportunities
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166
Homemade dividends



Assume either no taxes or taxes that
are the same for both capital gains and
dividends,
Then, SH can make their own
‘dividends’ by selling shares
(alternative means of cash inflow for
investors).
They can neutralize dividends by
purchasing more shares if dividends
are paid by the company
(C) C.L. Mattoli, 2008
167
In the Real World
Reasons that dividends might be
relevant are usually based on things
like:
1. Tax differentials
2. Psychology
3. Agency costs
4. Information

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168
Residual Dividend




Assume a company wants to maintain its
capital structure but wants to minimize its
need to sell new equity.
Then, it will look to invest free cash flow in
positive NPV projects and payout any
leftovers.
This is called residual dividend policy.
We would expect, then, young fast-growing
firms to have a low payout ratio and older
mature firms with less opportunity to grow to
have high payouts.
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169
Stable Dividend




As opportunities wax and wane, a residual
dividend policy could have a very
unpredictable pattern.
The definition of a stable dividend policy is
one in which the firm pays a fixed payout
ratio.
That will be effected either semi-annually,
called cyclical policy or yearly.
Most firms try to at least not cut dividends
because it can send a negative signal to the
markets.
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170
Compromise Policy

1.
2.
3.
4.
5.

5 Goals dominate real world policy:
Avoid cutting +NPV projects to pay D.
Avoid cuts in dividends.
Minimize need to sell equity.
Maintain target capital structure.
Maintain a target payout ratio.
Companies can satisfy goals with regualr
and extra dividends.
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171
Additional Policy Considerations




The clientele effect refers to that certain groups
of investors will gravitate to high or low payout
ratio stocks.
Thus, companies might design dividend policy
to attract certain investors, and it must keep that
in mind when administering policy on an ongoing
basis.
Firm’s must also be aware of changes in the
demand side of the market for dividends.
Investors take signals, i.e., infer information
from dividend announcements.
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172
Bonus Shares: Stock Dividends


As an alternative to cash, dividends can also
be paid out in shares, e.g., stock dividend of
0.1 shares per share of outstanding stock
(called bonus shares in Australia).
Even though there is no value paid for
shares, and the value of the firm has not
changed, investors can take a bonus share
issue as a positive signal from
management. Then, the market value will
increase.
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173
Share Repurchases




A real alternative to cash dividends is for the
company to repurchase some of its shares.
That way, investors can get some cash.
It should have no impact on value, if cash is paid
to investors by dividend or by repurchasing
shares.
Tax-wise, though, tax must be paid on
dividends, while tax is paid only by those who
sell shares into the repurchase.
In addition, signals can be inferred from
repurchasing: if the company believes that its
shares are a good buy, then, maybe they are
undervalued.
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174
DRIP’s



While some people like cash and, therefore,
cash dividends, other don’t like dividends and
would prefer gains in principal.
Dividend reinvestment plans (DRIP’s) give
shareholders a chance to not get dividends
but to get growth in principal, instead.
For those signed up for the plan, the
company takes their dividends and
exchanges the cash for new share at a
discount to market value with no transactions
fees.
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175
Splits & Reverse Splits




Beyond bonus shares, companies can also do
share splits, e.g., each old share becomes 2
new shares, or
Reverse splits, whereby each old share might
become ½ a new share.
Companies do this, mainly to adjust the prices of
their stocks for investors to purchase
comfortably.
The reason is that shares are normally sold in
blocks of 100 shares; lower amounts are called
odd-lots, and their purchase is more expensive
in transaction costs.
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176
Splits & Reverse Splits




So, many companies try to adjust the price of
their stocks, in the market, so many
investors, or certain investors can purchase
them.
Thus, a price of $25/share means
$2,500/block.
Warren Buffet of Berkshire Hathaway has
taken the other tact and has a share price for
his company’s stock in the range of several
hundred thousand US$/share, so that only
the wealthy can own his shares.
Again, this is marketing and stock design.
(C) C.L. Mattoli, 2008
177
Ending




Practice exam today at 2-4
Exam Friday, 20th, 2:30, rms 406/503
Help: email, text, set up office visit.
Good luck.
(C) C.L. Mattoli, 2008
178
END
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179