BUSINESS FINANCE FINS1613

SUMMARY
1.1 Finance: A Quick Look
The four main areas of finance are:
Corporate Finance Business Finance
o Making corporate decisions.
Raising capital
Investment decisions from managers point of view
Maximizing firm value
Distributing earnings to shareholders
o Financial firms are referred to as the sell side of the market
o Investment banks
Investments
o Deals with financial assets, such as equity(shares) and debt
Pricing of risk and determination of returns
o Financial firms involved are referred to as the buy side of the market.
o Superannuation funds, hedge funds, investment management and brokerage firms
Financial Institutions
o Businesses that deal in financial matters.
o Commercial side: Originations and extensions of loans to businesses
o Consumer side: Originations and extensions of mortgage loans or other personal loans.
o Determine whether an extension to a loan is warranted based on financial position and
performance.
o Insurers determine risks and the insurance premiums for that risk.
International Finance
o International aspects of corporate finance, investments and financial institutions.
o Political risk, exchange rate risk, commodities and international market risk, international
business and market conditions.
o Multinational corporations and financial institutions with overseas operations.
1.2 Business Finance and The Financial Manager
When starting a business you have several financial decisions to make, the most important ones include:
Investment amount and type of investments to make determine size, profits, risk, liquidity
Financing how the firm will raise money affect financing costs and financial risk (Capital
Budgeting)
How everyday finance matters are going to be addressed, i.e. collecting money from debtors, etc
(Capital Structure)
Dividend how much of profits are given out as dividends vs retained (Working Capital Management)
The role of financial managers are to answer these questions:
The top financial manager within a firm is usually the chief financial officer (CFO)
Business Finance deals with the decisions made by corporate treasury and capital expenditures.

Capital budgeting:
The process of planning and managing a firms long term investment decisions.
Management aims to identify whether long term investments are profitable or not
Determine the size of cash flow, the timing of cash flows and the risk of future cash flows.
Capital structure:
The mixture of debt and equity maintained by a firm.
How the firm obtains the financing it needs to support its long term investments.
How much should the firm raise, what are the least expensive sources of funds for the firm.
Working Capital:
A firms short term assets and liabilities
Managing the firms working capital is a day-to day activity that ensures the firm has sufficient
resources to continue its operations and avoid costly interruptions.
o How much cash, inventory
o Sell on cash or credit to customers
o Source of short term financing (Where and How)
1.3 Forms of Business Organisation
Types of companies:
Sole proprietorships:
o A business owned by a single individual
o Simple to establish, few regulations, owners keeps all profits., avoid corporate income tax
o Difficult to raise large capital, unlimited liability, only lasts as long as owner, transfer of
ownership is difficult
Partnerships:
o Owned and run by two or more people informal or legally binding
o Cheap and easy to establish
o General partners have unlimited liability, limited partners have limited liability
A limited partner do not have much say in how the business is run
o Difficult to raise capital, only lasts as long as owner, difficult to transfer ownership
Corporations:
o A business created as a distinct legal entity owned by one or more individuals or entities.
Has the same rights as a person can borrow money, own property, sue/d, enter
partnerships, etc
o Unlimited life, easily transfer ownership, limited liability, easy to raise capital
o Liable for corporate tax, and then dividends are taxed when paid to shareholders, difficult to
setup as legal formalities are lengthy and costly
Charter includes: name, purpose, share amounts, directors, whether shares are issued to
new investors or existing owners.
o Owners are separate to management.

1.4 The Goal of Financial Management

Profit Maximisation:
Profit maximisation is a very airy-fairy term and is not specific.
o What profits? End of year? Before tax? After tax?
Will it be achieved through cost-cutting which may have negative long-term impacts?
Does it refer to earnings per share or accounting net income?
The Goal of Financial Management in a Corporation:
Maximise the current value of the existing shares
o Assuming shareholders purchase shares to make a capital gain and financial managers make
decisions for shareholders
Maximise the market value of the existing shareholders equity.
o If the corporation is not listed on an exchange and has no shares.
Social and ethical responsibilities
o safety and welfare of employees, customers, environment
o Not conducting illegal operations to maximize firm value
ASX introduced a Corporate Governance Council to recommend guidelines on best
practice.
1.5 The Agency Problem and Control of the Corporation
Agency Relationships:
The relationship between shareholders and management is called an agency relationship.
Whenever one group (principles) hire another (the agent) to perform a service, there is a potential
conflict of interest, such a conflict is called an agency problem.
Management Goals:
Managers are different to shareholders, they may not have the same objectives.
A corporation is considering a new investment, which is relatively risky, but will increase share price.
Management does not go ahead with the investment, in the fear that it might fail and they may lose jobs.
o Shareholders lose out on a possible increase in share price.
o This is known as an agency cost, when managers fail to take advantage of a valuable opportunity
for the firm.
Do Managers Act in The Shareholders Interest?
Whether managers act in the best interest of shareholders, depends on two issues:
o How closely aligned are the management goals with shareholder growth
o The job security of management can they be replaced in shareholder interest are not pursued.
Managerial Compensation is dependent on firm productivity and firm profitability. Further, managers
are given stock in a company and thus reducing the agency problem (they will act in the best interest
of the shareholders because they are shareholders).
Control of the firm Control rests with shareholders. Shareholders can engage in a proxy fight to
replace existing management. Management can also be replaced by M&A activity (particularly
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acquisitions), whereby well managed companies acquire poorly managed ones, and former managers
are often left jobless.
Stakeholders:
Entities apart from shareholders or creditors that has a claim on the cash flow of the firm.
1.6 Financial Markets and The Corporation
Cash Flows to and from the Firm:
1. Firm issues securities to raise cash
2. Firm invest in assets
3. Firms operations generate cash flow
4. Cash is paid to government as taxes, other stakeholders may receive cash
5. Reinvested cash flows are ploughed back into firm
6. Cash is paid out to investors in the form of interest and dividends.

In financial markets it is debt and securities that are bought and sold

Primary versus Secondary Markets:

The term primary market refers to the original sale of securities by governments and corporations
o In a primary market transaction, the corporations is the seller and the transaction raises money
for the corporation. The two types of transactions are:
A public offering involves selling securities to the general public (IPOs)
A private placement is a negotiated sale involving a specific buyer
o There are a lot of rules and regulations involved with public offerings, and it is expensive and
must be registered with Australian Securities and Investment Commission (ASIC)
o Instead corporations often sell securities via private placement to large financial institutions as to
avoid legal costs and as it does not have to be registered with ASIC.
The secondary markets are those in which securities are bought and sold after the original sale.
o A secondary market transaction involves one owner or creditor selling to another.
The secondary market provides the means for transferring ownership of corporate
transactions.
o There are two types of secondary markets:
Dealer markets Over the counter (OTC); Dealers buy and sell for themselves, dealer
makes profit on the difference between the buy and sell price (aim to buy low sell high)
Auction market In the auction market brokers and agents match buyers and sellers and
charges a fee for this service. Auction markets has a physical location.
The equity shares of all large firms in Australia and New Zealand trade on organized auction markets
(exchanges)
o Shares that trade on an organized exchange are said to be listed on that exchange.

4.1 Future Value and Compounding:

Time Value of Money
A dollar today is worth more than a dollar tomorrow
o You could earn interest on the dollar while you waited
o Inflation, goods will be more expensive tomorrow.
Future Value (FV)
Refers to the amount of money an investment will grow to over some period of time at some given
interest rate.
o Cash value of an investment at some time in the future.
t
o
F V t =Principal(1+r ) Principal = Present Value
The process of leaving your money and accumulating interest in an investment is called compounding.
o Compounding the interest means earning interest on interest compound interest
o Simple interest is interest earned on the original principal each period.
o Compound interest FV Simple Interest FV
4.2 Present Value and Discounting:
Present Value (PV)
Refers to the current value of future cash flows discounted at the appropriate discount rate.
o Reverse of future value. How much the money is worth to you today
o How much you need now, to obtain an amount in the future.
FV
o PV =
n
(1+r )
The process of finding the present value of a sum of money is called discounted cash flow (DCF)
valuation
o The discounting rate is the rate used to calculate PV in FV cash flows
5.1 Future and Present Values of Multiple Cash Flows:
For multiple cash flows:
1. Determine the FV/PV of each individual cash flow
2. Add the FV/PV of each cash flow to determine the FV/PV of the stream of cash flows.
FV =C1 ( 1+r )

PV =

n1

+C2 ( 1+ r )

C1
C2
C3
Cn
+
+
++
2
3
(1+r ) (1+r ) (1+ r)
(1+r )n
5

n2

+ +C n

5.2 Valuing Level Cash Flows: Annuities and Perpetuities:

Level Cash Flows:
Annuity - A series of constant (level) cash flows paid for a finite number of periods
o Ordinary annuity Payments are made at the end of each period
o Annuities Due Payments are made at the start of each period
o FV of annuity due > FV of ordinary annuity b/c payments made earlier and therefore earn more
interest
Perpetuity An annuity with infinite number of periods
PV and FV for Ordinary Annuities
n
C
1
PV t :Ordinary Annuity = 1
r
1+r
C
FV t :Ordinary Annuity = ( (1+r )n1 )
r
C
1+ g
PV t : Growth Ordinary Annuity=
1
rg
1+r

( ( ))

( ( ))

PV and FV for Annuities Due

C
1 n
1
(1+ r)
r
1+r
C
n
FV t : Annuities Due = ( (1+ r ) 1 ) (1+r )
r

( ( ))

PV t : Annuities Due =

PV for Perpetuities

PV perpetuity =

C
r

PV growth perpetuity=

C
r g

5.3 Comparing Rates: The Effect of Compounding:

Effective Annual Rate (EAR)
The EAR is the actual interest rate you would receive expressed as if it was compounded annually.
o It is the actual rate you receive, not the quoted rate.
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Annual Percentage Rate

The APR (nominal) is the quoted interest rate per annum with a non-annual compounding.
o Semi-annual
o Quarterly
o Monthly

EAR= 1+

APR n
1
n

Period Rate
The rate charged by the lender in each period
o To convert APR into periodic
APR
Periodic Rate=

n
o To convert EAR into periodic

Periodic Rate=(1+ EAR ) n 1

5.4 Loan Types and Loan Amortisation:

Pure Discount Loans
The borrower receives funds today and repays as a lump sum with interest at some time in the future.
Interest Only Loans
The borrower receives funds today and pays interest only each period and then a lump sum at the end.
Amortised Loans:
The borrower receives fund today and pay interest and part of the principal each period.
6.1 Bills of Exchange and Bill Evaluation:
Bill of Exchange
A bill is a certain sum of money to be paid to the bearer at a fixed or determinable time in the future.
Called a discount security because interest in not explicitly paid.
o You dont receive the full amount, and then pay back the face value at some time in the future
o The difference between the amount received and face value represents the interest
Face Value
o The principal amount that is repaid at the end of the agreed term. par value
o The amount stated on the bill
Maturity
o Date on which the principal amount is paid
o Bills are typically issued for a period of days
Bill Value=

F
r t
1+
365
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6.3 Bonds and Bonds Evaluation:

Bonds
A type of interest only loan, where borrower pays interest every period and then principal at the end of
loan.
Face Value
o The principal amount of a bond that is repaid at the end of term par value.
Coupon
o Stated interest payment made on a bond a series of regular interest payments
Coupon rate
o The annual coupon divided by the face value of the bond
Maturity
o Date on which the principal amount of a bond is paid
Yield to Maturity
o The market required rate of return for the bond.
Bond Pricing:
Since a bond consists of coupon payments that are regular interest payments, this equates to an annuity.
The principal to be repaid at maturity represent a lump sum payment.
Bond Value=

C
1
F
1
+
t
ytm
( 1+ ytm ) (1+ ytm)t

Relationship between Price of Bond and Yield

If ytm = coupon rate
o Par value = bond price
If ytm > coupon rate
o Par value > bond price
o Discount bond
If ytm < coupon rate
o Par value < bond price
o Premium bond
Bond price fluctuates inversely with changes to ytm.
Interest Rate Risk:
The risk that arises for bond owners from fluctuating interest rates.
Longer maturity bonds have more interest rate risk than shorter bonds
o Effects of discounting are greater on cash flows that are further away in time
Lower coupon rate bonds have more interest risk than higher coupon rate bonds
o If coupon rate is lower, the bonds value has a greater relative weight on the par value, increasing
the effects of discounting.
6.4 More on Bond Features:

Bonds are debt investment instruments. A corporation that issues a bond is the borrower/debtor, while
the bearer is the lender or creditor
Debt does not represent ownership interest in the firm
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The interest payment is the cost of using debt as a source of funds.

o Having debts creates risk for financial failure

Bond Characteristics
Maturity: short v intermediate v long term
Placement: private v public
Issuer: corporations v governments
Security: secured v unsecured
o In the event that the issuer defaults the investors have a claim on the issuers assets that will
enable them to get their money back.
Seniority: senior v junior
o Preference in position over other lenders
Credit Rating: investment grade v low grade junk bonds
Issuer exercisable features: callability, covenants
o Ability to repurchase bond before maturity, part of the trust deed limiting certain actions.
Exotic Features: convertible, floating, and others
o Bond can be swapped for shares, adjustable coupon payments.
6.8 Inflation and Interest Rates:
Nominal Interest Rates
They are the interest rate that are quoted in the market
o They are not adjusted for inflations
Real Interest Rates
The real rate of return is the percentage change in how much you can buy with the number of dollars
you have
o The interest rates that have been adjusted for inflations
The Fisher Effect:
The relationship between nominal and real interest rates
1+i nominal =( 1+i real ) ( 1+ )
i nominal i real +
Where = inflation
6.9 Determinants of Bond Yields:
The Term Structure of Interest Rates
Relationship between yield to maturity and time to maturity
o On default free, pure discount securities
Normal yield curve upward sloping structure
o Long term yields are higher than short term yields
Inverted yield curve downward sloping structure
o Short term yields are higher than long term yields
Factors Affecting Required Returns
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Default risk premium The portion of a nominal interest rate that represents compensation for the
possibility of default
Liquidity premium The portion of a nominal interest rate that represents compensation for the lack of
liquidity
Maturity premium Longer term bonds will tend to have higher yields.

7.1 Ordinary Share Valuation:

P 0=

As a shareholder you can receive cash in two ways

o Dividends the company pays
o Selling you shares
The value of a share is then the present value of the dividends and the proceeds from selling that share.
D 1+ P 1
1+r

Dividend Discount Model

If we continue to just take dividends forever and delay the time at which we sell our share, then the price
of the share is given by:
P 0=

D1
D2
D
Dt
+
++
=

(1+r ) (1+ r)
(1+r ) t =1 (1+r )t

Constant Dividends (Zero Growth)

Same dividend at regular intervals forever
o Treat it as a perpetuity
P 0=

D
r

Constant Growth Dividends

Dividends is expected to grow at a constant rate every period
D 1=D0 (1+ g)t

The constant growth model has the general equation:

(1+ g)t
(1+ g) D1
P0=D0
=D 0
=
t
r g r g
t=1 (1+r )
Note:
D
r= 1 + g=dividend yield+ capital gains yield
P
o Dividend yield return from dividends
o Capital gains yield growth rate
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Supernormal Dividend Growth

Dividend growth in non-constant initially, but it settles down to a constant growth eventually

7.2 Some Features of Ordinary and Preference Shares:

Shares
A share is a stake in a company
o An owner who has the right to pick the manages and receive any profits
Ordinary Shares
Voting rights:
o Shareholders elect directors
o One share one vote
o Proxy voting voting on behalf of other shareholder(s)
The right to share proportionally in dividends paid
Rights to remaining assets after liquidation residual claim
Preference Shares
Shares with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes
without voting rights
o Dividends are paid to preference shareholder first, then to ordinary shareholders.
Dividends
Common dividends
o Dividends that are declared by the board of directors and paid to ordinary shareholders
o There is no liability of the firm until declared
Preference Dividends
o Paid to preference shareholders first
o They are not a liability and can be deferred indefinitely
o Dividends tend to be cumulative
10.1 Returns:
Financial Market

The financial market is the place where you can raise capital
o It determines the prices of bonds and stocks
Understanding this can help make better decisions pertaining the financial market.
o There is a trade-off between risk and return
o The higher the risk, the higher the expected return.

Dollar Returns:
The return on an investment expressed in dollar terms as:
o Dollar Returns = Dividend Income + Capital Gain/Loss
Capital gains is the difference between the price received when sold and price when bought
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Percentage Returns
Total % Return = Dividend yield + Capital Gain Yield
Total Return=

D t+1 + Pt +1Pt
Pt

Capital gains yield=

Dividend Yield=

Pt +1Pt
Pt

Dt +1
Pt

10.3 Average Returns: The First Lesson:

Historical Average Return:
Arithmetic average
T

ri

r +r ++r T i=1
Historical Average Return= 1 2
=
T
T
Risk-Free Rate
Rate of return on a riskless investment
Zero risk premium
Risk Premium
The excess return on top of risk-free rate
Award for bearing investment risk
10.4 The Variability of Returns:

Variance ( 2 )
The average squared distance between the actual return and the average return
o Variability of returns
T

(r ir )2

VAR ( R )= 2= i=1

T 1

Standard Deviation
The positive square root of the variance
o Return volatility
o Often preferred because it is in the same units as average returns
SD ( R ) == VAR ( R)
Normal Distribution
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A symmetrical, bell shaped frequency distribution that is completely defined by its average (mean - )
and standard deviation ().
It is useful for describing the probability of ending up in a given range.
Returns generally have a normal distribution

10.5 More on Average Returns:

Arithmetic Average Return
The return earned in average period over multiple periods
o What was your return in average year
Overly optimistic for long horizons
T

ri

Arithmetic Average= i =1
T
Geometric Average Return
The average compound return earned per year over multiple periods
o What was your average compound return per year
o Geometric < Arithmetic
Overly pessimistic for short horizons
1
T

Geometric Average=[ ( 1+r 1) ( 1+ r 2 ) ( 1+r T ) ] 1

[ ]
T

i=1

1
T

(1+r i ) 1

Depending on time period:

15 20 years: use arithmetic average
20 40 years: split the difference between them
> 40 years: use geometric average
10.6 Capital Market Efficiency:
Efficient Capital Market
Market in which security prices reflect available information
The Efficient Market Hypothesis:
Stock prices are in perfect equilibrium
Stocks are fairly priced
Stock markets are information efficient
Share prices will always reflect information in the market, hence investors should not expect to earn
positive abnormal returns
You can still make returns, return is dependent upon the level of risk you are bearing.
Poor investment decisions will still lead to poor returns.
Strong Market Efficiency
All private and public information is reflected in the prices
You cannot make abnormal profits
Semi-Strong Market Efficiency
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All public information is reflected in the prices

You cant make abnormal profits from public information (fundamental analysis)

Weak Market Efficiency

Share prices only reflect historical price and trade information
Cannot make abnormal profits based on past price information
Technical analysis will not lead to abnormal profits
Empirical evidence suggests markets are generally weak.
8.1 Net Present Value
Role of financial manager
Capital budgeting
o Choosing what to invest in
Capital structure
o Deciding how to finance the investments
Working capital management
o Managing every day activities and funds
Dividend policy
o How profits will be returned to investors

Capital Budgeting Design Criteria

Does the decision rule factor in the time value of money
Does it factor in risk
Does the decision rule tell us if we are creating value for the firm
Independent Projects
Projects that have no impact on another projects cash flows
The decision to accept/reject project will have no impact on other projects
Firm can accept one or more, or it could reject all
Mutually Exclusive Projects
Projects that when you accept, you must decline all other ones
o Could be because of financial constraints or limitation to available assets
Projects should be ranked in order to determine which one to take
Net present value (NPV):
NPV is the value of an investment taking into account the discounted value of all future cash flows
If NPV > 0 then accept as will generate more cash than it costs
If NPV = 0 then the project will break even
If NPV < 0 then reject
If mutually exclusive, choose project with highest NPV
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Calculating NPV
Estimate future cash flows
Estimate required return for the level of risk you are bearing
Find PV of cash flows and subtract from initial investment
n

NPV =
t=1

Ct
(1+r )t

CF 0

Advantages
Meets all decision rule criteria
NPV is consistent with firms objective of maximizing shareholders wealth
Preferred method
8.2 The Payback Rule:
Payback period
The amount of time it takes for an investment to produce enough cash to cover the initial cost of the
investment
Calculating Payback period
Estimate future cash flows
Subtract future cash flows from initial cost until initial cost is recovered
Decision Rule
Accept project is payback period is less than some predetermined limit
Advantages
Easy to understand
Adjusts for cash flow uncertainty
Biased towards liquidity
Disadvantages
Ignores time value of money
Requires predetermined threshold
Ignores cash flow after threshold
Biased towards long term projects
8.3 The Average Accounting Return (AAR):
Average accounting return is defined as:
AAR =

average net income

average book value

Average book value depends on how the asset is depreciated

o Take arithmetic mean of first book value and last book value
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Decision Rule
Accept the project if the AAR is greater than the target rate
Advantages
Easy to calculate
Required information is readily available
Disadvantages
Not a true rate of return
Time value of money ignored
Uses an arbitrary threshold
Based on book values, not market values
8.4 The Internal Rate of Return (IRR):

The IRR is the discount rate that makes the NPV = 0.

o Involves trial and error, or excel

Decision Rule
Accept the project if IRR is greater than the required return
IRR and NPV
IRR and NPV lead to identical decisions iff
o Conventional cash flow first is negative, rest is positive
o Independent project
If there is a conflict, USE NPV
Multiple IRR
Non-conventional cash flows lead to multiple IRRs
o Another cash flow begins after the initial outflow
IRR is no longer useful in this case
Mutually exclusive projects
Using IRRs becomes a problem because the timing and size of cash flow becomes important
At some required return the NPVs will crossover and one project will suddenly become more appealing
than the other.
Advantages
Easy to understand
Knowing a return is intuitively appealing
If the IRR is high enough dont need to calculate required return
Disadvantages
Can produce multiple IRRs
Cannot rank mutually exclusive projects
Modified IRR
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Helps control problems of IRR

Discount approach
o Discount future outflows to present value and add to initial outflows
Reinvestment method
o Compound all cash flows except the first forward to the end
Combination method
o Discount outflows to present and compound inflows to the end
Discount rates are externally supplied

MIRR v IRR
MIRR avoids multiple IRRs
Managers prefer rate of return comparisons and MIRR is better for this
Different ways to calculate MIRR
o Which one is best?
Interpreting MIRR becomes harder
8.5 The Profitability Index:

The profitability index is defined as the present value of future cash flows divided by the initial
investment
Measures the value created per dollar invested

Decision Rule
Accept project is PI>1.0
Advantages
Closely related to NPV
Useful when funds are limited
Disadvantages
The profitability index does not consider the scale of the project, which can lead to incorrect
comparisons of mutually exclusive projects.
9.1 Project Cash Flows:
Relevant Cash Flows
A project where the cash flows of the project will increase the firms overall cash flows if the project is
taken on
Incremental Cash Flows
The difference between a firms future cash flows with the project and without the project
How much the project will generate for the firm
Standalone Principle
The assumption that you can evaluate a project based on its incremental cash flows
9.2 Incremental Cash Flows:
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Sunk Costs
A cost that has already been incurred and cannot be recovered
o Not a relevant cash flow
o Exclude from DCF analysis
E.g. Consulting fees that have already been paid
Opportunity Costs
The most valuable alternative that is given up if a particular investment is taken
o Should be considered in DCF analysis
E.g. Using a pre-owned building for a project
o Opportunity we could sell the building
o Opportunity cost is the amount the building will sell for today
Side Effects
The cash flows of a new project that come at the expense of the a firms existing project
o Should be considered in DCF analysis
E.g. When you launch a new product line, you must consider the loss in sales of other product lines as a
result of this new product
Net Working Capital
Changes in the short term that represent the cost of running the day to day business
o Should be included in DCF analysis
Financing Costs
We do not include interest paid or any other financing costs, such as dividends or principal repaid on
debt securities
Financing effects have already been takin into account by the discount rate.

9.3 Pro Forma Financial Statements and Project Cash Flows

Projected Financial Statements
Pro forma financial statements are useful for projecting future years operations
To prepare these statements we require an estimate on
o Unit sales
o Selling price per unit
o The variable cost per unit
o Total fixed costs
Free Cash Flows
Cash flow from assets
The incremental effect of a project on a firms available cash.

Free cash flow ( FCF )=Operating cash flow ( OCF ) Net working capital ( NWC ) Capital Expenditure ( CAPEX ) + After

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9.4 More on Project Cash Flows

Operating Cash Flows
Cash flows generated from a firms normal day to day operations
Adjust net profit by non-cash items to do not correspond to actual cash flows
o Depreciation
1.
2.

OCF=EBIT + DepreciationTaxes
OCF=( SalesCosts ) ( 1T )+ DepreciationT

Depreciation
Even though depreciation is deducted from net profit, it is not an actual cash outflow
o Thus we add it back to see how much cash has actually been generated
The benefit of deducting depreciation is that it reduced the tax paid
o Depreciation tax shield
Straight line write off a fixed amount per year until book value is nil
Diminishing value depreciate a fixed percentage of book value per year
Net Working Capital (NWC)
The difference between a firms current assets and current liabilities
o Capital available in short term to run business
Current accounts such as accounts receivable/payable and inventories
NWC= Current assets Current liabilities
We must adjust for NWC because:
o We make sales on credit and match it with an appropriate expense, however this is not
necessarily when the cash comes in
o There is a timing difference between accounting revenues/expenses and cash inflows/outflows

How to adjust for NWC

o Increases in current assets (accounts receivable/inventories) represent cash outflow deduct
o Decreases in current assets represents in cash inflow add
o Increases in current liabilities (accounts payable) represent cash inflows - add
o Decrease in current liabilities represent cash outflows - deduct

Capital Expenditure (CAPEX)

Payments of cash for long term assets (property, factory, equipment, etc)
Do not immediately appear as expenses, but depreciate slowly
Cash flow occurs immediately
o Capital expenditure represents negative cash flow at the start
After Tax Salvage
Assets that are no longer need can be sold
o Pay tax on capital gains
Capital gain=Sale priceBook value

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Book value=Purchase priceaccrued depreciation

After tax cash flow=Sale price( T capital gain )
9.5 Evaluating NPV Estimates:
NPV

The NPVs we calculate are just estimates, there is little certainty in the accuracy of the estimate and
hence we must conduct further analysis.
Typically a positive NPV is a good sign that we should take up the project, though we need to further
look at:
o Forecasting risk
How sensitive the NPV is change in cash flows
The more sensitive the greater the forecasting risk
o Sources of value
Why does this project create value

9.6 Scenario and other What-If Analyses:

Scenario Analysis
The determination of what happens to NPV estimates when we ask what-if questions.
We look at NPV from the best, worst and cases in between
Scenario analysis tells us what can possibly happen to our project, but it does not tell us whether we
should take it not,
Sensitivity Analysis
Investigation of what happens to NPV when only one variable is changed.
The greater the volatility in NPV when that one variable changes the larger the forecasting risk
associated with that variable and the more attention we should give in regars to its estimation.
Problems with Scenario and Sensitivity Analysis
Neither can provide a decision rule
Ignores diversification
o Measures only stand-alone risk
If your scenarios end up with mostly positive NPVs you should feel comfortable with taking the project
If there is a variable that leads to a negative NPC with only small changes you may want to forego the
project.
9.7 Additional Considerations in Capital Budgeting:
Managerial Options and Capital Budgeting
Opportunities that managers can exploit if certain things happen in the future
Up until now we have assumed the project is static and that the projects basic features cannot be
changed, however in reality managers can modify the project as new information becomes available.
Ignoring these options in our DCF analysis means that we underestimate our NPV.
20

Option to Expand
If a project has a positive NPV, can we expand the project or repeat it to get a larger NPV
Option to Abandon
If we start a project, can we abandon (or scale back) the project if it does not cover its own expenses,
Option to Wait
The project can be postponed, to see if conditions improve.
Equivalent Annual Annuity (EAA)
The level of annual cash flows that generate the same present value as a project
It is used to evaluate alternative projects with different lives.
PV

EAA=

1
1
(1
)
r
( 1+r )n
When making a decision we must factor:
o The required life of the project
o The replacement costs

11.1 Expected Returns and Variances:

Expected Return
The expected return on an asset is given by:
n

E ( R )= pi Ri
i=1

Where:
o pi is the probability that state i can occur
o Ri is the expected future return of the asset if state i occurs
o N = total number of possible states
Expected return is the return you would expect to get if you repeat s process many times
Expected Return Risk

E ( )=

i=1

pi [ RiE (R)]2

11.2 Portfolios
Portfolio
Group of assets such as shares and bonds held by an investor
o Portfolio weight percentage of the total value of portfolio in a particular asset.
The risk and return of a portfolio are entirely determined by the risk and return of the individual assets
that make up the portfolio.
Portfolio Expected Returns
21

The portfolio expected return is weighted average of the expected return of each asset in the portfolio
R
m

E( p)= w j E ( R j )
j=1

Where:
o Wj is the portfolio weight of asset j
o Rj is the return of asset j
o M = total number of assets

The expected return on a portfolio can also be calculated by determining the portfolio return in each of
the future states and then computing the expected value as we did for individual securities.
R
n

E( p)= pi R P ,i
i=1

Where:
o i= particular state out of the possible n states
pi is the probability that state i can occur
o
RP ,i is the expected future return of the asset if state i occurs
o
o n = total number of possible states
Portfolio Risk
We first find the expected portfolio return, then compute the portfolio return standard deviation using the
same formula as individual assets:
R

E( p)= w j E ( R j )
j=1

E ( p)=

pi [R P , iE( R P )]2
i=1

11.3 Announcements, Surprises and Expected Returns:

Expected and Unexpected Returns:
The expected return and the realized future return are usually not equal.
There is an unexpected component that is not anticipated at time t that occurs at time t+1
o Denoted by U= t+1
Rt +1=E ( Rt +1 ) + t +1
Total Return=Expected return+Unexpected return
22

In efficient markets abnormal profits have zero expected value, hence:

E [ t +1 ]=0
o
o This suggests current market expectations are not biased

11.4 Risk: Systematic and Unsystematic:

Total Risk
Total risk = assets market risk + assets specific risk
Market Risk
A risk that influences a large number of assets. Also called systematic risk
E.g. GDP, unemployment, interest rates, exchange rates, etc
Asset Specific Risk
A risk that affects at most a small number of assets. Also called unsystematic/diversifiable risk.
E.g. Employment Strike within company
11.5 Diversification and Portfolio Risk
Diversification
Spreading an investment across a number of assets will eliminate some but not all, of the risk.
With many assets in a portfolio positive/negative shocks specific to each asset will cancel each other out,
reducing overall risk
o More assets, less unsystematic risk
Market risk affects all securities, thus no matter how many assets in a portfolio, market risk cannot be
eliminated.
11.6 Systematic Risk and Beta
Systematic risk principle
The expected return on a risky asset depends only on the assets systematic risk.
Measuring Systematic Risk
The beta coefficient is the amount of systematic risk present in a particular risky asset relative to that in
an average risky asset
o In other words it is a measure of a stocks risk relative to the market portfolio.
We define the market portfolio to have a =1
Thus stocks with > 1 are particularly sensitive to market fluctuations and a stock with < 1 are
less sensitive.

The risk premium of an asset is tied to the market risk premium:

Market risk premium = r M r f
Risk premium on asset A = r A r f
E [ r A r f ] = A E [ r M r f ]

23

What is the relationship between beta and risk?

Beta only measures the risk of a stock relative to market fluctuations.
However, a stock with a low beta may still be risk overall and a stock with a high beta might have lower
overall risk.
You tend to find high beta stocks in companies that are in high procyclical industries
Portfolio Beta
The weighted average of the betas of the securities in the portfolio.
n

P = wi i
i=1

11.7 The Security Market Line

Capital Asset Pricing Model (CAPM)
It is the relationship between an assets risk premium and the market risk premium
E [ r A r f ] = A E [ r M r f ]

The CAPM defines the relationship between risk and return for any asset.

E [ r A ] =r f + A E [r M r f ]
This means that returns come from either:
o Compensation on time value of money,
o Assets risk premium, A E [ r M r f ]

Rf

Security Market Line

The relationship between expected returns and betas can be graphically represented by a straight line.
o This representation is called the Security Market Line(SML)
The reward to risk ratios must be the same across all assets since they are all on the same SML
o This is just the gradient of the SML
E [ R i ]Rf
SML Slope=
i
If the portfolio is the market portfolio then the SML slope changes to:
SML Slope=E [ Rm ] R f

o Since =1

SML Graph
R (%)
[Required return]
Undervalued
24

Rm

Overvalued

Rf
Risk ()
=1
Key Terminology
Expected return return market expects from the asset in the future calculated from price and
expected cash flows IRR
Realized return past return received by investors in the asset mean of actual previous returns
Required return return calculated from theory based on assets market risk

Motivations for estimating cost of capital:

o To provide required rate of return (hurdle rate) to use in DCF evaluation
o To provide cost of capital for accounting calculations of Economic Value Added (EVA)
o Regulators setting prices for monopoly --> aim for zero EVA
Components of capital:
o Debt:
Money raised from investors in return for contractual payments
Long term (bonds or debentures), Short term (bank bills, overdraft)
Debt may be secured --> default therefore cost of secured debt --> hence risk and cost
of other unsecured debt
Cost of debt = kd
o Preferred shares:
Receive fixed dividends
Preferred because no dividend can be paid on ordinary shares until preferred shareholders
have been fully paid
Equity because no legal right to dividend, can only be paid from profit
Companies will pay preferred dividends of they can
Cost of preferred stock = kp
o Ordinary equity:
Owners of company
Entitled to all remaining funds after other have all been paid
Vote at general meetings, appoint/remove directors
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All limited companies must have shareholders

Cost of ordinary equity = ks
o Watchpoints:
Balance sheets prepared using accrual accounting --> finance techniques such as DFC uses
cash accounting therefore components of capital balance sheet headings
Equity shares, retained profits, reserves only distinguished for tax purposes --> in finance all
are ordinary equity
Trade creditors, accruals are all cash flow timing issues --> in finance, cash flow is explicit
only interested in point where it becomes cash flows and hence not part of cost of capital
Tax considerations rationale:
o Usually calculate costs of capital after allowing for company tax because:
Maximizing shareholder value is maximizing after tax value
To capture investment decisions on tax related cash flows
o Tax allowable debt:
Market return is after tax cost of capital for equity
Interest is tax deductible for the company
If company is paying tax, after tax cost of debt =
(1-t) x (Market cost of debt)
Historic vs current market costs:
o Should we use market cost of capital, or cost of the capital to us eg) from retained profits?
o Opportunity costs issue --> must use current market costs
o Rationale could also use this money to repurchase securities --> this would save the company the
market cost of capital = opportunity cost. Alternatively, the investors could reinvest their capital at
market rate must use as hurdle
Estimating component costs of capital:
o Debt:
Pretax cost of debt = market yield to maturity of issued debt
After tax cost of debt = pretax cost of debt x (1-t)
ie. kdAT = kdBT(1-t)
To calculate yield when not given:
Set up in bond (or other) calculation formula
If x% coupon and x% market rate will trade at FVso if P > FV, yield < x%
Estimate yieldif value > P, yield must be etc
o Preferred shares:
Assume companies will always pay preferred dividend when calculating cost of capital --> as
failure to pay often results in vote entitlement which dilutes ordinary shareholder control
Perpetual preferred shares are a perpetuity
Cost = dividend / price
Pp = Dp / kp
-->
kp = Dp / Pp
Dividends of preferred stock not tax deductible
Do not adjust for tax or floatation cost
o Equity:
CAPM:
Uses SML relationship
ks = krf + s(km krf)
For:
o Backed by theory
26

o Consistent uses market data to estimate market cost of equity

Against:
o Only useful for listed companies
o Estimation problems for
o Assumes shareholder diversified
Discounted cash flow from dividend growth model:
Current price = discounted PV of future dividend cash flows
ks = k(^)s = (D1 / Po) + g(^)
Estimating growth rate:
o From analysts estimates
o Expected growth = retention rate x ROE, where:
ROE is the expected future return on equity
Retention rate is the % of equity earning retained ie. (1 payout ratio)
For:
o Only requires single current share price and dividend
o May be used for unlisted company (price derived from private transactions)
o No assumption that shareholders are diversified
Against:
o Very hard to estimate growth rate
o Using retention ratio x ROE is using accounting data to estimate market cost
of equity
Own bond yield plus risk premium:
Assumes relative bond yields reflect relative equity risk
ks = bond yield + risk premium
Risk premium judgement --> 3-5%
For:
o Simple to implement --> used by those who dont understand other methods
Against:
o No theoretical basis
o Bond yields are assumed to reflect difference in equity risk between
companies:
Bond determinants maturity, coupon, r, default risk
Equity risk determinants earning variability, market correlation,
leverage
Only leverage and default risk are somewhat related
Should you average? averaging does not imply better answer --> judgement call
Floatation costs (of equity):
o Cost of raising new capital eg) brokers, underwriters
o Negative signal that raising new equity may send
o Approaches:
Add to initial investment cost
Allow for in calculation via DCF model:
ks = D1 / Po(1-F) + g(^)
o Depends on type of capital and markets perception (re company riskiness and
negative signal)
o Mainly issue with equity, but equity raising infrequent --> cost per project
small
27

o Often ignored or treated outside the evaluation of other decisions

Notes:
Can use any one of above, or combination --> judgement needed
No correct answer --> estimates are imprecise
WACC (Weighted average cost of capital):
o Cost to company of securities sold to raise funds = return to investor of holder that portfolio
o WACC = k = wdkd(1-t) + wpkp + wsks
o Factors influencing WACC:
Investment policy of firm --> riskiness of its assets - risk = WACC
Market conditions eg) r, average risk premium
Firms capital structure and dividend policy
o Tax imputation and WACC:
Effective company tax rate and tax subsidy for debt will be depending on amount of
company tax which is claimed as personal tax
Dividends must be grossed up by the attached franking credits eg) for cost of equity with
DFC, market/company return for CAPM regression
o WACC as hurdle rate:
Projects should be evaluated with cost of capital appropriate to the risk
WACC is average cost for all companies activities --> need some adjustment for individual
projects
Results of not adjusting for risk: (graph)
risk but positive NPV projects will be rejected
risk but negative NPV project will be accepted
average company risk will
returns to shareholder will be than they should be
o Types of project risk:
Standalone risk cash flow variability
Corporate risk effect of project on total firm cash flow
Market risk effect on firms market / beta risk
Market risk is theoretically correct for maximizing wealth of diversified shareholder
Corporate risk relevant to undiversified shareholder, creditors and employees
Balance these considerations using judgements
o Project risk adjustment procedures:
Subjective adjustment of WACC for projects of different risk
Evaluate project as if standalone company and estimate for market risk adjustment
Use one of above to establish cost of capital for each division and use that for the divisions
projects:
Pure play find companies that operate only in the same areas as the division,
estimate and average s --> difficult
Accounting beta regress divisions ROA against ROA of companies in similar
markets --> these s are somewhat correlates, but difficult to get ROAs for projects
that dont exist
Week 11 onwards
Capital Structure:
o Financial leverage use of debt and preferred stock
o Financial risk additional risk resulting from financial leverage
o Example re financial leverage

28

Ratios:
BEP Basic Earning Power = EBIT / assets
ROE Return on Equity = NI after tax / OE
TIE times Interest Earned = EBIT / interest
Conclusions:
To expected ROE, must have BEP > kd because if not, then interest expense >
operating income produced by debt-financed assets; therefore leverage income
As debt , TIE because EBIT is unaffected by debt and interest expense (Int Exp
= kdD)
BEP is unaffected by financial leverage
The effects of taxes on capital structure:
o Classical tax system:
Company income is taxed, then shareholders pay tax on dividends
o Imputation taxation systems:
Company tax is paid, shareholders get a franking credit on dividends
Capital gains tax tax paid on real capital profits (1/2 personal rate)
o Effect on value of the firm:
VL = VU + [ tcI / kd ]
VL = VU + PV of annual tax savings
Effectively get govt paying some of your interest repayment as it is tax deductible why
not borrow everything
Costs of financial distress:
firm borrows, probability it will default
Direct costs liquidation costs (legal, accounting fees)
Indirect costs lost sales, value for assets in illiquid markets, managerial time, firm
specific human capital etc
Thus, Value = Value if all equity financed + PV of tax savings PV of expected
bankruptcy costs
Company taxes and personal taxes:
o VL = VU + [ 1 (1 tc)(1 ts)] D
(1 td)
where tc corporate tax rate , ts shareholder tax rate
(average div +
cap gains rates), td debt tax rate
o Provide [ ] > 0, VL > VU
o But with imputation, no advantage for un/levered firm
o Imputation removes any tax advantage for debt, other reasons for debt if
return > cost
Business risk:
o Uncertainty about future operating income (EBIT) how well can we predict operating income?
o Business risk does not include financing effects
o Determinants of business risk:
Uncertainty about demand (sales) variability, risk
Uncertainty about output prices
Uncertainty about costs
Product, other types of liability
Operating leverage:
Use of fixed costs rather than variable costs

29

If more costs are fixed (ie. do not when demand falls) operating leverage
Effect of operating leverage:
o operating leverage
business risk (because small sales causes big profit
break even point
area to make a loss, but past break even point profit region ie.
region of profit and losses
Profits can by by FC mechanise production process
variable costs may work, may not
Operating leverage can E(EBIT), but also risk in mean but at
cost of dispersion ie risk
Business risk vs financial risk:
o Business risk depends on business factors competition, product liability, operating leverage
shared between shareholders and debt holders
o Financial risk depends only on the types of securities issued debt = financial risk
shareholders only
Operating leverage and financial leverage combined:
o Degree of operating leverage:
DOL = 1 + (FC / NI)
o Degree of financial leverage:
DFL = 1 + [ I / (FC + NI) ]
o Degree of total leverage:
DTL = DOL x DFL
o Questions
Optimal capital structure:
o Capital structure (mix of debt, preferred and common equity) at which P0 is maximised
o Trades off E(ROE) and EPS against risk the tax benefits of leverage are exactly offset by the
debts risk costs
o Target capital structure is mix with which firm intends to raise capital
o If debt levels , riskiness of firm
o This riskiness = cost of debt, but also equity (ks)
o The Hamada Equation:
Quantifies the cost of equity due to financial leverage ie. if D , tell us the new cost of
equity
Uses the unlevered beta business risk of a firm if it had no debt
L = U [ 1 + (1 T)( D/E ) ]
Note: in CAPM is L
o Other factors re target capital structure:
Industry average debt ratio
TIE ratios under different scenarios TIE, rate lender will charge
Lender / rating agency attitudes
Reserve borrowing capacity
Effects of financing on control
Asset structure intangible assets able to borrow
Expected tax rate
Modigliani-Miller Irrelevance Theory:
o Capital structure of a firm is irrelevant to firms value
o Uses many assumptions eg) shareholders have same info as managers, no bankruptcy costs, no taxes
(MM vs reality graph)
o Incorporating signaling effects:
Signaling theory suggests firms should use debt than MM suggests
30

This unused debt capacity helps avoid stock sales, which stock price because of signaling
effects
If we assume:
Managers have better info than outsiders and that managers cat in best interest of
stockholders, then management would:
Issue stock if they think it is overvalued
Issue debt if they think stock is undervalued
Hence, investors view stock offering as a negative signal empirically cause share
price to
Conclusions on capital structure:
o Need to make calculations but only estimates
o judgmental component
o capital structures therefore differ widely, even within industries
Welsh: (level of detail?)
o Empirically found that external stock market influences capital structure mostly (specifically, lagged
stock returns)
o Concluded that managers are essentially inert ie. capital structure is imposed by external forces and
not management intervention
Dividend policy:
o Decision to pay out earning vs retain and reinvest
o Theories:
Dividend irrelevance:
Investors dont care about payout any OK
Investors are indifferent between dividends and capital gains create their own
dividend policy
ie. want cash sell stock; no cash use div to buy more stock
Proposed by MM but on unrealistic assumptions eg) no taxes, brokerage costs
difficult to test empirically
Bird-in-the-hand:
Investors prefer a high payout
Investors think dividends are risky than potential capital gains like dividends
payout = price
Tax preference:
Investors prefer a low payout
Retained earnings lead to long-term capital gains, which are taxed at rate to
dividends capital gains also deferred (therefore still preferred even if taxed
equally)
payout = price
Note: reverse implication for cost of equity eg) tax preference > irrelevance > bird-in-thehand
Dont know which theory is correct manager use judgment (must apply analysis with
judgment)
o Information content or signaling hypothesis:
Managers wont dividends unless they think it is sustainable so investors view dividend
as managements view of the future
Therefore price could reflect E(EPS) not desire for dividends
o Clientele effect:

31

Different groups of investors prefer different dividend policies

Firms past dividend policy determines its current clientele
Therefore clientele effect impedes changing dividend policy (tax, brokerage costs) change
unfavourable to existing clientele
Residual dividend model:
Payout as dividends residual of earnings after taking out retained earnings needed for the
capital budget
This minimises floatation and equity signaling costs, hence minimises WACC
Dividends = Net Income (Target equity ratio x Total capital budget)
Then divide this by Net Income for ratio
Implies that dividend will change every year empirically wrong
Change in investment opportunities:
good investment = capital budget = dividend payout
good investment = payout
Advantage minimises frequency of new stock issues and floatation costs
Disadvantages results in variable dividends, sends conflicting signals, risk, doesnt appeal
to any clientele
Conclusion consider residual model when setting target payout, but dont follow rigidly
adjust slowly only if circumstances allow
Dividend reinvestment plan (DRIP):
Shareholders can reinvest dividends in shares of the companys common stock get more
stock instead of cash
Types of plans:
Open market:
o Dollars to be invested are turned over to a trustee, who buys shares on the
open market
o brokerage costs due to volume, convenient
o Equity capital ie. no of shares, doesnt change
New stock:
o Firms issue new stock (usually at a discount), keeps money and uses it to buy
assets
o Convenient way for company to expand capital base
Firms that need new equity use new stock plans
Firms with no need for new equity use open market plans
Setting dividend policy:
Forecast capital needs over a planning horizons eg) 5 years
Set a target capital structure
Estimate annual equity needs
Set target payout based on residual model
Generally, some dividend growth rate emerges try to maintain this growth rate, varying
capital structure somewhat if necessary
Stock repurchases:
Buying own stock back from shareholders
Reasons:
Alternative to distributing cash as dividends allows investors to realise capital
gains as opposed to dividends
To dispose of one-time cash from an asset sale

32

 To make a large capital structure change

Advantages:
Stockholder can tender or not
Helps avoid setting dividends that cant be maintained
Repurchased stock can be used in takeovers or resold to raise cash as needed
greenmail reacquisition of shares from hostile bidder at a premium
Income received is capital gains rather than taxed dividends
Stockholders may take as positive signal management thinks stock is undervalued
Disadvantages:
May be viewed as a negative signal poor investment opportunities. Repurchase is
a zero NPV project (div = price) can signal that this is the best option available to
firm (assumes however that market is efficient)
Penalties if purpose was to avoid taxes on dividends
Selling stockholders may be ill-informed, hence treated harshly
Firm may have to bid up prices to complete purchase, thus paying too much for its
own stock
Reasons for undertaking share buybacks (Lamba and Ramsay 2001):
Leverage D/E ratio
Information signaling might signal undervaluation
Anti-takeover mechanism buyout hostile shareholders
Wealth transfer more wealth to shareholders if undervalued
Free cash flow cash left after all + NPV projects. Managers reluctant to give up
FCF b/c of possible wage may invest in NPV projects instead therefore buy
back positive
Earnings per share (magic?) false: assets would therefore expect earning to , PE
ratio would likely change more risky as D/E (cant work, otherwise would do it
to max)
Conclusions (of the article):
o Share buy backs are good news
o Share markets are efficient at pricing with buybacks
o Buybacks signal stock is undervalued wealth transfer to those who stay
with the company
o Stock dividends and stock splits:
Stock dividend firm issues new shares instead of cash dividend price as + signal
Stock split firm increases the number of shares outstanding no change in price
Both number of shares
All things remaining constant, both will cause price to to keep each investors wealth
unchanged
Both may get stock to an optimal price range
Stock splits generally occur when management is confident, so are interpreted as positive
signals
Note cum-dividend (declared but not paid) vs ex-dividend (after paid)
o Australian Tax System:
Before imputation capital gains taxed at full income rates after indexation for CPI
Now (since 1999) no indexation but tax rate is half that of income

33

Maximizing firm value:

o Managers want to maximize share price not always the same as maximizing value of
shareholders investment agency issues
o Determination of share price:
Expected cash flows generated by assets
Timing of these cash flows earlier preferable
Riskiness of cash flows
o Determination of cash flows:
Investment decisions
The way investments are funded debt vs equity
Dividend policy
o Share price, EPS, cash flows are correlated all when sales
o Take care when using EPS or cash flows as an indicator of share price as also depends on
expected future earnings and cash flows

34