Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
MANAJEMEN KEUANGAN
CHAPTER 1
WHAT IS CORPORATE FINANCE ?
What is Corporate Finance?
Corporate finance attempts to find the answers to the
following questions:
Cash Flow Risk
The role of the financial manager is to deal with the
uncertainty associated with investment decisions.Assessing
the risk associated with the size and timing of expected
future cash flows is critical to investment decisions.
Which is the better project?
–What investments should the business take on?
THE INVESTMENT DECISION
–How can finance be obtained to pay for the required
investments?
THE FINANCE DECISION
–Should dividends be paid? If so, how much?
THE DIVIDEND DECISION
The Financial Manager
Financial managers try to answer some or all of these
questions. The top financial manager within a firm is
usually the General Manager–Finance.
–Corporate Treasurer or Financial Manager,oversees cash
management, credit management, capital expenditures and
financial planning.
–Accountant,oversees taxes, cost accounting, financial
accounting and data processing.
The Investment Decision
Capital budgetingis the planning and control of cash
outflows in the expectation of deriving future cash inflows
from investments in non-current assets.
Involvesevaluatingthe:
–sizeoffuturecashflows
–timingoffuturecashflows
–riskoffuturecashflows.
Cash Flow Size
Accounting income does not mean cash flow.For example, a
sale is recorded at the time of sale and a cost is recorded
when it is incurred, not when the cash is exchanged.
Cash Flow Timing
A dollar today is worth more than a dollar at some future
date.There is a trade-off between the size of an
investment’s cash flow and when the cash flow is received.
Which is the better project?
Capital Structure
A firm’s capital structure is the specific mix of debt and
equity used to finance the firm’s operations.Decisions need
to be made on both the financing mix and how and where
to raise the money.
Working Capital Management
How much cash and inventory should be kept on hand?
Should credit terms be extended? If so, what are the
conditions?
How is short-term financing acquired?
Dividend Decision
Involves the decision of whether to pay a dividend to
shareholders or maintain the funds within the firm for
internal growth.Factors important to this decision include
growth opportunities, taxation and shareholders’
preferences.
Corporate Forms of Business Organisation
The three different legal forms of business
organisation are:
sole proprietorship
partnership
company.
Sole Proprietorship
The business is owned by one person.
The least regulated form of organisation.
Owner keeps all the profits but assumes unlimited liability
for the business’s debts.
Life of the business is limited to the owner’s life span.
Amount of equity raised is limited to owner’s personal
wealth.
Partnership
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PE1
1959
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
The business is formed by two or more owners.
All partners share in profits and losses of the business and
have unlimited liability for debts.
Easy and inexpensive form of organisation.
Partnership dissolves if one partner sells out or dies.
Amount of equity raised is limited to the combined personal
wealth of the partners.
Income is taxed as personal income to partners.
Cash Flows between the Firm and the Financial Markets
Company
A business created as a distinct legal entity composed of
one of more individuals or entities.
Most complex and expensive form of organisation.
Shareholders and management are usually separated.
Ownership can be readily transferred.
Both equity and debt finance are easier to raise.
Life of a company is not limited.
Owners (shareholders) have limited liability.
Possible Goals of Financial Management
Survival
Avoid financial distress and bankruptcy
Beat the competition
Maximise sales or market share
Minimise costs
Maximise profits
Maintain steady earnings growth
Problems with these Goals
Each of these goals presents problems.
These goals are either associated with increasing
profitability or reducing risk.
They are not consistent with the long-term interests of
shareholders.
It is necessary to find a goal that can encompass both
profitability and risk.
Financial Markets
Financial marketsbring together the buyers and sellers of
debt and equity securities.
Money marketsinvolve the trading of short-term debt
securities.
Capital marketsinvolve the trading of long-term debt
securities.
Primary marketsinvolve the original sale of securities.
Secondary marketsinvolve the continual buying and selling
of issued securities.
Structure of Financial Markets
The Firm’s Objective
The goal of financial management is to maximise
shareholders’ wealth.
Shareholders’ wealth can be measured as the current value
per share of existing shares.
This goal overcomes the problems encountered with the
goals outlined above.
Agency Relationships
The agency relationshipis the relationship between the
shareholders (owners) and the management of a firm.
The agency problemis the possibility of conflict of interests
between these two parties.
Agency costsrefer to the direct and indirect costs arising
from this conflict of interest.
Do Managers Act in Shareholders’ Interests?
The answer to this will depend on two factors:
how closely management goals are aligned with
shareholder goals
the ease with which management can be replaced if it does
not act in shareholders’ best interests.
Alignment of Goals
The conflict of interests is limited due to:
management compensation schemes
monitoring of management
the threat of takeover
other stakeholders.
Two-period Perfect Certainty Model
Explains the behaviour of firms and individuals.
Relies on three assumptions:
 –perfect certainty
 –perfect capital markets
 –rational investors.
The certainty model uses two periods—now (period 1) and
the future (period 2).Individuals make consumption choices
based on their tastes and preferences and the investment
opportunities available to them.
Utility curves represent indifference between period 1
(consume now) and period 2 (invest now, consume later)
consumption.
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PE1
1960
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Utility curves
Representation of Opportunities
Opportunities facing firms in a two-period world include:
 –investment/production
 –payment of dividends.
The production possibility frontier represents attainable
combinations of period 1 (pay dividend now) and period 2
(invest now, pay dividend later) dollars from a given
endowment of resources.
Production possibility frontier
Optimal Investment Policy
Fisher’s Separation Theorem
In a perfect capital market, it is possible to separate the
firm’s investment decisions from the owners’ consumption
decisions.
The Investment Decision
The point of wealth and utility maximisation for all
shareholders can be reached through one of two rules:
–Net present value rule: invest so as to maximise the net
present value of the investment.
–Internal rate of return rule: Invest up to the point at which
the marginal return on the investment is equal to the
expected rate of return on equivalent investments in the
capital market.
Implications of Fisher’s Analysis
It is only the investment decision that affects firm value.
Firm value is not affected by how investments are financed
or how the distribution (dividends) are made to the owners.
CHAPTER 2
FINANCIAL STATEMENTS, TAXES,AND CASHFLOW
Utility Maximisation
Firms should invest funds until they reach a point on the
production frontier that is just tangential to the market line.
This then places the owner on the highest possible utility
curve given the resources available.At this point, the
owner’s utility is maximised.However, a problem exists if
there is more than one owner.
Solution for Multiple Owners
Introduce a capital market—resources can be transferred
between the present and the future.
Add the market line.
This produces an optimal investment policy where
production possibility frontier is tangential to the market
line.
Consumption decisions can be made using the capital
market.
The Statement of Financial Position
Shows a firm’s accounting value on a particular date.
Equation:
Assets = Liabilities + Shareholders’ Equity
Assets are listed in order of liquidity.
Net working capital = Current Assets –Current Liabilities
Liquidity
The speed and ease with which an asset can be converted
to cash without significant loss of value.
Current assets are liquid (e.g. debtors).
The more liquid a business is, the less likely it is to
experience financial distress, but liquid assets are less
profitable to hold.
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1961
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Statement of financial position
The Statement of Financial Performance (Income
statement)
Measures a firm’s performance over a period of time.
Equation:
Revenues –Expenses = Profit
The difference between net profit and cash dividends is
called retained earnings, which is added to the retained
earnings account in the Statement of Financial Position.
Example—Statement of Financial Performance
Debt versus Equity
Creditors have first claim on a firm’s cash flow; equity
holders have a residual claim.Financial leverage is the use of
debt in a firm’s capital structure.Financial leverage increases
the potential reward to shareholders, but also increases the
potential for financial distress and business failure.
Example—Statement of Financial Position
Market Value versus Book Value
Generally Accepted Accounting Principles (GAAP) require
audited financial statements to show assets at historical
cost or book value.Revaluations of assets to fair value are
permitted.The value of a firm relates to market value, or the
price that could be obtained in the current market place.
Example—Market Value versus Book Value
ABC Company has fixed assets with a book value of $1700
but they have been revalued to have a market value of
$2000. Net working capital has a book value of $1000, but if
all current accounts were liquidated, the company would
collect $1400. ABC Company has $1500 in long-term debt—
both book value and market value.
Recording of Financial Statement Entries
The realisation principle is to recognise revenue at the time
of sale.Costs are recorded according to the matching
principle, that is, revenues are identified and costs
associated with these revenues are matched and recorded.
Differences
The figures on the Statement of Financial Performance may
differ from actual cash inflows and outflows during a period
due to:
–Revenues and costs being recorded when they are
realised, not when they are received or paid.
–The existence of non-cash items such as depreciation.
Corporate and Personal Tax Rates
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PE1
1962
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Tax Rates
The average tax rateis the total tax bill divided by taxable
income, that is, the percentage of income that goes in
taxes.. The marginal tax rateis the extra tax paid if one more
dollar is earned.A flat rateis where there is only one tax rate
that is the same for all income levels. An example is the tax
rate that applies to companies in Australia.
Statement of Financial Performance or Income statement
('000s)
Example—Tax Rates
An individual has a taxable income of $28 500.
Total tax liability is $4930 (based on the current tax scales).
The average tax rate is 17.30 per cent.
The marginal tax rate is 30 per cent.
Cash Flow from Assets
The total cash flow from assets consists of:
–operating cash flow—the cash flow that results from dayto-day activities of producing and selling; less
–capital spending—the net spending on non-current assets;
less
–additions to net working capital (NWC)—the amount spent
on net working capital.
Cash flow from assets
Cash Flow from Assets
Cash flow from assets = cash flow to debtholders + cash
flow to shareholders
The cash flow to debtholders includes any interest paid less
the net new borrowing.The cash flow to shareholders
includes dividends paid out by a firm less net new equity
raised.
Cash Flow Summary
Operating cash flow = Earnings before interest and taxes
(EBIT) + Depreciation –Taxes
Net capital spending = Ending net fixed assets –Beginning
net fixed assets + Depreciation
Change in NWC = Ending NWC –Beginning NWC
Statement of Financial Position ('000s)
Cash Flows to Debtholders and Shareholders
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PE1
1963
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
CHAPTER 3
WORKING WITH FINANCIAL STATEMENTS
Cash
Cash is generated by selling a product or service, asset or
security.Cash is spent by paying for materials and labour to
produce a product or service and by purchasing assets.
Recall:
Cash flow from assets = Cash flow to debtholders + Cash
flow to shareholders
Cash Flow
Sources of cashare those activities that bring in cash.Uses of
cashare those activities that involve spending cash.The
firm’s statement of cash flowsis the firm’s financial
statement that summarises its sources and uses of cash
over a specified period.
Statement of Financial Position ('000s)
Statement of Cash Flows
A statement that summarises the sources and uses of cash.
Changes are divided into three main categories:
–Operating activities—includes net profit and changes in
most current accounts
–Investment activities—includes changes in fixed assets
–Financing activities—includes changes in notes payable,
long-term debt and equity accounts as well as dividends.
Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
–Any increase in current assets (except cash)
–Decrease in accounts payable
Investment activities
+ Ending fixed assets
–Beginning fixed assets
+ Depreciation
Financing activities
–Decrease in notes payable
+ Increase in notes payable
–Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
–Dividends paid
Statement of Financial Performance ('000s)
Putting it all together, the net addition to cash for the
period is:$91.55 –145.00 + 58.45 = $5.00
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PE1
1964
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
‘Players’ in Accounting Standards
AccountantsGovernment
RegulatorsOther users
Ratio Analysis
Financial ratiosare relationships determined from a firm’s
financial information.Used to compare and investigate
relationships between different pieces of financial
information, either over time or between companies.Ratios
eliminate the size problem.
Categories of Financial Ratios
Liquidity—measures the firm’s short-term solvency.
Capital structure—measures the firm’s ability to meet longrun obligations (financial leverage).
Asset management (turnover)—measures the efficiency of
asset usage to generate sales.
Profitability—measures the firm’s ability to control
expenses.
Market value—per-share ratios.
Profitability Ratios
Liquidity Ratios
Capital Structure Ratios
Market Value Ratios
The Du Pont Identity
Breaks ROE into three parts:
–operating efficiency
–asset use efficiency
–financial leverage
Turnover Ratios
Uses for Financial Statement Information
Internal uses:
–performance evaluation
–planning for the future
External uses:
–evaluation by outside parties
–evaluation of main competitors
–identifying potential takeover targets
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1965
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Benchmarks for Comparison
Ratios are most useful when compared to a benchmark.
Time-trend analysis—examine how a particular ratio(s) has
performed historically.
Peer group analysis—using similar firms (competitors) for
comparison of results.
Global Industry Classification Standard (GICS) used by ASX is
a useful way to find a peer company.
Problems with Ratio Analysis
No underlying theory to identify correct ratios to use or
appropriate benchmarks.
Benchmarking is difficult for diversified firms.
Firms may use different accounting procedures.
Firms may have different recording periods.
One-off events can severely affect financial performance.
Assume that:
1.Sales are projected to rise by 25 per cent
2.The debt/equity ratio stays at 2/3
3.Costs and assets grow at the same rate as sales
Pro-Forma Financial Statements
CHAPTER 4
LONG-TERM FINANCIAL PLANNING AND CORPORATE
GROWTH
What is Financial Planning?
Formulates the way financial goals are to be
achieved.Requires that decisions be made about an
uncertain future.Recall that the goal of the firm is to
maximise the market value of the owner’s equity—growth
will result from this goal being achieved.
Dimensions of Financial Planning
The planning horizonis the long-range period that the
process focuses on (usually two to five years).Aggregationis
the process by which the smaller investment proposals of
each of a firm’s operational units are added up and treated
as one big project.Financial planning usually requires three
alternative plans: a worst case, a normal case and a best
case.
Accomplishments of Planning
Interactions—linkages between investment proposals and
financing choices.
Options—firm can develop, analyse and compare different
scenarios.
Avoiding surprises—development of contingency plans.
Feasibility and internal consistency—develops a structure
for reconciling different objectives.
Elements of a Financial Plan
An externally supplied sales forecast (either an explicit sales
figure or growth rate in sales).
Projected financial statements (pro-formas).
Projected capital spending.
Necessary financing arrangements.
Amount of new financing required (‘plug’ figure).
Assumptions about the economic environment.
What is the plug?
Notice that projected net income is $12.50, but equity only
increases by $7.50. The difference, $5.00 paid out in cash
dividends, is the plug.
Percentage of Sales Approach
A financial planning method in which accounts are varied
depending on a firm’s predicted sales level.
Dividend payout ratiois the amount of cash paid out to
shareholders.
Retention ratiois the amount of cash retained within the
firm and not paid out as a dividend.
Capital intensity ratiois the amount of assets needed to
generate $1 in sales.
Example—Financial Performance Statement
Example—Pro-Forma Financial Performance Statement
Example—A Simple Financial Planning Model
Recent Financial Statements
Example—Steps
Use the original financial position statement to create a proforma; some items will vary directly with sales.
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1966
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Calculate the projected addition to retained earnings and
the projected dividends paid to shareholders.
Calculate the capital intensity ratio.
Example—Financial Position Statement
Example—Results of Model
The good news is that sales are projected to increase by 25
per cent.The bad news is that $535 of new financing is
required.This can be achieved via short-term borrowing,
long-term borrowing and new equity issues.The planning
process points out problems and potential conflicts.
Assume that $225 is borrowed via notes payable and $310
is borrowed via long-term debt.
‘Plug’ figure now distributed and recorded within the
financial position statement.
A new (complete) pro-forma financial position statement
can be derived.
Example—Pro-Forma Financial Position Statement
Example—Partial Pro-Forma Financial Position Statement
External Financing and Growth
The higher the rate of growth in sales/assets, the greater
the external financing needed (EFN).Need to establish a
relationship between EFN and growth (g).
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PE1
1967
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Example—Statement of Financial Performance
If the required increase in assets exceeds the internal
funding available (that is, the increase in retained earnings),
then the difference is the external financing needed(EFN).
Example—External Financing Needed
Increase in total assets= $1000 ×20%= $200
Addition to retained earnings = 0.14($500)(36%) ×1.20= $30
The firm needs an additional $200 in new financing.
$30 can be raised internally.
The remainder must be raised externally (external financing
needed).
Ratios Calculated
p(profit margin)=14%
R(retention ratio)=36%
ROA (return on assets)=7%
ROE (return on equity)= 12.7%
D/E(debt/equity ratio)=.818
Growth
Next year’s sales forecasted to be $600.
Percentage increase in sales:
Relationship
Setting EFN to zero, gcan be calculated to be 2.56 per cent.
This means that the firm can grow at 2.56 per cent with no
external financing (debt or equity).
Increase in Assets
What level of asset investment is needed to support a given
level of sales growth?
Financial Policy and Growth
The example so far sees equity increase (via retained
earnings), debt remain constant and D/Edecline.
For simplicity, assume that the firm is at full capacity.
The indicated increase in assets required equals:
If D/Edeclines, the firm has excess debt capacity.
If the firm borrows up to its debt capacity, what growth can
be achieved?
A×g
where A= ending total assets from the previous period
How will the increase in assets be financed?
Sustainable Growth Rate (SGR)
The sustainable growth rateis the growth rate a firm can
maintain given its debt capacity, ROE and retention ratio.
Internal Financing
Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
This addition to retained earnings represents the level of
internal financingthe firm is expected to generate over the
coming period.
Example—Sustainable Growth Rate
Continuing from the previous example:
The expected addition to retained earnings is:
Where
S= previous period’s sales
g= projected increase in sales
p= profit margin
R= retention ratio
External Financing Needed
The firm can increase sales and assets at a rate of 4.82 per
cent per year without selling any additional equity and
without changing its debt ratio or payout ratio.
Growth rate depends on four factors:
–profitability (profit margin)
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1968
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
–dividend policy (dividend payout)
–financial policy (D/Eratio)
–asset utilisation (total asset turnover)
Do you see any relationship between the SGR and the Du
Pont identity?
Summary of Growth Rates
1.Internal growth rate
This growth rate is the maximum growth rate that can be
achieved with no external debt or equity financing.
2.Sustainable growth rate
The SGR is the maximum growth rate that can be achieved
with no external equity financing while borrowing to
maintain a constant D/Eratio.
Important Questions
It is important to remember that we are working with
accounting numbers and we should ask ourselves some
important questions as we go through the planning process.
How does our plan affect the timing and risk of our cash
flows?
Does the plan point out inconsistencies in our goals?
If we follow this plan, will we maximise owners’ wealth?
CHAPTER 5
FIRST PRINCIPLES OF VALUATION : THE TIME VALUE
OF MONEY
–interest earned$33.10
Using simple interest, the total interest earned would only
have been $30. The other $3.10 is from compounding.In
general, the future value, FVt,of $1 invested today at r per
cent for tperiods is:
The expression (1 + r)tis the future value interest
factor(FVIF).
Example—Future Value of a Lump Sum
Whatwill$1000amounttoinfiveyearstimeifinterestis12perce
ntperannum,compoundedannually?
From the example, now assume interest is 12 per cent per
annum, compounded monthly.Always remember that tis
the number of compounding periods, not the number of
years.
Interpretation
The difference in values is due to the larger number of
periods in which interest can compound.Future values also
depend critically on the assumed interest rate—the higher
the interest rate, the greater the future value.
Future Values at Different Interest Rates
Time Value Terminology
Future value (FV) is the amount an investment is worth
after one or more periods.Present value (PV) is the current
value of one or more future cash flows from an investment.
The number of time periods between the present value and
the future value is represented by ‘t’.The rate of interest for
discounting or compounding is called ‘r’.All time value
questions involve four values: PV, FV, rand t. Given three of
them, it is always possible to calculate the fourth.
Interest Rate Terminology
Simple interestrefers to interest earned only on the original
capital investment amount.Compound interestrefers to
interest earned on both the initial capital investment and on
the interest reinvested from prior periods.
Future Value of $1 for Different Periods and Rates
Future Value of a Lump Sum
You invest $100 in a savings account that earns 10 per cent
interest per annum (compounded) for three years.
After one year:$100 x(1 + 0.10) = $110
After two years: $110 x(1 + 0.10) = $121
After three years:$121 x(1 + 0.10) = $133.10
Future Value of a Lump Sum
The accumulated value of this investment at the end of
three years can be split into two components:
–original principal$100
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1969
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Given any three factors in the present value or future value
equation, the fourth factor can be solved.r can be solved in
one of three ways:
Use a financial calculator
Take the nthroot of both sides of the equation
Use the future value tables to find a corresponding value.
In this example, you need to find the rfor which the FVIF
after 21 years is 5 (500/100).
Present Value of a Lump Sum
Youneed$1000inthreeyearstime.Ifyoucanearn10per
Centperannum,howmuchdoyouneedtoinvestnow?
Interpretation
In general, the present value of $1 received in tperiods of
time, earning per cent interest is:
The Rule of 72
The ‘Rule of 72’ is a handy rule of thumb that states:If you
earn r per cent per year, your money will double inabout
72/rper cent years.For example, if you invest at 6 per cent,
your money will double in about 12 years.This rule is only
an approximate rule.
Future Value of Multiple Cash Flows
The expression (1 + r)–tis the present value interest
factor(PVIF).
Example—Present Value of a Lump Sum
Your rich grandmother promises to give you $10 000 in 10
yearstime. If interest rates are 12 per cent per annum, how
much isthat gift worth today?
You can solve by either:
–compounding the accumulated balance forward one year
at a time
–calculating the future value of each cash flow first and
then totalling them.
Solutions
Solution 1
–End of year 1:($1000 1.10) + $1500 =$2600
–End of year 2:($2600 1.10) + $2000 =$4860
–End of year 3:($4860 1.10) + $2500 =$ 846
Present Values at Different Interest Rates
Solution 2
Present Value of $1 for
RatesPresentvalueof $1 ($)
Different
Periods
and
Future value calculated by compounding forward one
period at a timeTime(years)
Future value calculated by compounding each cash flow
separately (Calculation of FV for Multiple Cash Flow Stream)
Solving for the Discount Rate
You currently have $100 available for investment for a 21yrs
period. At what interest rate must you invest this amount in
order for it to be worth $500 at maturity?
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Present Value of Multiple Cash Flows
You will deposit $1500 in one year’s time, $2000 in two
years time and $2500 in three years time in an account
paying 10 per cent interest per annum. What is the present
value of these cash flows?
Example 1
You will receive $500 at the end of each of the next five
years. The current interest rate is 9 per cent per annum.
What is the present value of this series of cash flows?
You can solve by either:
–discounting back one year at a time
–calculating the present value of each cash flow first and
then totalling them.
Solution 1
Solution 2
Present value calculated by discounting each cash flow
separately
Example 2
You borrow $7500 to buy a car and agree to repay the loan
by way of equal monthly repayments over five years. The
current interest rate is 12 per cent per annum, compounded
monthly. What is the amount of each monthly repayment?
Future Value of an Annuity
The compounding term is called the future valueinterest
factor for annuities (FVIFA).
Example :
What is the future value of $200 deposited at theend of
every year for 10 years if the interest rate is6 per cent per
annum?
Present value calculated by discounting back one period at a
time
Perpetuities
The future value of a perpetuity cannot be calculated as the
cash flows are infinite.The present value of a perpetuity is
calculated as follows:
Annuities
An ordinary annuityis a series of equal cash flows that occur
at the end of each period for some fixed number of
periods.Examples include consumer loans and home
mortgages.A perpetuityis an annuity in which the cash flows
continue forever.
Comparing Rates
The nominal interest rate(NIR) is the interest rate expressed
in terms of the interest payment made each period.The
effective annual interest rate(EAR) is the interest rate
expressed as if it was compounded once per year.When
interest is compounded more frequently than annually, the
EAR will be greater than the NIR.
Present Value of an Annuity
Calculation of EAR
C= equal cash flow
The discounting term is called the present value interest
factor for annuities(PVIFA
m = number of times the interest is compounded
Comparing EARS
Considerthefollowinginterestratesquotedbythreebanks:
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–Bank A:15%, compounded daily
–Bank B:15.5%, compounded quarterly
–Bank C:16%, compounded annually
Bond Yields
Yield to maturityis the market interest rate that equates a
bond’s present value of interest payments and principal
repayment with its price.There is an inverse relationship
between market interest rates and bond price.
Bond Price Sensitivity to Interest Rates (YTM)
Which is the best rate? For a saver, Bank B offers the best
(highest) interest rate. For a borrower, Bank C offers the
best (lowest) interest rate.The highest NIR is not necessarily
the best.Compounding during the year can lead to a
significant difference between the NIR and the EAR.
Types of Loans
A pure discount loanis a loan where the borrower receives
money today and repays a single lump sum in the future.An
interest-only loan requires the borrower to only pay interest
each period and to repay the entire principal at some point
in the future.An amortised loanrequires the borrower to
repay parts of both the principal and interest over time.
Bond Value
Amortisation of a Loan
Example 1—Bond Value
Example 2—Bond Value
CHAPTER 6
VALUING SHARES AND BONDS
Debt Securities
Debt securities are issued when an organisation wishes to
borrow money from the public on a long-term basis.Bonds
are issued by the government.Debentures are secured and
issued by a corporation.Notes are unsecured debt securities
issued by a corporation.More recently, these are all known
as bonds.
Bond Features
Coupon paymentsare the stated interest payments.
Payment is constant and payable every year or halfyear.Face value(par value) is the principal amount repayable
at the end of the term.Coupon rateis the annual coupon
divided by the face value.Maturityis the specified date at
which the principal amount is payable.
Interest Rate Risk
Interestrateriskistheriskthatarisesforbondholdersfromchang
esininterestrates.All other things being equal, the longer the
time to maturity, the greater the interest rate risk.All other
things being equal, the lower the coupon rate, the greater
the interest rate risk.
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1972
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Interest Rate Risk and Time to Maturity
Example—Constant Growth Dividend
Company XYZ has just paid a dividend of 15 cents per share,
which is expected to grow at 5 per cent per annum. What
price should you pay for the share if the required rate of
return on the investment is 10 per cent?
Non-constant Growth Dividend
The growth rate cannot exceed the required rate of return
indefinitely but can do so for a number of years.Allows for
‘super normal’ growth rates over some finite length of
time.The dividends have to grow at a constant rate at some
point in the future.
Computing Yield to Maturity
Yield to maturity (YTM) is the rate implied by the current
bond price.Finding the YTM requires trial and error if you do
not have a financial calculator and is similar to the process
for finding rwith an annuity.If you have a financial
calculator, enter N, PV, PMT and FV, remembering the sign
convention (PMT and FV need to have the same sign, PV the
opposite sign).
Example—Non-constant Growth Dividend
A company has just paid a dividend of 15 cents per share
and that dividend is expected to grow at a rate of 20 per
cent per annum for the next three years, and at a rate of 5
per cent per annum forever after that.Assuming a required
rate of return of 10 per cent, calculate the current market
price of the share.
Solution—Non-constant Growth Dividend
YTM with Annual Coupons
Ordinary Share Valuation
Share valuation is more difficult than debenture valuation
for a number of reasons:
–uncertainty of promised cash flows
–shares have no maturity
–observing the market rate of return is not easy.
The market value of a share is the present value of all
expected net cash flows to be received from the share,
discounted at a rate of return that reflects the riskiness of
those cash flows.The expected net cash flows to be received
from a share are all future dividends.Dividend growth is an
important aspect of share valuation.
Zero Growth Dividend
Shares have a constant dividend into perpetuity, with no
growth in dividends.The value of a share is then the same as
the value of an ordinary perpetuity.
Constant Growth Dividend
Dividends grow at a constant rate each time period. Called
the constant dividend growth model.
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Share Price Sensitivity to Dividend Growth, g
Net present value is a measure of how much value is
created by undertaking an investment.Estimation of the
future cash flows and the discount rate are important in the
calculation of the NPV.
Steps in calculating NPV:
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for
projects of this risk level.
The third step is to find the present value of the cash flows
and subtract the initial investment.
NPV Illustrated
Share Price Sensitivity to Required Return, r
An investment should be accepted if the NPV is positive and
rejected if it is negative.NPV is a direct measure of how well
the investment meets the goal of financial management—to
increase owners’ wealth.A positive NPV means that the
investment is expected to add value to the firm.
Components of Required Return
Payback Period
The amount of time required for an investment to generate
cash flows to recover its initial cost.Estimate the cash
flows.Accumulate the future cash flows until they equal the
initial investment.The length of time for this to happen is
the payback period.An investment is acceptable if its
calculated payback is less than some prescribed number of
Payback Period Illustrated
CHAPTER 7
NET PRESENT VALUE AND OTHER INVESTMENT
CRITERIA
Net Present Value (NPV)
Net present valueis the difference between an investment’s
market value (in today’s dollars) and its cost (also in today’s
dollars).
Advantages of Payback Period
Easy to understand.
Adjusts for uncertainty of later cash flows.
Biased towards liquidity.
Disadvantages of Payback Period
Time value of money and risk ignored.
Arbitrary determination of acceptable payback period.
Ignores cash flows beyond the cut-off date.
Biased against long-term and new projects.
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Discounted Payback Period
The length of time required for an investment’s discounted
cash flows to equal its initial cost.Takes into account the
time value of money.More difficult to calculate.An
investment is acceptable if its discounted payback is less
than some prescribed number of years.
A project is accepted if ARR > target average accounting
return.
Example—ARR
Example—Discounted Payback
Assume initial investment = $240
Discounted payback period is just under three years
Ordinary and Discounted Payback
Disadvantages of ARR
The measure is not a ‘true’ reflection of return.
Time value is ignored.
Arbitrary determination of target average return.
Uses profit and book value instead of cash flow and market
value.
Ordinary payback?
Discounted payback?
Advantages and Disadvantages of Discounted Payback
Advantages
-Includes time value of money
-Easy to understand
-Does not accept negative estimated NPV investments
-Biased towards liquidity
Disadvantages
-May reject positive NPV investments
-Arbitrary determination of acceptable payback period
-Ignores cash flows beyond the cutoff date
-Biased against long-term and new products
Advantages of ARR
Easy to calculate and understand.
Accounting information almost always available.
Internal Rate of Return (IRR)
The discount rate that equates the present value of the
future cash flows with the initial cost.Generally found by
trial and error.A project is accepted if its IRR is > the
required rate of return.The IRR on an investment is the
required return that results in a zero NPV when it is used as
the discount rate.
Example—IRR
Accounting Rate of Return (ARR)
Measure of an investment’s profitability.
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1975
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at 33.33%:NPV =0
at 42.86%:NPV =0
at 66.67%:NPV =0
Two questions:
1.What’s going on here?
2.How many IRRs can there be?
Multiple Rates of Return
IRR and Non-conventional Cash Flows
When the cash flows change sign more than once, there is
more than one IRR.When you solve for IRR you are solving
for the root of an equation and when you cross the xaxis
more than once, there will be more than one return that
solves the equation.If you have more than one IRR, you
cannot use any of them to make your decision.
Problems with IRR
More than one negative cash flow multiple rates of return.
Project is not independent mutually exclusive
investments.Highest IRR does not indicate the best project.
IRR, NPV and Mutually-exclusive Projects
Advantages of IRR
Popular in practice
Does not require a discount rate
Multiple Rates of Return
Assume you are considering a project forwhich the cash
flows are as follows:
What’s the IRR? Find the rate at whichthe computed NPV =
0:
at 25.00%:NPV =0
Present Value Index (PVI)
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Expresses a project’s benefits relative to its initial cost.
Accept a project with a PVI > 1.0.
Example—PVI
Assume you have the following information on Project X:
Initial investment = –$1100 . Required return = 10%. Annual
cash revenues and expenses are as follows:
Stand-aloneprinciple:wecanevaluatetheprojectonitsown.
Types of Cash Flows
Sunk costs  a cost that has already been incurred and
cannot be removed  incremental cash flow
Opportunity costs  the most valuable alternative that is
given up by the investment = incremental cash flow
Side effects  erosion = incremental cash flow
Financing costs  incorporated in discount rate 
incremental cash flow
Always use after-tax incremental cash flow
Investment Evaluation
Step1Calculatethetaxableincome.
Step2Calculatethecashflows.
Step3Discountthecashflows.
Step4Decision.
Is this a good project? If so, why?
This is a good project because the present value of the
inflows exceeds the outlay.
Each dollar invested generates $1.1645 in value or $0.1645
in NPV.
Example—Investment Evaluation
Purchase price $42 000
Salvage value $1000 at end of Year 3
Net cash flows
Year 1 $31 000
Year 2 $25 000
Year 3 $20 000
Tax rate is 30%
Depreciation 20% reducing balance
Required rate of return 12%
Advantages and Disadvantages of PVI (and NPVI)
Advantages
-Closely related to NPV, generally leading to identical
decisions.
-Easy to understand.
-May be useful when available investment funds are limited.
Disadvantages
-May lead to incorrect decisions in comparisons of mutually
exclusive investments.
Solution—Taxable Income
Capital Budgeting in Practice
We should consider several investment criteria when
making decisions.NPV and IRR are the most commonly used
primary investment criteria.Payback is a commonly used
secondary investment criteria.
CHAPTER 8
Solution—Cash Flows
MAKING CAPITAL INVESTMENTS DECISIONS
BASED ON CASHFLOW
Incremental Cash Flows
Theonlyrelevantcashflowsincapitalprojectevaluation.
Solution—NPV and Decision
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Interest
As the project’s NPV is positive, the cash flows from the
investment will cover interest costs (as long as the interest
cost is less than the required rate of return).Interest costs
should not therefore be included as an explicit cash
flow.Interest costs are included in the required rate of
return (discount rate) used to evaluate the project
Depreciation
The depreciation expense used for capital budgeting should
be the depreciation schedule required for tax
purposes.Depreciation itself is a non-cash expense;
consequently, it is only relevant because it affects
taxes.Prime cost vs diminishing value methods
Depreciation tax shield = DT
-D = depreciation expense
-T = marginal tax rate
Disposal of Assets
 If the salvage value > book value, a profit/gain is
made on disposal. This profit/gain is subject to tax
(excess depreciation in previous periods).
 If the salvage value < book value, the ensuing loss
on disposal is a tax deduction (insufficient
depreciation in previous periods).
Capital Gains
Capital gains made on the sale of assets such as rental
property are subject to taxation.Capital losses are not a tax
deduction but can be offset against future capital gains
Example—Incremental Cash Flows
A firm is currently considering replacing a machine
purchased two years ago with an original estimated useful
life of five years. The replacement machine has an economic
life of three years. Other relevant data is summarised
below:
Solution—NPV and Decision
Decision: NPV < 0, therefore REJECT.
Setting the Bid Price
How to set the lowest price that can be profitably
charged.Cash outflows are given.Determine cash inflows
that result in zero NPV at the required rate of return.From
cash inflows, calculate sales revenue and price per unit.
Setting the Option Value
Option value =Asset value ×Probability of the Value–Present
value of the exercise price ×Probability the exercise price
will be paid.
Annual Equivalent Cost (AEC)
When comparing two mutually-exclusive projects with
different lives, it is necessary to make comparisons over the
same time period.AEC is the present value of each project’s
costs to infinity calculated on an annual basis.Select the
project with the lowest AEC.
Example—AEC
Project A costs $3000 and then $1000 per annum for the
next four years.Project B costs $6000 and then $1200 for
the next eight years.Required rate of return for both
projects is 10 per cent.Which is the better project?
Solution—Project A
Solution—Taxable Income
Solution—Project B
Solution—Cash Flows
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The base case NPV is then:
NPV = – $20 000 + ($11 000 × 3.3522)
= $16 874
Fairways Example—Scenario Analysis
Inputs for scenario analysis:
Base case: Rentals are 20 000 buckets p.a., variable costs
are 10 per cent of rental income, fixed costs are $40 000,
depreciation is $4000 p.a.
Solution—Interpretation
Project A is better because it costs $1946 per year compared
to Project B’s $2325 per year.
CHAPTER 9
PROJECT ANALYSIS AND EVALUATION
Best case: Rentals are 25 000 buckets p.a., variable costs are
8 per cent of rental income, fixed costs are $40 000,
depreciation is $4000 p.a.
Worst case: Rentals are 18 000 buckets p.a., variable costs
are 12 per cent of rental income, fixed costs are
$40 000, depreciation is $4000 p.a.
Evaluating NPV Estimates
The basic problem: How reliable is our NPV estimate?
Projected cash flows are based on a distribution of possible
outcomes each period: resulting in an ‘average’ cash
flow.Forecasting risk: the possibility of an incorrect decision
due to errors in cash flow projections (GIGO system).
Ask: What sources of value create the estimated NPV?
Fairways Example—Scenario Analysis
Inputs for sensitivity analysis:
Base case: Rentals are 20 000 buckets p.a., variable costs
are 10 per cent of rental income, fixed costs are $40 000,
depreciation is $4000 p.a.
Scenario and Other ‘What If’ Analysis
Base case estimation
Estimated NPV based on initial cash flow projections.
Best case: Rentals are 25 000 buckets p.a. All other variables
are unchanged.
Scenario analysis
Examine effect on NPV of best-case and worst-case
scenarios.
Worst case: Rentals are 18 000 buckets p.a. All other
variables are unchanged.
Fairways Example—Sensitivity Analysis
Sensitivity analysis
Examine effect on NPV by changing only one input variable.
Simulation analysis
Vary several input variables simultaneously to construct a
distribution of possible NPV estimates.
Fairways Driving Range Example
Fairways Driving Range expects annual rentals to be 20 000
buckets at $3 per bucket. Equipment costs $20 000 and is
depreciated using the straight-line method over five years
to a zero salvage value. Variable costs are 10 per cent of
rentals income and fixed costs are $40 000 per year.
Assume no increase in working capital and no additional
capital outlays. The required rate of return is 15 per cent
and the tax rate is 30 per cent.
Fairways Example—Net Profit
Estimated annual cash flow:
$10 000 + $4000 – $3000 = $11 000
At 15%, the 5-year annuity factor is 3.3522.
Break-even Analysis
Useful for analysing the relationship between sales volume
and profitability.Break-even point is the sales volume at
which the present value of the project’s cash inflows and
outflows are equal  NPV = 0.
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Important distinction between variable costs and fixed
costs.Accounting break-even is the sales volume that results
in a zero net profit.
Solve algebraically for break-even quantity (Q):
Fixed and Variable Costs
There are two types of costs that are important in breakeven analysis: variable and fixed.
-Variable costs change when the quantity of output changes
-Total variable costs= quantity ×cost per unit
-Fixed costs are constant, regardless of output, over some
time period
-Total Costs = fixed + variable = FC + Vq
Example:
Your firm pays $3000 per month in fixed costs. You also pay
$15per unit to produce your product.
(Total cost if you produce 1000 units = 3000 + 15(1000) = 18
000)
(Total cost if you produce 5000 units = 3000 + 15(5000) = 78
000)
Average versus Marginal Cost
Average Cost
-TC/number of units
-Will decrease as number of units increases
Marginal Cost
-The cost to produce one more unit
-Same as variable cost per unit
Example: What is the average cost and marginal cost under
each situation in the previous example?
-Produce 1000 units: Average = 18 000/1000 = $18
-Produce 5000 units: Average = 78 000/5000 = $15.60
If sales do not reach 16 296 buckets, Fairways willincur
losses in both the accounting sense and thefinancial sense.
Accounting of Break-even Point
Generalexpression
Q= (FC + D)/(P–v)
where:
Q=totalunitssold
FC=totalfixedcosts
D=depreciation
P=priceperunit
V=variablecostperunit
Using Accounting Break-even
Accounting break-even is often used as an early-stage
screening number.If a project cannot break even on an
accounting basis, then it is not going to be a worthwhile
project.Accounting break-even gives managers an indication
of how a project will impact accounting profit.
Summary of Break-even Measures
Fairways Example—Accounting Break-even Analysis
Fairways Example—Break-even Measures
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Operating Leverage
The degree to which a firm is committed to its fixed costs.
The higher the degree of operating leverage, the greater the
danger from forecasting risk.The lower the degree of
operating leverage, the lower the break-even point.DOL
depends on the current sales level.
Fairways Example—DOL
Let Q = 20 000 buckets and, ignoring taxes, OCF = $14 000
and FC = $40 000.
A 10 per cent increase (decrease) in quantity sold will result
in a 38.57 per cent increase (decrease) in OCF.
Note: Higher DOL equals greater volatility (risk) in OCF and
leverage is a two-edged sword—sales decreases will be
magnified as much as increases.
Percentage Return Example
Per dollar invested we get 5 cents in dividends and 9
cents in capital gains—a total of 14 cents or a return of
14 per cent.
Percentage Returns
Managerial Options and Capital Budgeting
A static DCF analysis ignores management’s ability to
modify the project as events occur.
Contingency planning
 The option to expand.
 The option to abandon.
 The option to wait.
Strategic options
1. ‘Toe hold’ investments.
2. Research and development.
Capital Rationing
A condition which prevents management from undertaking
all acceptable projects because of a shortage of funds.
1. Soft rationing occurs when management limits the
amount that can be invested in new projects during
some specified time period.
2. Hard rationing occurs when the firm is unable to
raise the financing for a project.
CHAPTER 10
Inflation and Returns
Real return is the return after taking out the effects
ofinflation. Real return shows the percentage change in
buying power. Nominal return is the return before taking
out the effects ofinflation. The Fisher effect explores the
relationship between real
SOME LESSONS FROM CAPITAL MARKET HISTORY
Dollar Returns
The gain (or loss) from an investment.Made up of two
components:
1. income (e.g. dividends, interest payments)
2. capital gain (or loss).
Not necessary to sell investment to include capital gain or
loss in return.
Average Equivalent Returns & Risk Premiums 1978–2002
Percentage Returns
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Average Returns: The First Lesson
Risky assets on average earn a risk premium (i.e. there is a
reward for bearing risk).
Frequency of Returns on Ordinary Shares 1978–2002
The Normal Distribution
Variance
 Measure of variability.
 The mean of the squared deviations from the
average return.
Example—Variance
ABC Co. have experienced the following returns in the last
five years:
Variability: The Second Lesson
The greater the risk, the greater the potential reward.This
lesson holds over the long term but may not be valid for the
short term.
Capital Market Efficiency
The efficient market hypothesis (EMH) asserts that the price
of a security accurately reflects all available
information.Implies that all investments have a zero
NPV.Implies also that all securities are fairly priced.If this is
true then investors cannot earn ‘abnormal’ or ‘excess’
returns.
Price Behaviour in Efficient andInefficient Markets
Calculate the average return and the standard deviation.
The Historical Record
Conclusion: Historically, the riskier the asset, thegreater the
return.
What Makes Markets Efficient?
There are many investors out there doing research:As new
information comes into the market, this information is
analysed and trades are made based on this
information.Therefore, prices should reflect all available
public information.If investors stop researching stocks, then
the market will not be efficient.
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1982
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Common misconceptions about EMH
Efficient markets do not mean that you can’t make
money.They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken and that
there is not a bias in prices that can be exploited to earn
excess returns.Market efficiency will not protect you from
making the wrong choices if you do not diversify—you still
don’t want to put all your eggs in one basket
Price Behaviour in Efficient and Inefficient Markets
Efficient market reaction: The price instantaneously adjusts
to and fully reflects new information. There is no tendency
for subsequent increases and decreases.
Delayed reaction: The price partially adjusts to the new
information. Several days elapse before the price
completely reflects the new information.
Overreaction: The price over-adjusts to the new
information.
It ‘overshoots’ the new price and
subsequently corrects itself.
Example—Calculating Variance
Example—Expected Return and Variance
Forms of Market Efficiency
Weak form efficiency: Current prices reflect information
contained in the past series of prices.
Semi-strong form efficiency: Current prices reflect all
publicly available information.
Strong form efficiency: Current prices reflect all information
of every kind.
CHAPTER 11
RISK AND RETURN TRADE OFF
Expected Return and Variance
1. Expected return—the weighted average of the
distribution of possible returns in the future.
2. Variance of returns—a measure of the dispersion of
the distribution of possible returns.
3. Rational investors like return and dislike risk.
Example—Calculating Expected Return
Portfolios
A portfolio is a collection of assets.An asset’s risk and return
is important in how it affects the risk and return of the
portfolio.The risk–return trade-off for a portfolio is
measured by the portfolio’s expected return and standard
deviation, just as with individual assets.
Portfolio Expected Returns
The expected return of a portfolio is the weighted average
of the expected returns for each asset in the portfolio.
You can also find the expected return by finding the
portfolio return in each possible state and computing the
expected value as we did with individual securities.
Example—Portfolio Return andVariance
Assume 50 per cent of portfolio in asset A and50 per cent in
asset B.
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1983
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Example—Portfolio Return and Variance
.
The Effect of Diversification onPortfolio Variance
Diversification
The process of spreading investments across different
assets, industries and countries to reduce risk.
Total risk = systematic risk + non-systematic risk
Non-systematic risk can be eliminated by diversification;
systematic risk affects all assets and cannot be diversified
away.
The Principle of Diversification
Diversification can substantially reduce the variability of
returns without an equivalent reduction in expected
returns.This reduction in risk arises because worse than
expected returns from one asset are offset by better than
expected returns from another.However, there is a
minimum level of risk that cannot be diversified away and
that is the systematic portion.
Announcements, Surprises and Expected Returns
Key Issues
What are the components of the total return?
What are the different types of risk?
Portfolio Diversification
Expected and Unexpected Returns
Total return (R) = expected return (E(R))+ unexpected return
(U)
Announcements and News
Announcement = expected part + surprise
It is the surprise component that affects a stock’s price and,
therefore, its return.
Risk
Systematic risk: that component of total risk which is due to
economy-wide factors.
Non-systematic risk: that component of total risk which is
unique to an asset or firm.
Standard Deviations of Monthly Portfolio Returns
Systematic Risk
The systematic risk principle states that the expected return
on a risky asset depends only on the asset’s systematic risk.
The amount of systematic risk in an asset relative to an
average risky asset is measured by the beta coefficient.
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Beta
Security A
Security B
Std
30%
10%
Deviation
0.60
1.20
Security A has greater total risk but less systematic risk
(more non-systematic risk) than Security B.
Measuring Systemic Risk
What does beta tell us?
-A beta of 1 implies the asset has the same systematic risk
as the overall market.
-A beta < 1 implies the asset has less systematic risk than
the overall market.
-A beta > 1 implies the asset has more systematic risk than
the overall market.
Beta Coefficients for Selected Companies
Return, Risk and Equilibrium
Key issues:
What is the relationship between risk and return?
What does security market equilibrium look like?
The ratio of the risk premium to beta is the same for every
asset. In other words, the reward-to-risk ratio for the
market is constant and equal to:
Example—Asset Pricing
Asset A has an expected return of 12 per cent and a beta of
1.40. Asset B has an expected return of 8 per cent and a
beta of 0.80. Are these two assets valued correctly relative
to each other if the risk-free rate is 5 per cent?
Asset B offers insufficient return for its level of risk, relative
to A. B’s price is too high; therefore, it is overvalued (or A is
undervalued).
Example—Portfolio Beta Calculations
Security Market Line
The security market line (SML) is the representation of
market equilibrium.The slope of the SML is the reward-torisk ratio:
(E(RM) –Rf)/ßM
But since the beta for the market is ALWAYS equal to one,
the slope can be rewritten.Slope = E(RM) –Rf = market risk
premium
Example—Portfolio Expected Returns and Betas
Assume you wish to hold a portfolio consisting of asset A
and a riskless asset. Given the following information,
calculate portfolio expected returns and portfolio betas,
letting the proportion of funds invested in asset A range
from 0 to 125 per cent.Asset A has a beta of 1.2 and an
expected return of 18 per cent.The risk-free rate is 7 per
cent.Asset A weights: 0 per cent, 25 per cent, 50 per cent,
75 per cent, 100 per cent and 125 per cent.
The Capital Asset Pricing Model (CAPM)
An equilibrium model of the relationship between risk and
return.
What determines an asset’s expected return?
–The risk-free rate—the pure time value of money.
–The market risk premium—the reward for bearing
systematic risk.
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1985
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–The beta coefficient—a measure of the amount of
systematic risk present in a particular asset.
CHAPTER 12
CURRENT INVESTMENTS DECISIONS
Calculation of Systematic Risk
Where:
Cov = covariance
i = random distribution of return for asset i
M = random distribution of return for the
market
R
Covariance and Correlation
The covariance term measures how returns change
together—measured in absolute terms.The correlation
coefficient measures how returns change together—
measured in relative terms.
Current Investment Decisions
Involve the administration of the company’s current assets
(cash and marketable securities, receivables and inventory),
and the financing needed to support these assets. Problems
in using discounted cash flow techniques to evaluate these
decisions:
1. identification of all relevant cash inflows and
outflows
2. determining the size and timing of these cash flows
3. determining the correct discount rate.
Operating Cycle versus Cash Cycle
Operating cycle—the time period between the acquisition
of inventory and the collection of cash from receivables.
Operating cycle = Inventory period + A/cs receivable period
Security Market Line versus Capital
Cash cycle—the time period between the outlay of cash for
purchases and the collection of cash from receivables.
Cash cycle = Operating cycle – A/cs payable period
Cash Flow Time Line
SML explains the expected return for all assets.
CML explains the expected return for efficient portfolios.
Risk of a Portfolio
Variance of a two-asset portfolio is calculated as:
weighted variance of the expected return foreach asset in
the portfolio+twice the weighted covariance of the
expectedreturn on the first asset with the expectedreturn on
the second
Example—Risk of a Portfolio
Example—Operating Cycle
The following information has been provided for Overcredit
Co.:
Problems with CAPM
Difficulties in estimating beta
-thin trading
-non-constant beta
Sales for the year were $510 000 (assume all credit) and
the cost of goods sold was $350 000.Calculate the operating
cycle and cash cycle.
Using CAPM
-adding explanatory variables
-measure of market return
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Financing of current assets
-Flexible policy—less short-term debt and more long-term
debt
-Restrictive policy—more short-term debt and less longterm debt
The size of the firm’s investment in current assets is
determined by its short-term financial policies.
Flexible policy actions include:
1. keeping large cash and securities balances
2. keeping large amounts of inventory
3. granting liberal credit terms.
Restrictive policy actions include:
 keeping low cash and securities balances
 keeping small amounts of inventory
 allowing few or no credit sales.
Costs of Investments
Need to manage the trade-off between carrying costs and
shortage costs.
Carrying costs increase with the level of investment in
current assets, and include the costs of maintaining
economic value and opportunity costs.
Shortage costs decrease with increases in the level of
investment in current assets, and include trading costs and
the costs related to being short of the current asset. For
example, sales lost as a result of a shortage of finished
goods inventory.
Carrying Costs and Shortage Costs
Example—cash cycle
Short-term Financial Policy
Size of investments in current assets
-Flexible policy—maintain a high ratio of current assets to
sales
-Restrictive policy—maintain a low ratio of current assets to
sales
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EOQ Example With Quantity Discounts
Smile Camera Shop is offered a 2-cent-per-roll discount if
2000–3500 rolls of film are ordered, and a 3-cent-per-roll
discount if more than 3500 rolls are ordered at a time.
Determine the optimal order quantity.
Calculate the total cost for each quantity:
Smile Camera Shop would be better off purchasing in lots of
2000
Inventory Management Under Uncertainty
Inventory management requires two decisions:
1. quantity to be ordered
2. reorder point
Safety stock is the additional inventory held when demand
is uncertain so as to reduce the probability of a stock
out.Reorder point takes into account the lead time from
placement of an order to receipt of the goods.
EOQ Example Under Uncertainty
Smile Camera Shop’s EOQ (with quantity discounts)is 2000
rolls of film and five orders are placed eachyear. Determine
the reorder point if it takes 30 daysto fill an order, a safety
stock of 100 is desired anddaily usage is 30 rolls.
The Inventory Model
The economic quantity (EOQ) is the optimal quantity of
inventory ordered that minimises the costs of purchasing
and holding the inventory.
Where
TC = total cost
X = order size
EOQ = economic order qty
A = acquisition costs
Y = total demand
C = carrying costs
P = price per unit
Example—EOQ
Smile Camera Shop sells 10 000 rolls of film per year, each
with a wholesale price of $3.20. The cost of processing each
order placed is $10.00 and carrying costs are 20 cents per
roll per year. Calculate the EOQ.
Cash Budget
Forecast of cash receipts and disbursements over the next
short-term planning period.Primary tool in short-term
financial planning. ItsHelps determine when the firm should
experience cash surpluses and when it will need to borrow
to cover working-capital costs.Allows a company to plan
ahead and begin the search for financing before the money
is actually needed.
Example—Cash Budget
Projected sales for the first six months of 2004:
Jan.
$130 000
Apr.
$140 000
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1988
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Feb.
$125 000
May $155 000
Mar. $145 000
Jun.
$145 000
Analysis of collection of accounts receivable:
collected in month of sale
20%
collected in month following sale
60%
collected in second month following sale
20%
Actual sales for November and December were $125 000
and $120 000 respectively.
Wages and other expenses are 30 per cent of total monthly
sales.Purchases are 50 per cent of the month’s estimated
sales, all paid for in the month of purchase.Monthly interest
payments are $15 000 (interest rate is 1.5 per cent per
month).An annual dividend of $60 000 is payable in
March.The beginning cash balance is $30 000.The minimum
cash balance is $20 000.
Cash Collections
CHAPTER 13
CASH AND LIQUIDITY MANAGEMENT
Cash Disbursements
Reasons for Holding Cash
Speculative motive—the need to hold cash to take
advantage of additional investment opportunities, such as
bargain purchases.
Precautionary motive—the need to hold cash as a safety
margin to act as a financial reserve.
Cash Budget
Transaction motive—the need to hold cash to satisfy normal
disbursement and collection activities associated with a
firm’s ongoing operations.
Compensating balance requirements—cash balances kept at
commercial banks to compensate for banking services the
firm receives.
Target Cash Balance
Key Issues:
What is the trade-off between carrying a large cash balance
versus a small cash balance? That is, carrying costs versus
shortage costs.
Short-term Financial Planning
What is the proper management of the cash balance? BAT
model versus Miller–Orr model
The BAT Model
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Example—Miller–Orr Model
Assume L = $0, F = $10, i = 0.5 per cent per month andthe
standard deviation of monthly cash flows is $2000.
Assumptions
-Cash is spent at the same rate every day
-Cash expenditures are known with certainty
Optimal cash balance is where opportunity cost of holding
cash ([C/2]*R) = trading cost ([T/C]*F):
F = fixed cost of making a securities trade to replenish cash
T = total amount of new cash needed for transactions
purposes over the relevant planning period
R = the opportunity cost of holding cash (the interest rate
on marketable securities)
Miller–Orr Model
Assumes that, if left unmanaged, a company’s cash balance
would follow a random walk with zero drift.Cash balance is
allowed to wander freely between an upper limit (U*) and a
lower limit (L).If cash holdings reach U*, management
intervenes by withdrawing U* – C* dollars to return the
cash balance to the target level C*.If cash balance reaches
L,management intervenes by injecting C* – L dollars to
return the cash balance to the target level C*.
Miller–Orr Model Implications
Considers the effect of uncertainty (through 2 in net cash
flows). The higher the 2, the greater the difference
between C* and L.The higher the 2, the higher is the upper
limit and the average cash balance.
All things being equal:
1. the greater the interest rate, the lower is the C*
2. the greater the order costs, the higher is the C*.
Miller–Orr Model With Overdraft
Yield on short-term investments < cost of bank overdraft <
yield on long-term investments.A dollar invested in shortterm assets earns less than the costs saved by applying that
dollar to reduce overdraft usage.The company invests
nothing in short-term assets and as much as possible in
long-term assets, while meeting its liquidity needs through
using the overdraft facility.
Understanding Float
What is float?
The difference between book cash and bank cash,
representing the net effect of cheques in the process of
being cleared.
U* is the upper control limit. L is the lower control limit. The
targetcash balance is C*. As long as cash is between L and
U*, notransaction is made.
Types of float:
Disbursement float—the result of cheques written;
decreases book balance but does not immediately change
available balance.
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Collection float—the result of cheques received; increases
book balance but does not immediately change available
balance.
Net float—the overall difference between the firm’s
available balance and its book balance.
Float Management
Objectives:
1. In cash collection—speed up cheque collections
(reduce float components).
2. In cash disbursement—control payments and
minimise costs (increase float components).
Components of float:
1. Mail float—cheques trapped in postal system.
2. Processing float—until receiver of cheque deposits
cheque.
3. Availability float—until cheque clears in the banking
system.
Mail float + processing float + availability float = total time
delay.
Short-term Securities
Characteristics of short-term securities include:
1. Maturity maturities usually less than 90 days.
Investments then avoid interest rate risk but have
low returns.
2. Default risk idle cash generally invested in less
risky securities (e.g. government issues).
3. Marketability idle funds usually invested in highly
liquid securities.
Investing Cash
Temporary Cash Surpluses
-Seasonal or cyclical activities—buy marketable securities
with seasonal surpluses, convert securities back to cash
when deficits occur.
-Planned or possible expenditures—accumulate marketable
securities in anticipation of upcoming expenses.
Financing Seasonal or Cyclical Activities
Measuring and Costing the Float
The cost of collection float to the firm is theopportunity cost
from not being able to use thatcash.
Managing the Float
Factoring—the selling of receivables to a financial
institution (the factor), usually ‘without recourse’.Credit
insurance—protection against the risk of bad debt
losses.Delaying disbursements—increases the disbursement
float.
Investing Idle Cash
Temporary cash surpluses can be invested in marketable
securities.Temporary cash deficits—sell marketable
securities or use short-term bank financing.The temporary
surpluses/deficits are a result of:
–seasonal or cyclical activities
–planned or possible expenditures.
Regulation of Financial Intermediaries
The Securities Markets
Regulation of Financial Intermediaries
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Terminology to know:
Cost of the Credit
2/10, net 30 = buyer pays in 10 days to get a 2 per cent
discount, or within 30 days for no discount.Buyer has an
order for $1500 and ignores the credit period  gives up
$30 discount.
The benefit obviously lies in paying early
CHAPTER 14
CREDIT MANAGEMENT
Components of Credit Policy
Terms of sale : The conditions on which a firm sells its
goods and services for cash or credit.
Credit analysis : The process of determining the probability
that customers will not pay.
Collection policy : Procedures that are followed by a firm in
collecting accounts receivable.
Accounts receivable = Average daily sales × average
collection period
Credit Policy Effects
Revenue effects—Payment is received later, but price and
quantity sold may increase
.
Cost effects—Cost of sale is still incurred even though the
cash from the sale has not been received.
The cost of debt—The firm must finance receivables and,
therefore, incur financing costs.
The probability of non-payment—The firm always gets paid
if it sells for cash, but risks losses due to customer default if
it sells on credit.
The cash discount—Discounts induce buyers to pay early;
the size of the discount affects payment patterns and
amounts.
Evaluating a Proposed Credit Policy
P= price per unit
Q’= new quantity expected to be sold
v= variable cost per unit
Q = current quantity sold per period
R= periodic required return
The benefitof switching is the changein cash flow:
Terms of the Sale
Credit period : The length of time that credit is granted,
usually between 30 and 120 days.
Cash discount : A discount that is given for a cash purchase
to speed up the collection of receivables.
Credit instrument : Evidence of indebtedness such as an
invoice or promissory note.
Length of the Credit Period
Factors that influence the length of the credit period
include:
o buyer’s inventory period and operating
cycle
o perishability and collateral value of goods
o consumer demand for the product
o cost, profitability and standardisation
o credit risk of the buyer
o the size of the account
o competition in the product market
o customer type.
Evaluating a Proposed Credit Policy
The present value of switching is:
PV = [(P – v) × (Q’ – Q)]/R
The cost of switching is the amount uncollected for the
period plus the additional variable costs of production:
Cost = PQ + v(Q’ – Q)
And the NPV of the switch is:
NPV = –[PQ + v(Q’ – Q)] + [(P – v)(Q’ – Q)]/R
Example—Evaluating a Proposed Credit Policy
ABC Co. is thinking of changing from a cash-only policy to a
‘net 30 days on sales’ policy. The company has estimated
the following:
P = $55
v = $32 Q = 160
Q’ = 175
R = 2%
Solution
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As the NPV of the change is negative, ABC Co.should not
switch.
The Costs of Granting Credit
Opportunity costs are lost sales from refusing credit. These
costs go down when credit is granted.Carrying costs are the
cash flows that must be incurred when credit is granted.
They are positively related to the amount of credit
extended.
1. The required return on receivables.
2. The losses from bad debts.
3. The costs of managing credit and credit collections.
Optimal Credit Policy
Break-even Point
The switch is a good idea as long as thecompany can sell an
additional 7.87 units.
Discounts and Default Risk
ABC Co. currently has a cash price of $55 per unit. If the
company extends the 30 day credit policy, the price will
increase to $56 per unit on credit sales. ABC Co. expects 0.5
per cent of credit to go uncollected (). All other
information remains unchanged. Should the company
switch to the credit policy?
Credit Analysis
Process of deciding which customers receive credit.
One-time sale—risk is variable cost only.
Repeat customers—benefit is gained from one-time sale in
perpetuity.
Grant credit to almost all customers onceas long as variable
cost is low relative to price (high markup).
The Five Cs of Credit
Character : Customer’s willingness to pay.
Capacity : Customer’s ability to pay.
Capital : Financial reserves/borrowing capacity.
Collateral : Pledged assets.
Conditions : Relevant economic conditions.
Collection Policy
Monitoring receivables:
- Keep an eye on average collection period relative to your
credit terms.
Ageing schedule—compilation of accounts receivable by the
age of each account; used to determine the percentage of
payments that are being made late.
Discounts and Default Risk
NPV of changing credit terms:
Collection procedures include:
 delinquency letters
 telephone calls
 employment of collection agency
 legal action.
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CHAPTER 15
SHORT-TERM FINANCING
The Financial System
Banks
Trading banks includes activities such as deposits, loans,
insurance, superannuation and stockbroking, usually
through subsidiaries and affiliated companies.
Retail banking involves transactions with the general
public.
Financial Markets
Wholesale banking involves transactions with companies
or businesses.
Hold approximately 44 per cent of market share.
Merchant Banks
Primarily concerned with wholesale finance.Responsible for
the development of CMTs, rebatable preference shares, the
commercial bills market, the promissory note market, the
currency hedge market and the unofficial deposit
market.Activities now include ‘investment banking’.Market
share has decreased dramatically since the 1980s, now
approximately 5 per cent
The Listed Market
Superannuation and Life Insurance Companies
Crucial for the saving and provision of funds for retirement
(superannuation) or ‘one-off’ events such as death,
disability or trauma (insurance).Diversified operations to
include general insurance, short-term money market
dealing and merchant banking.Hold approximately 30 per
cent of market share.
Finance Companies
Initially responsible for the provision of hire purchase and
instalment credit, financing of vehicles and home loans,
lease financing and factoring.Funds obtained mainly
Through the issue of debentures.Deregulation in 1980s led
to many finance companies’ activities being absorbed by
their large parent banks.Market share now only
approximately 6 per cent.
Financial Intermediaries
Building Societies and Credit Unions
Building societies :
1. Traditionally provide housing finance to small
savers.
2. Diversified activities to include lending for other
purposes.
Credit unions
Pool the funds of people with common interests to provide
consumer-type financing and lending to ‘members’.
Both have very small market share, totalling approximately
2 per cent.
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Unit Trusts
Pool funds of small investors with the aim of earning a
greater return collectively than that achieved
individually.Cash management trusts, equity trusts,
property trusts, mortgage trusts
Other Intermediaries
Authorised foreign exchange dealers  perform a full range
of foreign exchange transactions.
Australian Stock Exchange (ASX) and share brokers 
provide the medium for buying and selling shares and other
listed securities.
Friendly societies  non-profit, state-controlled
intermediaries for small groups to pool funds to be used for
funerals, sickness or, simply, savings.
Financing Policy for an ‘Ideal’ Economy
CompromiseFinancing Policy
Optimal Amount of Short-term Borrowing
Factors to consider:
Cash reserves—reducing the probability of financial distress
vs investments in zero NPV securities.
Maturity hedging—match maturity of asset with maturity of
liability.
Relative interest rates—cheaper to have short-term
borrowing than long-term borrowing.
Alternative Asset Financing Policies
With a compromise policy, the firm keeps a reserve of
iquidity which it uses to initially finance seasonal ariations in
current asset needs. Short-term borrowing is used when the
reserve is exhausted.
Short-term Financing
Used for:
1. Working capital requirements in the day-to-day
operations of the business.
2. Transactions that are self-financing over short
periods.
Main providers are trading banks, merchant banks and
finance companies.
Short-term Financing Sources
Overdrafts
A credit arrangement where the bank permits the customer
to draw more money from the bank account than has been
put in it, up to an agreed limit.Repayable on demand
although this is rarely required. Interest rate is variable and
account balance fluctuates between positive (deposit) and
negative (loan) over the business cycle.
Short-term loans
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An advance of funds made by a financial institution for a
specific purpose, repayable over a fixed period.
Transferable loan certificates
Derivative debt products
Short-term Financing Sources
Bills of exchange
1. A negotiable instrument requiring the payment of a
specific sum of money, either on demand or at a
specified time.
2. Trade bills versus accommodation bills.
3. Three parties to a bill: drawer (borrower), acceptor
(endorser) and payee (owner).
4. Discounted value (price) of a bill:
Sources of Long-term Financing
1. Debentures—secure, fixed-term loan instruments
issued by companies.
2. Secured notes—same as debentures with lower
security.
3. Unsecured notes—shorter-term loans to a company
offering no assets as security.
4. Convertible notes—debt that provides an option to
convert to equity at maturity.
5. Fixed deposits—unsecured loans at fixed rates for
definite terms.
6. Mortgages—the conveyance of property for the
security of debt.
7. Eurobonds—unsecured fixed-interest borrowings
denominated in a currency of a country other than
its country of issue.
8. Eurocurrency FRNs—a foreign currency borrowing
whose rates adjust to reflect market interest rates.
9. Leasing—purchaser of equipment leases the asset
to another party.
10. Project financing—syndicate financing of very large
(and expensive) projects.
11. Transferable loan certificates—marketable evidence
of the existence of a debt.
12. Derivative debt products—instruments used to
manage interest rate risk:
1. interest rate swaps
2. forward rate agreements (FRAs)
3. interest rate futures
4. options on futures contracts.
Short-term Financing Sources
Promissory notes
A negotiable instrument whereby the borrower promises to
repay the face value to the holder at maturity. .Different to
bills of exchange because they are unsecured (no acceptor).
Most borrowers are well-known large organisations. There
is an active secondary market.
Inventory loans
A short-term loan used specifically to purchase inventory,
including a blanket inventory lien, a trust receipt and field
warehouse financing.
Letters of credit
Irrevocable and unconditional undertaking by a bank to
repay a loan if the borrower defaults.
Short-term eurocurrency funding
Financing in a currency outside the country of issue.
Factoring
Selling of accounts receivables to a factor.
CHAPTER 16
LONG-TERM FINANCING : AN INTRODUCTION
What is Debt?
An obligation to pay a specific amount of money to another
party.
Characteristics of debt:
 short-term vs long-term
 fixed vs floating interest rate loans
 secured vs unsecured
 domestic vs foreign
Types of Long-term Debt
Debentures
Secured and unsecured notes
Convertible notes
Fixed deposit loans
Mortgages
Eurobonds
Eurocurrency term loans
Leasing
Project finance
Debt versus Equity
Corporations try to create debt securities that are really
equity to get the tax benefits of debt and the bankruptcy
benefits of equity.Interest on debt is fully tax deductible, so
the distinction is important for tax purposes.Hybrid
securities have characteristics of both debt and equity:
 convertible notes
 subordinated debt
 preference shares.
The Debenture Trust Deed
Legal document binding the corporation and its creditors.
Provisions in a trust deed include:
1. the basic terms of the issue
2. the amount of the debentures issued
3. property used as security
4. repayment arrangements
5. call provisions
6. any protective covenants.
Debt Ratings
Letter grades that designate investment quality.Assigned to
a debt issue by independent rating agencies such as
Moody’s and Standard & Poor’s.Long-term ratings range
from Aaa to C; short-term ratings range from Prime-1 to
Prime-3.Ratings relieve individual investors of the task of
evaluating the investment quality of an issue.
Different Types of Debentures
1. Zero coupon debentures—initially priced at a deep
discount as they make no coupon payments.
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2. Floating-rate debentures—coupon payments are
tied to an interest rate index and are therefore
adjustable.
Usually contain a put provision,
together with coupon ceilings and floors.
3. Income debentures—coupons dependent on
company income.
4. Put debentures—holder can force the buy back of
debt at a stated price.
Securitisation
The process of transforming financial institutions’ assets
such as mortgages, into marketable securities, by pooling
and selling the rights to the income streams.
The call provision effectively costs $50.
Solution—Debentures
What is the NPV per debenture of the refunding if
interest rates fall to 5 per cent?
Advantages:
Investor—negotiable security provides both regular income
and final payout.
Mortgage agency—conversion of an illiquid asset into a
marketable security.
As NPV is positive, refunding should commence.
Debenture Refunding
Process of replacing all or part of an issue of outstanding
debentures.Used to refinance a higher-interest loan with a
lower-interest one.Call provision allows a company to
repurchase or ‘call’ part or all of the debt issue at stated
prices over a specified period.Debtholders demand a
coupon that exactly compensates them for the possibility of
a call.
Cost of call provision = Value of call position
Example—Debentures
Assume:
Current interest rate on debentures is 10 per cent
Probability of interest rate changes by the end of
the year:
— fall to 5 per cent (50 per cent probability)
— rise to 15 per cent (50 per cent probability)
Call premium = $20
Call period = by the end of the year
Face value of debenture = $100
Debentures are perpetual
Reasons for Issuing Callable Debentures
Superior interest rate forecasting—company insiders may
think they know more about interest rate decreases than
debtholders.
Taxes—call provisions provide tax advantages to both
debtholders and the company.
Future investment opportunities—allows the company to
buy back debentures to take advantage of superior
investment opportunities.
Preference Shares
1. Shares with dividend priority over ordinary shares,
normally with a fixed dividend rate, sometimes
without voting rights.
2. Cumulative vs non-cumulative dividends.
3. Irredeemable vs redeemable shares.
4. Non-participating vs participating shares.
Most preference shares issued are cumulative, irredeemable
and non-participating.
Solution—Debentures
Market price of debenture (if not callable):
Reasons for Issuing Preference Shares
Redeemable preference shares can be used to enhance the
balance sheet by increasing the equity base.As subordinate
debt, they can be included in a bank’s capital base.They can
be used to avoid the threat of bankruptcy that exists for
debt.Companies unable to take advantage of the tax
deductibility of debt favour preference shares.A means of
raising equity without surrendering control.
If issue is callable, what coupon (C) must beoffered?
Ordinary Shares
Equity without priority for dividends or in bankruptcy.
This is higher than the non-callable coupon.
What is the cost of the call provision?
Types of companies:
1. companies limited by shares
2. companies limited by guarantee
3. companies limited by both shares and guarantee
4. unlimited companies
5. no liability companies.
Shareholders’ Rights
 The right to share proportionally in dividends paid.
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


The right to share proportionally in assets remaining
after liabilities have been paid in liquidation.
The right to elect the directors and to vote on
important shareholder matters (one share = one
vote).
The right to share proportionally in any new shares
sold (pre-emptive right).
CHAPTER 17
ISSUING SECURITIES TO THE PUBLIC
Dividends
1. Payment by a corporation to shareholders; made in
either cash or shares.
2. The return on capital to shareholders.
3. They are not a liability of the company unless
declared by the board of directors.
4. They are not a business expense and are therefore
not tax deductible.
5. They are fully taxable in the hands of the
shareholder. However, an imputation credit may be
allowed.
Issuing Securities to the Public
Analyse funding needs and how they can be met.
Approval from board of directors for a public issue.
Outside expert opinions sought for support of issue.
Pricing, time-tabling, prospectus prepared, marketing.
Prospectus filed with ASIC and ASX.
Underwriting agreement executed.
Prospectus registered.
Public announcement of offering.
Funds received.
Shares allotted, holdings registered.
Shares listed for trading on ASX.
Classes of Ordinary Shares
Different classes of ordinary shares may be distinguished
by:
1. voting rights
2. dividend entitlement
3. priority to dividend payment
4. priority to capital repayment and surplus asset
distribution in the event of liquidation.
New Issues
Flotation is the initial offering of securities to the public.
Primary issues used to:
 convert from a private company to a public
company
 spin-off a portion of the business of a listed
company
 form a new public company
 privatise a public organisation, or demutualise a
mutual society.
Reasons for different classes:
 debt characteristics for some shares
 retain control in small/newly listed firms
 taxation issues
 nature of company (e.g. home units).
Size of the Capital Market
Advantages of Public Company Listing
1. Access to additional capital.Increased negotiability
of capital.
2. Growth not limited by cash resources.
3. Enhancement of corporate image.
4. Can attract and retain key personnel.
5. Gain independence from a spin-off.
Disadvantages of Public Company Listing
 Dilution of control of existing owners.
 Additional responsibilities of directors.
 Greater disclosure of information.
 Explicit costs.
 Insider trading implications.
Secondary Issues
Private placements—securities are offered and sold to a
limited number of investors who are often the current
major investors in the business.
Rights issues—issue of shares made to all existing
shareholders, who are entitled to take up the new shares in
proportion to their present holdings.
Financial Distress
The disadvantage of using debt is the possibility of financial
distress, which can be defined as:
o business failure
o legal bankruptcy
o technical insolvency
-- accounting insolvency..
Terms are determined by:
1. amount of funds required by the company
2. the market price of the company’s securities
3. general economic conditions
4. desire to benefit shareholders
5. nature of the company’s shareholders
Underwriting
.Firm underwriting :
A guarantee that funds will be
made available to a company at a specific time on agreed
terms and conditions.
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Standby underwriting : Where the bidding company has
insufficient cash in a successful bid or if cash is offered as an
alternative to a share bid.
Best efforts underwriting :
Underwriter must use ‘best
efforts’ to sell the securities at the agreed offering rate.
Role of underwriter
–pricing the issue
–marketing the issue
–engaging sub-underwriters
–placing the shortfall
Sub-underwriter
–A group of underwriters formed to reduce the risk and to
help to sell an issue.
Underwriting Fees
The underwriter’s fee is a reflection of the:
1. size of the issue
2. issue price
3. general market conditions
4. market attitude towards shares
5. time period required for underwriting.
Fees also include brokerage and management feesAverage
Averageinitial return
Rights Offerings—Basic Concepts
Rights offering :
Issue of ordinary shares to existing
shareholders.
Allows current shareholders to avoid the dilution that can
occur with a new share issue.
‘Rights’ are given to the shareholders specifying:
1. number of shares that can be purchased
2. purchase price
3. time frame.
Shareholders can either exercise their rights or sell them.
They neither win nor lose either way.
Subscription price : The dollar cost of one of the shares to
be issued, generally less than the current market price.
New Equity Sales—Research Findings
Shares prices tend to decline after a new equity issue
announcement, but rise following a debt announcement.
Why?
1. Management has superior information about firm
value and knows when the firm is overvalued →
sell equity.
2. Excessive debt usage.
3. Substantial issue costs.
4. Management needs to understand the signals that
an equity issue sends.
Ex-rights date : Beginning of the period when shares are
sold without a recently declared right, normally four trading
days before the holder-of-record date. The share price will
drop by the value of the right.
Holder-of-record date : Date on which existing shareholders
are designated as the recipients of share rights.
Ex-rights Share Prices
The Cost of Issuing Securities
Theoretical Rights Price
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due to less-than-proportionate purchase of new
shares.
2. Dilution of market value—loss in share value due to
use of proceeds to invest in negative NPV projects.
3. Dilution of book value and earnings per share (EPS)
—reduction in EPS due to sale of additional shares.
This has no economic consequences.
Example—Rights Issue
Lemon Co. currently has 5 million shares on issue with a
market price of $8 each. To finance new projects, the
company needs to raise an additional $6 million. To raise
the finance, the company makes a rights issue at a
subscription price of $6 per share.
The number of new shares to be sold:
The holder of one right is entitled to subscribe to one new
share at $6 per share.To issue 1 million shares, the company
would have to issue 1 million rights.The company has 5
million shares on issue, which means that for every 5 shares
held, a shareholder is entitled to receive one right (1-for-5
rights issue).
Calculate the theoretical rights price:
Corporate Debt
The late 1980s saw a major growth in the Australian
corporate debt market due to:
a. the substantial cutback in the level of
government borrowing
b. the fall in interest rates from extremely high
levels
c. the flight to quality
d. the shortage of government bonds
e. the attractiveness of raising funds in the
domestic market relative to that of the
euromarket.
Long-term Debt
Differences between direct, private long-term financing and
public issues of debt include:
o direct loans avoid ASIC registration costs
o direct loans have more restrictive
covenants
o term loans and private placements are
easier to renegotiate than public issues
o private placements are dominated by life
insurance companies and pension funds,
whereas commercial banks dominate the
term-loan market.
CHAPTER 18
If an outsider buys a right, it will cost $1.67.The right can be
exercised at a subscription price of $6.Total cost of a new
share = $1.67 + $6 = $7.67.
The Value of Rights
COST OF CAPITAL AND CAPITAL STRUCTURES
The Cost of Capital: Preliminaries
Vocabulary—the following all mean the same thing:
1. required return
2. appropriate discount rate
3. cost of capital.
The cost of capital is an opportunity cost—it depends on
where the money goes, not where it comes from.The
assumption is made that a firm’s capital structure is fixed—
a firm’s cost of capital then reflects both the cost of debt
and the cost of equity.
*$8.00 – 7.67 = 0.33
**$0.33 × 5 = $1.65
New Issues and Dilution
Dilution
Loss in existing shareholders’ value in terms of either
ownership, market value, book value or EPS.
Types of dilution
1. Dilution
of
proportionate
ownership—a
shareholder’s reduction in proportionate ownership
Cost of Equity
The cost of equity is the return required by equity investors
given the risk of the cash flows from the firm.There are two
major methods for determining the cost of equity:
–Dividend growth model
–SML or CAPM.
The Dividend Growth Model Approach
According to the constant growth model:
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Rearranging:
Example—Cost of Equity Capital: Dividend Approach
Reno Co. recently paid a dividend of 15 cents per share.
This dividend is expected to grow at a rate of 3 per cent per
year into perpetuity. The current market price of Reno’s
shares is $3.20 per share. Determine the cost of equity
capital for Reno Co
Advantages
 Adjusts for risk.
 Accounts for companies that don’t have a constant
dividend.
Disadvantages
1. Requires two factors to be estimated: the market
risk premium and the beta co-efficient.
2. Uses the past to predict the future, which may not
be appropriate.
The Cost of Debt
The cost of debt, RD, is the interest rate on new borrowing.
RD is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds.
Estimating g
One method for estimating the growth rate is to use the
historicalaverage.
The historic cost of debt is irrelevant
The Dividend Growth Model Approach
Advantages
1. Easy to use and understand.
Disadvantages
 Only applicable to companies paying dividends.
 Assumes dividend growth is constant.
 Cost of equity is very sensitive to growth estimate.
 Ignores risk.
The yield to maturity is 14.4 per cent, so this is used
as the cost of debt, not 12 per cent.
The SML Approach
Required return on a risky investment is dependent on
three factors:
o the risk-free rate, Rf
o the market risk premium, E(RM) – Rf
o the systematic risk of the asset relative to
the average, 
Notice that the cost is simply the dividend yield.
Example—Cost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 yearsago at
par. The bond is currently priced at $86.What is our cost of
debt?
The Cost of Preference Shares
Preference shares pay a constant dividend every period.
Preference shares are a perpetuity, so the cost is:
Example—Cost of Preference Shares
An $8 preference share issue was sold 10 years ago. It sells
for $120 per share today.
The dividend yield today is $8.00/$120 = 6.67 per cent, so
this is the cost of the preference share issue.
The Weighted Average Cost of Capital
Example—Cost of Equity Capital: SML Approach
Obtain the risk-free rate (Rf) from financial press—
many use the 1-year Treasury note rate, say, 6 per
cent.Obtain estimates of market risk premium and security
beta:
historical risk premium = 7.94 per cent (Officer, 1989)
beta—historical
investment information services
estimate from historical data
Assume the beta is 1.40.
The SML Approach
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Interest payments on debt are tax deductible, so the aftertax cost of debt is:
Dividends on preference shares and ordinary shares are
nottax-deductible so tax does not affect their costs.
The weighted average cost of capital is therefore:


WACC is the return that the firm must earn on its
existing assets to maintain the value of its shares.
WACC is the appropriate discount rate to use for
cash flows that are similar in risk to the firm.
Divisional and Project Costs of Capital
When is the WACC the appropriate discount rate?
When the project’s risk is about the same as the firm’s risk.
Example—Weighted Average Cost of Capital
Zeus Ltd has 78.26 million ordinary shares on issue with a
book value of $22.40 per share and a current market price
of $58 per share. The market value of equity is therefore
$4.54 billion. Zeus has an estimated beta of 0.90. Treasury
bills currently yield 4.5 per cent and the market risk
premium is assumed to be 7.94 per cent. Company tax is 30
per cent.
Other approaches to estimating a discount rate:
 divisional cost of capital—used if a company has
more than one division with different levels of risk
 pure play approach—a WACC that is unique to a
particular project is used
 subjective approach—projects are allocated to
specific risk classes which, in turn, have specified
WACCs.
The firm has four debt issues outstanding:
The SML and the WACC
Example—Cost of Equity(SML Approach
Example—Cost of Debt
If a firm uses its WACC to make accept/reject decisions for
all types of projects, it will have atendency towards
incorrectly accepting risky projects and incorrectly rejecting
less riskyprojects.
The weighted average cost of debt is 7.15 per cent.
Example—Capital Structure Weights
Market value of equity = 78.26 million × $58 = $4.539
billion.
Market value of debt = $1.474 billion.
Example—Using WACC for all Projects
What would happen if we use the WACC for all projects
regardless of risk?
Assume the WACC = 15 per cent
Project A should be accepted because its risk is low (Beta =
0.60), whereas Project B should be rejected because its risk
is high (Beta = 1.2).
The SML and the SubjectiveApproach
WACC
 The WACC for a firm reflects the risk and the target
capital structure to finance the firm’s existing assets
as a whole.
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Assume a corporate tax rate of 30 per cent.
Example—NPV (No Flotation Costs)
With the subjective approach, the firm places projects into
one of several risk classes. The discountrate used to value
the project is then determined by adding (for high risk) or
subtracting (for low risk)an adjustment factor to or from the
firm’s WACC.
Flotation Costs
The issue of debt or equity may incur flotation costs such as
underwriting fees, commissions, listing fees.Flotation costs
are relevant expenses and need to be reflected in any
analysis.
Example—Project Cost includingFlotation Costs
Saddle Co. Ltd has a target capital structure of 70per cent
equity and 30 per cent debt. Theflotation costs for equity
issues are 15 per cent ofthe amount raised and the flotation
costs for debtissues are 7 per cent. If Saddle Co. Ltd
needs$30 million for a new project, what is the ‘true
cost’ of this project?
The weighted average flotation cost is 12.6 percent.
Flotation costs decrease a project’s NPV and
could alter an investment decision.
CHAPTER 19
DIVIDENS AND DIVIDEND POLICY
Types of Dividends
A dividend is a payment made out of a firm’s earnings to its
owners (shareholders).Dividends are usually paid in the
form of cash.
Types of cash dividends include:
1. regular cash dividends
2. extra dividends
3. special dividends
4. liquidating dividends.
Share dividends are also paid, and share repurchases are a
dividend alternative.
Procedure for Dividend Payment
Example—Flotation Costs and NPV
Apollo Co. Ltd needs $1.5 million to finance a new project
expected to generate annual after-tax cash flows of $195
800 forever. The company has a target capital structure of
60 per cent equity and 40 per cent debt. The financing
options available are:
An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new equity
is 15 per cent.
An issue of long-term debentures. Flotation costs of debt
are 5 per cent of the capital raised. The return on new debt
is 10 per cent.
1. Declaration date: the board of directors declares a
payment of dividends.
2. Ex-dividend date: if you buy the share on or after
this date the seller is entitled to keep the dividend.
Under ASX rules, shares are traded ex-dividend on
and after the seventh business day before the
record date.
3. Record date: declared dividends are distributable to
shareholders of record on a specific date.
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4. Payment date: the dividend cheques are mailed to
shareholders of record.
The Ex-date Price DropEx date
The share price will fall by the amount of the dividend on
the exdate (Time 0). If the dividend is $1 per share, the price
will beequal to $10 –1 = $9 on the ex date.
Before ex date (Time –1)Dividend = $0Price = $10
On ex date (Time 0)Dividend = $1Price = $9
 Flotation costs: Higher dividend payouts may
require a new share issue, which could be expensive
and decrease the value of the firm.
 Dividend restrictions: Debt contracts might limit the
percentage of income that can be paid out as
dividends.
A high payout is better if one considers:
 Desire for current income instead of capital gain.
 Uncertainty resolution: ‘bird-in-hand’ story.
 Tax benefits: There are some investors who do
receive favourable tax treatment from holding high
dividends (e.g. corporate investors).
 Legal benefits.
Examples of Imputed Tax Credits
Do Dividends Matter?
Yes: the value of a share is based on the present value of
expected future dividends.
No: the value of a share is not affected by a switch in
dividend policy.
Does Dividend Policy Matter?
Dividend policy versus cash dividends
An illustration of dividend irrelevance : Original dividends
Assume an additional $200 of dividends is offered, financed
by an issue of debt or shares. New dividend plan:
To Date …
Based on the home-made dividend argument, dividend
policy is irrelevant.Because of high taxation of some
individual investors, a high-dividend policy may be
best.Because of new issue costs, a low-dividend policy is
best.
Dividends and Signals
Changes in dividends convey information
P0= $1200/1.2 + $760/1.22= $1 527.78
Dividend Policy Irrelevance
Any increase in dividends at one point is offset exactly by a
decrease somewhere else.An alternative explanation is
home-made dividends. Individual investors can undo
corporate dividend policy by reinvesting dividends or selling
shares.Companies may help with creating home-made
dividends by offering shareholders automatic dividend
reinvestment plans (DRIPs).
Dividends and the Real World
A low payout is better if one considers:
 Taxes: Optimal dividend policy is determined by
various shareholder situations. Some shareholders
prefer high franked dividends, others prefer the
company to pay no dividend and retain the funds
for reinvestment (tax on dividend income vs capital
gains tax).
Dividend increases:
 Management believes it can be sustained.
 Expectation of higher future dividends, increasing
present value.
 Signal of a healthy, growing firm.
Dividend decreases:
 Management believes it can no longer sustain the
current level of dividends.
 Expectation of lower dividends indefinitely;
decreasing present value.
 Signal of a firm that is having financial difficulties.
The information content makes it difficult to interpret the
effect of the dividend policy of the firm.
Clientele Effect
Shares attract particular groups based on dividend yield and
the resulting tax effects.Some investors prefer low dividend
payouts and will buy shares in those companies that offer
low dividend payouts.Some investors prefer high dividend
payouts and will buy shares in those companies that offer
high dividend payouts.
Residual Dividend Policy
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Issue costs eliminate any indifference between financing by
internal capital and new shares.Dividends are paid only if
profits are not completely used for investment
purposes.Desired debt-to-equity ratio is maintained.
Relationship Between Dividends andInvestment
Share Repurchases
Company buys back its own shares.Similar to a cash
dividend in that it returns cash from the firm to the
shareholders.This is another argument for dividend policy
irrelevance in the absence of taxes or other imperfections.
Equal access purchase: Offer made by company to all
shareholders to purchase shares in the same proportion as
their holdings.
On-market purchase: Purchase by a company of its own
shares on the open market.
Employee share purchase: Repurchase shares from
employees that were issued under employee incentive
scheme.
Key Concepts in Dividend Policy
Dividend stability—dividends are only increased if the
increase is sustainable.
Dividend streaming—shareholders can choose different
dividend schemes to suit their tax position (franked vs
unfranked dividends)
Special dividends—‘one-off’’ extra dividends.
Dividend reinvestment schemes—company reinvests
individuals’ dividends into fully paid shares of the company.
Avoids transactions costs and need for prospectus, and
shares are usually offered at a discount.
Selective purchase:
shareholders.
Repurchase of shares from specific
Odd-lot purchase:
shares.
Repurchase of small parcels of
Cash Dividend versus ShareRepurchase
Assume no taxes, commissions or other market
imperfections.Consider a firm with 50 000 shares
outstanding, netprofit of $100 000 and the following
balance sheet.
Australian Equity Raisings 2001
Price per share is $20 ($1 000 000/50 000).
EPS = $2.00 ($100 000/50 000).
PE ratio = 10.
The firm is considering either:
Paying a $1 per share cash dividend.
OR
Repurchasing 2500 shares at $20 a share.
Cash Dividend Option
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restructure, what is the minimum level of EBIT the company
needs to maintain EPS (the break-even EBIT)? Ignore taxes.
With no debt:
EPS = EBIT/500 000
Price per share is $19.00 ($950 000/50 000).
EPS = $2.00 ($100 000/50 000).
PE ratio = 10.
With $2.5 million in debt @ 10%:
EPS = (EBIT – $250 0001)/250 0002
1
Share repurchase option
Price per share is $20.00 ($950 000/47 500).
EPS = $2.10 ($100 000/47 500).
PE ratio = 9.5.
Share Dividends and Share Splits
Bonus shares and share splits:
 involve issuing new shares on a pro-rata basis to the
current shareholders
 do not change the firm’s assets, earnings, risk
assumed and investors’ percentage of ownership in
the company
 increase the number of shares outstanding
 reduce the value per share
A common explanation is to adjust the share price to a
‘more desirable trading range’.
Interest expense = $2.5 million × 10% = $250 000
Debt raised will refund 250 000 ($2.5 million/$10)shares,
leaving 250 000 shares outstanding
2
These are then equal:
EPS = EBIT/500 000 = (EBIT – $250 000)/250 000
With a little algebra:
EBIT = $500 000
EPSBE = $1.00 per share
Financial Leverage, EPS and EBITEBIT ($ millions, no taxes)
EPS ($)
Reverse Splits
The firm reduces the number of shares outstanding.
Reasoning:
1. reduction in transaction costs
2. increase in share marketability (trading range)
3. regain respectability.
Share Ownership Plans
Encourage the financial participation of employees in the
company, including:
 fully paid shares
 partly paid shares
 special classes of shares
 options
 phantom or shadow shares
 employee share trusts.
CHAPTER 20
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
POLICY
Key issues
What is the relationship between capital structure and firm
value?
What is the optimal capital structure?
Example—Home-made Leverage and ROE
Home-made leverage is the use of personal borrowing to
alter the degree of financial leverage. Investors can
replicate the financing decisions of the firm in a costless
manner.
Example :
Original capital structure and home-made leverage
investor uses $500 of their own and borrows $500 to
purchase 100 shares.
Proposed capital structure investor uses $500 of their own,
together with $250 in shares and $250 in bonds.
Original Capital Structure and Home-made Leverage
Cost of capital
A firm’s capital structure is chosen if WACC is
minimised.This is known as the optimal capital structure or
target capital structure.
Example—Computing Break-even EBIT
ABC Company currently has no debt in its capital structure.
The company has decided to restructure, raising $2.5
million debt at 10 per cent. ABC currently has 500 000
shares on issue at a price of $10 per share. As a result of the
Proposed Capital Structure
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By M&M Proposition II, the required rate of return on
equity arises from sources of firm risk. Proposition II is:
RE= RA+ [RA–RD] ×[D/E]
Business risk—equity risk arising from the nature of the
firm’s operating activities (measured byRA).
Financial risk—equity risk that comes from the financial
policy (i.e. capital structure) of the firm (measured by [RA–
RD] ×[D/E]).
Capital Structure Theory
Modigliani and Miller Theory of Capital Structure
–Proposition I—firm value
–Proposition II—WACC
The value of the firm is determined by the cash flows to the
firm and the risk of the assets
Changing firm value:
–Change the risk of the cash flows
–Change the cash flows
M&M Proposition I
The SML and M&M Proposition II
How do financing decisions affect firm risk in both M&M’s
Proposition II and the CAPM?
Consider Proposition II: All else equal, a higher debt/equity
ratio will increase the required return on equity, RE.
RE= RA+ (RA–RD) ×(D/E)
Substitute RA= Rf+ (RM-Rf)Βa
and by replacement RE= Rf+ (RM-Rf)βE
The effect of financing decisions is reflected in the equity
beta, and, by the CAPM, increases the required return on
equity.
βE= βA(1 + D/E)
Debt increases systematic risk (and moves the firm along
the SML).
Corporate Taxes
The interest tax shield is the tax saving attained by a firm
from interest expense.
(The size of the pie does not depend on how it is sliced.)
The value of the firm is independent of its capital structure.
Value of firm Value of firm
M&M Proposition II
Because of Proposition I, the WACC must be constant, with
no taxes:
WACC = RA= (E/V) ×RE+ (D/V) ×RD
where RAis the required return on the firm’s assets
Assumptions:
 perpetual cash flows
 no depreciation
 no fixed asset or NWC spending.
For example, a firm is considering going from $0 debt to
$400 debt at 10 per cent.
Solve for REto get M&M Proposition II:
RE= RA+ (RA–RD) ×(D/E)
The Cost of Equity and the WACC
Tax saving = $16 = 0.40 x $40 = TC × RD × D
What is the link between debt and firm value?
Since interest creates a tax deduction, borrowing creates a
tax shield. The value added to the firm is the present value
of the annual interest tax shield in perpetuity.
M&M Proposition I (with taxes):
The firm’s overall cost of capital is unaffected by its capital
structure.
Business and Financial Risk
Key result
VL = VU + TCD
M&M Proposition I with Taxes
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–The bad news:all else equal, borrowing more money
increases the probability (and therefore the expected value)
of direct and indirect bankruptcy costs.
Key issue: The impact of financial distress on firm value.
Direct versus Indirect Bankruptcy Costs
Directcosts : Those costs directly associated with
bankruptcy, (e.g. legal and administrative expenses).
Indirect costs : Those costs associated with spending
resources to avoid bankruptcy.
Financial distress:
–significant problems in meeting debt obligations
–most firms that experience financial distress do recover.
Taxes, the WACC and Proposition II
Taxes and firm value: an example
EBIT = $100
TC = 30%
RU = 12.5%
Suppose debt goes from $0 to $100 at 10 per cent. What
happens to equity value, E?
The static theory of capital structure:
A firm borrows up to the point where the tax benefit from
an extra dollar in debt is exactly equal to the cost that
comes from the increased probability of financial distress.
This is the point at which WACC is minimised and the value
of the firm is maximised.
The Optimal Capital Structure and theValue of the Firm
VU = $100 × (1 – 0.30)/0.125 = $560
VL = $560 + (0.30 × $100) = $590
E = $490
WACC and the cost of equity (M&M Proposition II with
taxes):
RE=RU+(RU–RD)×(D/E)×(1–TC)
Conclusions
The WACC decreases as more debt financing is used.
Optimal capital structure is all debt.
The Optimal Capital Structure and theCost of Capital
Bankruptcy Costs
Borrowing money is a good news/bad news proposition.
–The good news:interest payments are deductible and
create a debt tax shield (TCD).
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The Capital Structure Question
With corporate and personal tax, and dividend imputation,
shareholders are again indifferent between corporate and
personal borrowing.
Dynamic Capital Structure Theories
 Pecking order theory : Investment is financed first
with internal funds, then debt, and finally with
equity.
 Information asymmetry cost : Management has
superior information on the prospects of the firm.
 Agency costs of debt : These occur when equity
holders act in their own best interests rather than
the interests of the firm
CHAPTER 21
OPTION, CORPORATE SECURITIES AND FUTURES
Managerial Recommendations
The tax benefit is only important if the firm has a large tax
liability.
Risk of financial distress:
–The greater the risk of financial distress, the less debt will
be optimal for the firm.
–The cost of financial distress varies across firms and
industries.
The Extended Pie Model
The Value of the Firm
Value of the firm = marketed claims + non-marketed claims:
–Marketed claims are the claims of shareholders and
bondholders.
–Non-marketed claims are the claims of the government
and other potential stakeholders.
Option Terminology
1. Call option : Right to buy a specified asset at a
specified price on or before a specified date.
2. Put option : Right to sell a specified asset at a
specified price on or before a specified date.
3. European option : An option that can only be
exercised on a particular date (on expiry).
4. American option : An option that can be exercised
at any time up to its expiry date.
5. Striking price : The contracted price at which the
underlying asset can be bought (call) or sold (put).
6. Expiration date : The date at which an option
expires.
7. Option premium : The price paid by the buyer for
the right to buy or sell an asset.
8. Exercising the option : The act of buying or selling
the underlying asset via the option contract.
Option Contract Characteristics
Expirationmonth
Optiontype
Contractsize
Expiry
Exerciseprice
Option Valuation
S1 = share price at expiration S0 = share price today
C1 = value of call option on expiration
C0 = value of call option today
E = exercise price on the option
Value of Call Option at Expiration
The overall value of the firm is unaffected by changes in the
capital structure.The division of value between marketed
claims and non-marketed claims may be impacted by capital
structure decisions.
Corporate Borrowing and Personal Borrowing
Without tax, corporate and personal borrowing are
interchangeable.
With corporate and personal tax, there is an advantage to
corporate borrowing because of the interest tax shield.
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Value of a Call Option Before Expiration
Black–Scholes Option Pricing Model
Note: The risk-free rate, the standard deviation and the
time to maturity must all be quoted using the same time
units.
Call Option Boundaries
Upper bound—a call option will never be worth more than
the share itself:
C0S0
Example—Black–Scholes Option Pricing Model
Lower bound—share price cannot fall below 0 and to
prevent arbitrage, the call value must be (S0 – E):
The larger of 0 or (S0 – E)
Intrinsic value—option’s value if it was about to expire =
lower bound.
Factors Determining Option Values
Call option value = Share price - PV of exercise price
The value of a call option depends on four factors:
share price
exercise price
time to expiration
risk-free rate.
Another Factor to Consider?
The above four factors are relevant if the option is to finish
in the money.If the option can finish out of the money,
another factor to consider is volatility.The greater the
volatility in the underlying share price, the greater the
chance the option has of expiring in the money.
From the cumulative normal distribution table:
N(d1) = N(1.34) = 0.9099
N(d2) = N(1.13) = 0.8708
Therefore, the value of the call option is:
The Factors that Determine Option Value
Equity: A Call Option
Equity can be viewed as a call option on the company’s
assets when the firm is leveraged.The exercise price is the
value of the debt.If the assets are worth more than the debt
when it becomes due, the option will be exercised and the
shareholders retain ownership.If the assets are worth less
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than the debt, the shareholders will let the option expire
and the assets will belong to the bondholders.
Equity Option Contracts
Types of equity option contracts offered in Australia:
–Exchange traded put and call options on company shares
–Exchange traded long dated contracts issued by a financial
institution that can then trade them (warrants)
–Over-the-counter options on company shares
–Convertible notes issued by companies, comprising both a
debt and an equity component.
Warrants
A long-lived option that gives the holder the right to buy
shares in a company at a specified price.
Types of warrants available:
equity warrants
low exercise price warrants
fractional warrants
endowment warrants
basket warrants
currency warrants
fully covered warrants
index warrants
instalment warrants
Company Options
A holder is given the right to purchase shares in a company
at a specified price over a given period of time.Usually
offered as a ‘sweetener’ to a debt issue.These options are
often detached and sold separately.
Company Options versus Exchange-traded Options
Company options have longer maturity periods and are
often European-type options.Company options are issued
as part of a capital-raising program and are therefore
limited in number.The clearing house has no role in the
trading of company options.Company options are issued by
firms.
Earnings Dilution
Put and call options have no effect on the value of the
firm.Company options do affect the value of the
firm.Company options cause the number of shares on issue
to increase when:
–the options are exercised
–the debts are converted.
This increase does not lower the price per share but EPS will
fall.
Futures Contracts
An agreement between two parties to exchange a specified
asset at a specified price at a specified time in the future.
Do not need to own an asset to sell a future contract.
Either buy before delivery or close out position with an
opposite market position.
Futures Markets
Enable buyers and sellers to avoid risk in commodities (and
other) markets with high price variability → hedging.
Involves standardised contracts.
Deposit required by all traders to guarantee performance.
Adverse price movements must be covered daily by further
deposits called margins (‘marked to market’).
Futures also available for short-term interest rates, to
protect against interest rate movements.
Futures Quotes
Commodity, exchange, size, quote units : The contract size
is important when determining the daily gains and losses for
marking-to-market.
Delivery month : Open price, daily high, daily low,
settlement price, change from previous settlement price,
contract lifetime high and low prices, open interest
–The change in settlement price multiplied by the contract
size determines the gain or loss for the day:
 Long—an increase in the settlement price leads to a
gain
 Short—an increase in the settlement price leads to
a loss
Forward Contracts
A contract where two parties agree on the price of an asset
today to be delivered and paid for at some future
date.Forward contracts are legally binding on both
parties.They can be tailored to meet the needs of both
parties and can be quite large in size.Positions :
–Long—agrees to buy the asset at the future date
–Short—agrees to sell the asset at the future date
Open interest is how many contracts are currently
outstanding.
Because they are negotiated contracts and there is no
exchange of cash initially, they are usually limited to large,
creditworthy corporations.
Factors Determining the Term Structure
Risk preferences : borrowers prefer long-term credit
whereas lenders prefer short-term loans (explains upwardsloping yield curve only).
Term Structure of Interest Rates
Yield curve shows the different interest rates available for
investments of different maturities, at a point in time.The
relationship between interest rates of different maturities is
called the term structure.
Supply : demand conditions—segmented capital markets
can cause supply-demand imbalances (explains all yield
curve shapes).
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Expectations about future interest rates (most favoured
explanation)
CHAPTER 22
MERGERS, ACQUISITIONS AND TAKEOVERS

Market bid : An announcement by a stockbroker
that a broking firm will stand in the market to
purchase the target company’s shares for a
specified price for a specified period.
The Legal Framework
Legal Forms of Acquisitions
Merger complete absorption of one company by another.
Consolidation creation of a new firm by combining two
existing firms.
Advantages of mergers and consolidations:
 simplicity (buyer assumes all assets and liabilities)
 inexpensive.
Acquisition of assets transfer of assets and liabilities of
the target company to the acquiring company.
Taxes and Acquisitions
Generally, assets purchased after 19 September 1985 are
subject to capital gains tax (CGT) when sold.CGT can be
deferred under rollover provisions.CGT still applies when
the consideration is shares, and when more than 50 per
cent of pre-19 September 1985 shareholders have changed
(regardless of purchase date).
Acquisition of shares (tender offer) acquire sufficient
Voting shares to gain management control via a direct
public offer for the shares.
Gains from Acquisition
Synergy the value of the combined companies is higher
than the sum of the value of the individual companies.
Disadvantages of mergers and consolidations:
 shareholders of both firms must approve
 difficulty in obtaining cooperation of target
company’s management.
Majority control versus effective control.
Acquisition Classifications
Horizontal acquisition : between two firms in the same
industry.
Vertical acquisition : the buyer expands backwards by
acquiring a firm with the source of raw materials or
forwards by acquiring a firm that is closer in the direction of
the ultimate consumer.
Conglomerate acquisition : involves companies in unrelated
industries.
A Note on Takeovers
Need to determine incremental cash flows.
Incremental Cash Flows
= Revenue – Cost – Tax – Capital requirements
A. Increased revenues
1. Gains from better marketing efforts.
2. Strategic benefits—‘beachhead’ into new markets.
3. Increased market power—monopoly.
B. Decreased costs
1. Economies of scale.
2. Economies of vertical integration.
3. Complementary resources.
Incremental Cash Flows
C. Tax gains
1. Use of net operating losses.
2. Use of excess or unused franking credits.
3. Use of unused debt capacity.
4. Asset revaluations.
Takeover Situations
 Creeping takeover : Holdings in a target company
can be increased by no more than 3 per cent every
six months.
 Off market bid : A formal written offer is made to
acquire the shares of a target company.
D. Changing capital requirements
1. Reduced investment needs.
2. More efficient asset management.
3. Sell redundant assets.
Mistakes to Avoid
Do not ignore market values.
Estimate only incremental cash flows.
Use the correct discount rate.
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Be aware of transactions costs.
Acquisitions and EPS Growth
Pizza Shack and Checkers Pizza are merging to form Stop ’n’
Go Pizza. The merger is not expected to create any
additional value. Stop ‘n’ Go, valued at $1 875 000, is to
have 125 000 shares outstanding at $15 per share.
How much does Firm A have to give up?
Example—Cash Acquisition
Cost of acquiring Firm B is $675.
NPV of the cash acquisition is:
The value of Firm A after the merger is:
Price per share after the merger is $18.20.
EPS has increased (and the P/E ratio has decreased) because
the total number of shares is less.The merger has not
‘created’ value.
Diversification
Does not create value in a merger.
Is not, in itself, a good reason for a merger.
Reduces unsystematic risk.
BUT
Shareholders can do this for themselves more easily and
less expensively.
The Cost of an Acquisition
The net incremental gain from a merger of Firms A and B is:
V = VAB – (VA + VB)
The total value of Firm B to Firm A is:
VB* = VB + V
The NPV of the merger is:
NPV = VB * – Cost to Firm A of the acquisition
The cost of the acquisition to Firm A depends on the
Medium of exchange used to acquire Firm B—cash or
shares. Whether cash or shares are used to finance the
acquisition depends on the following factors:
 Sharing gains: If cash is used, the selling firm’s
shareholders will not participate in the potential
gains (or losses) from the merger.
 Control: Control of the acquiring firm is unaffected
in a cash acquisition. Acquisition with voting shares
may have implications for control of the merged
firm.
Example—Cash or Shares?
Pre-merger information for Firm A and Firm B:
Both firms are 100 per cent equity financed.
The estimated incremental value of the acquisition is
Firm B has agreed to a sale price of $675, payable in cash or
shares. The value of Firm B to Firm A is:
Example—Share Acquisition
The value of the merged firm:
Firm A must give up $675/$15 = 45 shares. After the merger
there will be 165 shares outstanding, valued at $17.33 per
share.
True cost of the acquisition: 45 shares × $17.33 = $779.85
NPV of the merger to Firm A:
Cash acquisition preferred (higher NPV).
Defensive Tactics
Managers who believe their firms are likely to become
takeover targets and who wish to fend off unwanted
acquirers often implement one or more takeover defences.
These defensive tactics take several forms:
–Friendly shareholders offer the best defence.
–Poison pills—designed to ‘repel’ takeover attempts.
–Share rights plans—allow existing shareholders to
purchase shares at some fixed price in the event of a
takeover bid.
–Going private and leveraged buyouts—the publicly owned
shares in a firm are replaced with complete equity
ownership by a private group (often financed by debt).
Terminology of Defensive Tactics
1. Golden parachutes—compensation to top-level
management.
2. Poison puts—purchase securities back at a set price.
3. Crown jewels—selling off of major assets.
4. White knights—acquisition by a ‘friendly’ firm.
5. Lockups—option for a ‘friendly’ firm to purchase
shares or assets at a fixed price.
6. Shark repellant—designed to discourage unwanted
mergers.
.
Evidence on Acquisitions
Shareholders of target companies involved in successful
takeovers gainsubstantially.Abnormal gains of around 25
per cent reflect merger premium.
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Shareholders of bidding firms involved in successful
takeovers only experience gains of 5 per cent. There are a
variety of explanations for this:
–Overestimated anticipated gains
–Scale effect (bidders usually larger than targets)
–Agency problem
–Competitive market for takeovers
–Gains already reflected in bidder’s price (no new
information)
CHAPTER 23
INTERNATIONAL CORPORATE FINANCE
Domestic versus International Financial Management
Whenever transactions involve more than one currency, the
levels of, and possible changes in, exchange rates need to
be considered.The risk of loss associated with actions taken
by foreign governments also needs to be considered. This
political riskcan be difficult to assess and difficult to hedge
against.Financing opportunities encompass international
capital markets and instruments, which can reduce the
firm’s cost of capital.
International Finance Terminology
Cross rate
–The implicit exchange rate between two currencies quoted
in some third currency.
Euro
–The monetary unit for the European Monetary System
(EMS).
Eurobonds
–International bonds issued in multiple countries but
denominated in the issuer’s currency.
Eurocurrency
–Money deposited in a financial centre outside the country
whose currency is involved.
Foreign bonds
–International bonds issued in a single country usually
denominated in that country’s currency.
Hong Kong Stock Exchange
Hong Kong Futures Exchange
Shanghai Securities Exchange
Shenzen Stock Exchange
Osaka Stock Exchange
Tokyo Stock Exchange
Tokyo Int’l Financial Futures Exchange
Singapore Stock Exchange
Kuala Lumpur Stock Exchange
Americas
New York Stock Exchange
American Stock ExchangeBoston Stock Exchange
Cincinnati Stock Exchange
Chicago Stock ExchangePacific Stock Exchange
Philadelphia Stock Exchange
Chicago Board of Trade
Kansas City Board of Trade
Toronto Stock Exchange
Europe and the UK
Frankfurt Stock Exchange
London Stock Exchange
Paris Bourse
Swiss Stock Exchange
Participants in Foreign Exchange Market
Importers
Exporters
Portfoliomanagers
Foreignexchangebrokers
Traders
Speculators
Exchange Rates
Q: If you wish to exchange $100 for British pounds at an
exchange rate of $A1/£0.337, how many pounds will you
receive?
A: $A100 ×(0.337) = £33.7
Q: You paid 20 French francs for a croissant in France. If the
exchange rate is $A1/FF4.1184, how much did it cost in
dollars?
A: FF20 : 4.1184 = $A4.8563
Exchange Rate Quotations
Foreign exchange market
–The market in which one country’s currency is traded for
another.
Gilts
–British and Irish government securities.
London Interbank Offer Rate (LIBOR)
–The rate most international banks charge one another for
overnight Eurodollar loans.
Swaps
–Agreements to exchange two securities or currencies.
Global Capital Markets
Asia/Pacific Region
Australian Stock Exchange
Sydney Futures Exchange
New Zealand Stock Exchange
Example—Exchange Rates
If you wish to convert $A1000 to $US at the above exchange
rates:
–you SELL $A; therefore, the dealer BUYS $A
–$A1000 ×0.5190 = $US519
If you now convert $US519 back to $A:
–you BUY $A; therefore, the dealer SELLS $A
–$US519 : 0.5215 = $A995.21
The difference is the dealer fee ($A1000 -995.21 = $A4.79).
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Triangle Arbitrage
You have observed the following exchange rates:
Relative PPP Equation
You have just made $A25!
Cross Rates
To prevent triangle arbitrage:
–the $A can be exchanged for FF10 or DM2.00
Cross rate must be:
Example—Cross Rates
The exchange rates for the British pound and the Japanese
yen are:
$A1 = £0.3538
$A1 = ¥63.74
¥180.16/£ £0.3538¥63.74 or £0.0056/¥ ¥63.74£0.3538 rate
Example—Relative PPP
The German exchange rate is currently 1.3 DM per dollar.
The inflation rate in Germany over the next five years is
estimated to be 5 per cent per year, while the Australian
inflation rate is estimated to be 3 per cent per year. What
will be the estimated exchange rate in five years?
Solution—Relative PPP
The DM will become less valuable; $A will become more
valuable.The exchange rate change will be 5% – 3% = 2%
per year.
Example—Covered Interest Arbitrage (CIA)
Types of Transactions
Spot deal an agreement to trade currencies based on the
exchange rate today for settlement within two business
days.
Spot exchange rate the exchange rate on a spot deal.
Forward deal an agreement to exchange currency at
some time in the future.
Forward exchange rate the agreed-upon exchange rate to
be used in a forward deal.
Purchasing Power Parity
The idea that the exchange rate adjusts to keep purchasing
power constant among currencies.Absolute purchasing
power parity (PPP) is a commodity costs the same
regardless of what currency is used to purchase it or where
it is selling.
Interest Rate Parity (IRP)
The interest rate differential between two countries is equal
to the percentage difference between the forward
exchange rate and the spot exchange rate.
For absolute PPP to hold:
–transaction costs must be zero
–there must be no barriers to trade
–the items purchased must be identical in all locations.
Relative Purchasing PowerParity
The idea that the change in the exchange rate between two
currencies is determined by the difference in inflation rates
between the two countries.Relative PPP, therefore, explains
the changesin exchange rates over time rather than the
absolute levels of exchange rates.
Uncovered Interest Parity (UIP)
The expected percentage change in the exchange rate is
equal to the difference in interest rates.
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Combines IRP and UFR.
International Fisher Effect (IFE)
Real interest rates are equal across countries.
Combines PPP and UFR.
Ignores risk and barriers to capital movements.
Example—International Capital Budgeting
Pizza Shack is considering opening a store in Mexico. The
store would cost $A500 000 or 3 million pesos (at an
exchange rate of $A1/6.000 pesos). They hope to operate
the store for two years and then sell it to a local franchisee.
Assume that the expected cash flows are 250 000 pesos in
the first year and 5 million pesos in year 2 (including the
selling price of the store and fixtures). The Australian riskfree rate is 7 per cent and the Mexican risk-free rate is 10
per cent. The required return in Australia is 12 per cent.
Ignore taxes.
Translation Exposure
Uncertainty arising from the need to translate the results
from foreign operations (in foreign currency) to home
currency for accounting purposes.
Political Risk
Changes in value due to political actions in the foreign
country.Investment in countries that have unstable
governments should require higher returns.The extent of
political risk depends on the nature of the business:
–The more dependent the business is on other operations
within the firm, the less valuable it is to others.
–Natural resource development can be very valuable to
others, especially if much of the ground work in developing
the resource has already been done.
-- Local financing can often reduce political risk.
Types of Political Risk
Method 1: Home Currency
Using the interest rate parity relationship:

CHAPTER 24
Example—Method 2: Foreign Currency Approach
Using a 3 per cent inflation premium: (1.12 ×1.03) –1 =
15.36%
LEASING
Leasing versus Buying
Exchange Rate Risk
The risk related to having international operations in a
world where currency values vary.
Short-run exposure—uncertainty arising from day-to-day
fluctuations in exchange rates.
Long-run exposure—potential losses due to long-run,
unanticipated changes in the relative economic conditions
in two or more countries.
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Leasing
What is a lease?
–A lessee (user) enters an agreement in which they make
lease payments to the lessor (owner) in return for the use of
the leased property/asset.
Who are the major providers of lease finance in Australia?
–Finance companies and banks.
What assets are leased?
–Any asset including photocopiers, cars, construction
equipment, computers, shop/office fittings and equipment.
24-709
Types of Leases
Operating lease
Financial lease
–Sale and leaseback agreement
–Leveraged lease
Operating Leases
Short-term lease.
Cancellable prior to the expiry date at little or no cost.
Lessor is responsible for maintenance and upkeep of asset.
The sum of the lease payments does not provide for full
recovery of the asset’s costs.
Includes telephones, televisions, computers, photocopiers,
cars.
Financial Leases
Long-term lease.
Non-cancellable (without penalty) prior to expiry date.
Lessee is responsible for the maintenance and upkeep of
the asset.
Lease period approximates asset’s economic life.
The sum of the lease payments exceeds the asset’s
purchase price.
Includes specialist equipment, heavy industrial equipment.
Residual Value Clause
Lease continues for its full term
Lessee can purchase the asset for its residual value, return
the asset to the lessor (paying any shortfall from residual
value) or renew the lease.
Criteria for a Financial Lease
AAS17 ‘Accounting for Leases’ states that a financial lease
occurs where substantially all risks and benefits pass to the
lessee.A financial lease must be disclosed on the Statement
of Financial Position if at least oneof the following criteria is
met:
–the lease term is 75 per cent or more of the estimated
economic life of the asset
–the present value of the lease payments is at least 90 per
cent of the fair market value of the asset at the start of the
lease.
Leasing and Taxation
Lease premiums paid under a lease contract are tax
deductible.Any payment relating to the ultimate purchase
of the asset is not deductible.The residual payment does
not qualify as a tax deduction.Any profit made on the asset
previously leased is subject to capital gains tax.
Example—Lease versus Buy
Macca Co. has to decide whether to borrow the $15 000
needed to purchase a new gadget machine (with a
borrowing cost of 10 per cent) or to lease the machine for
$4000 per annum. If purchased, the asset could be
depreciated using the straight-line method over the threeyear life. The company tax rate is 30 per cent.Under the
lease agreement, Macca Co. would be responsible for
maintaining the machine?
Example—Lease versus Buy: Repayment Schedule
Lease is cancelled during its initial term
Lessee must pay outstanding premiums (less interest
component) plus residual value of asset.
Sale and leaseback agreements
Companies sell an asset to another firm and immediately
lease it back. Enables the company to receive cash and yet
maintain use of the asset.
Leveraged leases
The lessor arranges for funds to be contributed by one or
more parties—form of risk-sharing and transferring tax
benefits. Often used to finance large-scale projects.
Example—Lease versus Buy:Tax Subsidises Borrowing
Leasing and the Statement of Financial Position
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Example—Lease versus Buy:Tax Subsidises Leasing
Net Advantage of Leasing
Example—Lease versus Buy:Net Advantage of Leasing
Setting Lease Premiums
Lease premiums are paid in advance in Australia.
The advantage is greater than zero so Macca Co.
should lease.
Residual Value
The residual valueis the amount for which the asset may be
purchased by the lessee from the lessor at the end of the
lease term.
Example—Lease Premiums
KAZ Co. has started a four-year lease of a photocopier which
has a $70 000 purchase price. Had the company purchased
the copier, the interest rate quoted on borrowings was 1.5
per cent per month. KAZ has agreed with the lessor to a
residual value of $10 000 at the end of four years.What will
be the amount of the lease premiums?
Solution—Lease Premiums
The salvage valueis the amount the asset can be sold for in
the market place by the lessee (once they have acquired the
asset).
In the previous example, assume a residual value of $2000
and a salvage value of $1500.
Example—Lease the Asset with Residual Value
Example—Borrow to Purchase the Asset with Residual
Value
Advantages of Financial Leases
No restrictions on future borrowing.
Can be tailored to suit firm’s needs.
Eliminates the need to raise extra capital.
No unnecessary financial outlay.
May be excluded from the Statement of Financial Position.
Facilitates financing capital additions on a piecemeal basis.
Is an allowable cost under government contracting.
Offers tax advantages.
Advantages of Operating Leases
Frees up capital for alternative uses.
Increases the company’s working capital.
Provides greater control due to greater certainty in future
outlays.
Assures more competent upkeep of asset.
Avoids the risk of obsolescence.
Avoids the equipment disposal problem.
Future outlays cost less in real terms due to inflation.
Disadvantages of Leasing
Interest cost often higher.
May not offer the right to the residual value of the asset.
Allows the acquisition of assets without submitting formal
capital expenditure procedures.
May cause distortions in the evaluation of interfirm and
interdivision performance.
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Lacks the prestige associated with ownership.
Good Reasons for Leasing
Taxes may be reduced by leasing.
The lease contract may reduce certain types of uncertainty
that might otherwise decrease the value of the firm.
Leasing reduces the impact of obsolescence of an asset on a
firm.
Transaction costs may be lower for a lease contract than for
buying the asset.
Leasing may require fewer (if any) restrictive covenants
than secured borrowing.
Bad Reasons for Leasing
The perception of 100 per cent financing.
The apparent low cost.
Using leasing to artificially enhance accounting income.A
UTS SEMESTER GASAL 2012/2013
MANAJEMEN KEUANGAN
150 menit (Closed Book)
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JAWABAN
1.) a
AR Turnover = Sales /
AR
Average Collection
Period = 365 / (AR
Turnover)
Inventory Turnover =
COGS / Inventory
Fixed Asset Turnover =
Sales / Net Fixed Asset
Total Asset Turnover =
Sales / Total Asset
11.24 kali
32.49 hari
16.09 kali
4.60 kali
2.78 kali
b
Comparing: with peers
& with prior
performance
Efisiensi Penggunaan
aset: AR turnover,
inventory turnover,
fixed asset turnover,
TAT
C.
Du Pont Analysis:
ROE = Net income / Equity = Net Income / Sales x Sales /
Equity = Net Income / Sales x Sales / Asset x Asset / Equity
ROE = Profit Margin x Total
Asset Turnover x Equity
Multiplier
RoE = Profitability,
Operating
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efficiency, Leverage
2013
Profit Margin
TAT
Equity Multiplier
RoE
Debt Ratio
0.98
%
2.78
Find YTM of 002 --> Find YTM 001 -->
Find Price 001
Logic: YTM of 002, lower or higher
than its coupon?
Discount --> YTM
is higher than
Answer:
coupon
2012
1.15
%
2.78
Lower
Profita
bility
Stable
Higher
Levera
ge
2.22
6.02
%
1.63
5.21
%
55%
Just to
prove
higher
leverag
50% e
2013
2012
0.91
1.2
Use Trial and error --> Do this last.
Trial and Error
YTM
926,399,129.49
6% x 2 = 12%
Price of 001
5,288,934,649.68
b.
Year
Dividend
d.
Current Ratio =
Current Asset /
Curr. Liab.
Acid test Ratio =
(curr. Asset inventory) / Curr.
Liab
Debt Ratio
1 750.00
0.63
55%
0.89
50%
2 750.00
2.)
a
JWS001
Par
c
Same YTM as
JWS002
Price?
5,000,000,000.00
162,500,
000.00
every 3
13% months
10
years
3 900.00
Up 20%
4 1,080.00
Up 20%
5% constant
growth
Req. Rate of
Return
13%
Market Price
Rekomendasi:
overvalued or
undervalued?
10,000.00
Terminal Value
D5/R-g3
JWS002
Price
926,400,000.00
Par
1,000,000,000.00
every 6
10% months
5 years
c
50,000,0
00.00
14,175.00
P0
11,231.00
Market Price
So, stock is undervalued, Buy !
10,000.00
3. ) a.
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Income Statement
Sales
Cost
Taxable Income
Tax
Net Income
Dividend
Add to R/E
Sales up 25%
AR
440
600
1200
10.67
%
29.33
%
40.00
%
80.00
%
Fixed
Asset
Total
1800
3000
Pro
Forma
BS
Current
Asset
Cash
AR
NP
Total
Curr Liab
100 n/a
LTD
800 n/a
CS & PIS
800 n/a
0.2
400
1000 n/a
1800
3000
Current
Liability
200
550
80.00
% LTD
800 n/a
CS & PIS
2250
120.0
0% RE
3750
200.0
0% Total
800 n/a
1385.000
193 n/a
2185.000
193
3460.000
193
290.00
b
Maximum Growth
without External
Financing
Internal Growth
Rate =
RoA X b
% of
Sales
10.67
% AP
29.33 NP
475
Fixed
Asset
EFN
300
% of
Sales
1500
Total
AP
200.0
0% Total
750
Total
40.00 Current
% Liability
Total
875
297.5
577.5
192.4998075
385.0001925
% of
Sales
120.0
0% RE
Total
Inv
Total
Current
Asset
Net PPE
Curr.
Liab.
160
Net PPE
1875
1000
% of
Sales
Cash
Inv
Tot Curr
Asset
1500
800 0.5333333
700
238
462
154
308
Pro Forma
Sales
Cost
Taxable
Income
Tax (34%)
Net Income
Dividend
Add to R/E
Balance
Sheet
Curr.
Asset
%
%
20.00
375
%
100 n/a
462/3000 x (1-0.33)
0.1
1 - 462/3000 x (11 - RoA x b
0.33)
0.9
So, the maximum growth without external financing is
11%
Pro Forma
Sales
1,665.00
Cost
888.00
Taxable Income
777.00
Tax
264.18
Net Income
512.82
Dividend
170.94
Add to R/E
341.88
Pro
Forma
% of
Sale
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%
% of
Sale
2022
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
BS
Current
Asset
s
s
990,000,000,000
3 .00
Current
Liability
AR
488.40
Inv
Total
Current
Asset
666.00
10.6
7% AP
29.3
3% NP
Total
40.0 Current
0% Liability
1,332.00
80.0
0% LTD
Cash
177.60
Fixed
Asset
333.00
100 n/a
433
800 n/a
CS & PIS
Net PPE
1,998.00
800 n/a
120.
00% RE
Total
Total
3330
20.0
0%
200.
00% Total
Initial Outlay:
Izin
Financing Cost
Sunk Cost
Net working capital
52,900,000,000
.00
544,500,000,00
0.00
200,000,000.00
5,000,000,000.00 irrelevant
50,000,000,000.00 irrelevant
30,000,000,000.00
3yrs econ.
Life, can
be sold at
500,000,000,000.00 100Bio.
530,200,000,000.00
Net capital spending
Depreciation - mesin
166,666,666,666.67 per year
1,341.8
8
n/a
2141.88
0171
Year 1
Sales
800,000,000,0
00.00
Sales
943,000,000,
000.00
3374.88
0171
FC
40,000,000,00
0.00
FC
46,000,000,0
00.00
VC
440,000,000,0
00.00
VC
518,650,000,
000.00
Depreciatio
n
166,666,666,6 Depreciatio
66.67
n
166,666,666,
666.67
EBIT
153,333,333,3
33.33
EBIT
211,683,333,
333.33
Tax (35%)
Add:
Depreciatio
n
53,666,666,66
6.67
Tax (35%)
Add:
166,666,666,6 Depreciatio
66.67
n
74,089,166,6
66.67
Operating
Cash Flow
266,333,333,3 Operating
33.33
Cash Flow
304,260,833,
333.33
Because total Liabilities and Eq. is bigger than Assets, so no
EFN is needed
Plug
Ex: Pay 44.8 in dividends so the B/S is
Variable?
balanced
Year 2
4.) a
Year
Unit Price
Unit Sales
1 1,000,000,000.00
VC
FC
Ye
ar
800
2 1,150,000,000.00
820
3 1,200,000,000.00
825
166,666,666,
666.67
55% of Sales
40,000,000,000.00
Up by 15% every year
Sales
FC
VC
800,000,000,000
1 .00
40,000,000,000
.00
440,000,000,00
0.00
943,000,000,000
2 .00
46,000,000,000
.00
518,650,000,00
0.00
0
Operatin
g Cash
Flow
Changes
in NWC
1
266,333,33
3,333.33
2
304,260,
833,333.
33
(30,000,0
M a t a k u l i a h l a i n y a n g b e l u m a d a d i P D F i n i a k a n s a y a u p d a t e d i w w w . a k u n t a n s i d a n b i s n i s . wo rd p re s s . c o m
Contac t me : muhammad.f irman177@gmail.com /@f irmanmhmd (Line)
PE1
3
313,523,
333,333.
33
30,000,0
2023
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
00,000.00
)
Capital
Spending
Total
Project
Cash
Flow
00,000.0
0
b. Menghitung expected return dari portofolio.
c. menghitung standar deviasi dari saham A dan C
Aset
(500,200,
000,000.0
0)
6500000
0000
(530,200,
000,000.0 266,333,33
0)
3,333.33
304,260,
833,333.
33
408,523,
333,333.
33
NPV
304,260,
408,523,
(530,200,00 + 266,333,33
833,333.
333,333.
0,000.00)
3,333.33
+ 33
+ 33
(1+.15)^
(1+.15)^1
2
(1+.15)^3
jika NPV positif, accept the project
Payback
Period
Cover
initial
(530,200,00
Initial outlay
outlay of
0,000.00)
Cumulative
left
Year 1
266,333,333
,333.33
266,333,333,3
33.33
(263,866,666
,666.67)
Year 2
304,260,833
,333.33
570,594,166,6
66.67
40,394,166,6
66.67
Year 3
408,523,333
,333.33
979,117,500,0
00.00
263,866,666
so, 1 year + ,666.67
0.867238362
304,260,833
,333.33
Payback Period is 1+0.87 = 1.87 Years
UAS SEMESTER GASAL 2012/2013
MANAJEMEN KEUANGAN
Total
investasi
Saham A
Saham B
Saham C
Risk Free
rate
Jumlah
investasi
25000000
10000000
8000000
4000000
3000000
Boom
(25%)
20%
18%
16%
7%
Kondisi
ekonomi
Normal
(50%)
16%
13%
11%
7%
Recession
(25%)
13%
11%
8%
7%
Soal 2 (20%)
Dengan informasi dari AA Power Co. di bawah ini, hitunglah
WACC nya dengan asumsi pajak korporat sebesar 35%.
Debt: 9,000 jumlah beredar dengan kupon 5 persen, nilai
par : $1,000, dengan jangka waktu 5 tahun, dijual pada 92
persen dari par; pembayaran kupon dilakukan tahunan
(annually).
Common Stock: 260,000 jumlah beredar, dijual dengan
harga $57 per share; dengan nilai beta 1.05.
Preferred Stock: 15,000 jumlah saham beredar dengan 5
percent dividen dari preferred stock, dengan harga pasar
$93 perlembar dan par $100 perlembar saham.
Market: dengan market risk premium 8 persen dan risk free
rate sebesar 4.5 persen.
Soal 3 (20%)
a. Apakah skema pendanaan yang digunakan untuk
investasi pengembangan Angkasa Pura II?
b. Jelaskan kekurangan dan kelebihan masing-masing skema
pendanaan yang dipilih oleh Angkasa Pura II.
Soal 4 (20%)
PT Maxima mempunyai 10,000 saham yang beredar di
pasaran. Harga pasar saat ini ialah $15 per lembar
dengan EPS sebesar $1. Perusahaan mengumumkan 2:1
stock split. Anda memiliki 100 lembar saham dari PT.
Maxima.
a. Apa pengaruh kebijakan stock split pada harga saham,
EPS dan kepemilikan (ownership stake) dari
saham anda?
b. Jika PT. Maxima lebih memilih untuk menawarkan
kebijakan 10% stock dividend daripada kebijakan
stock split diatas, bagaimana pengaruh kebijakan stock
dividend tersebut pada harga saham, EPS dan
kepemilikan (ownership stake) dari saham anda?
Soal 5 (20%)
a. Berikut ini adalah informasi dari beberapa akun yang ada
di neraca PT. ABC:
150 menit (Closed Book)
Soal 1 (20%)
Anda adalah manajer investasi dari perusahaan sekuritas.
Gunakan informasi di bawah ini untuk:
a. Menghitung expected return tiap saham.
M a t a k u l i a h l a i n y a n g b e l u m a d a d i P D F i n i a k a n s a y a u p d a t e d i w w w . a k u n t a n s i d a n b i s n i s . wo rd p re s s . c o m
Contac t me : muhammad.f irman177@gmail.com /@f irmanmhmd (Line)
PE1
2024
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
2.) Dengan informasi dari AA Power Co. di bawah ini,
hitunglah WACC nya dengan asumsi pajak korpora sebesar
35%.
Debt: 9,000 jumlah beredar dengan kupon 5 persen, nilai
par : $1,000, dengan jangka waktu 5 tahun,dijual pada 92
persen dari par; pembayaran kupon dilakukan tahunan
(annually).
(a.1) Hitunglah operating dan cash cycle dari PT. ABC.
(a.2) Apa yang dapat dilakukan oleh PT. ABC untuk
mengurangi Cash Cycle-nya.
b. PT. XYZ saat ini menjual seluruh produknya dalam bentuk
tunai dan berencana mengubah kebijakan tersebut dengan
menjual secara kredit. Informasi terkait perubahan
kebijakan tersebut per periode dapat dilihat pada tabel
berikut ini:
Price per unit
Cost per unit
Unit sales per month
Current
100
56
2,750
New
104
56
2,800
Jika required return adalah 2.5% per periode, maka hitung
NPV dari kebijakan tersebut. Apakah kebijakan baru
tersebut layak atau tidak untuk diterapkan?
Common Stock: 260,000 jumlah beredar, dijual dengan
harga $57 per share; dengan nilai beta 1.05.
Preferred Stock: 15,000 jumlah saham beredar dengan 5
percent dividen dari preferred stock, dengan harga pasar
$93 perlembar dan par $100 perlembar saham.
Market: dengan market risk premium 8 persen dan risk free
rate sebesar 4.5 persen.
Market
Value:
Debt
C/S
P/S
Total
Weight:
8280000 Debt
14820000 C/S
1395000 P/S
24495000
Cost
Cost of Debt
(YTM)
JAWABAN
1.)
A. Hitung expected
return tiap saham
Saham A
Saham B
Saham C
Risk Free Rate
16.25%
13.75%
11.50%
0.07
B. Hitung expected
return portofolio
Weight:
Saham A
Saham B
Saham C
Risk Free
Exp. Return Portofolio
0.4
0.32
0.16
0.12
13.58%
Cost of C/S
Cost of P/S
YTM:
After
tax
33.80%
60.50%
5.70%
6.90%
4.49%
Re = Rf + β x (RmRf)
Re
0.129
D/Po
Rp
0.05
YTM =
WACC = Weight Debt x Cost of Debt + Weight C/S x Cost
ofC/S + Weight P/S x Cost of P/S = 9.61%
4)
Stock Split:
Sebelum
C. Standar deviasi saham
A dan C
Varians
Saham A
Saham C
St. Deviasi
0.0006
0.0249
0.0008
0.0287
Jumlah saham
beredar
Harga Pasar
Nilai Saham
Misal:
Sesudah
10000
15
150000
setelah
%change
M a t a k u l i a h l a i n y a n g b e l u m a d a d i P D F i n i a k a n s a y a u p d a t e d i w w w . a k u n t a n s i d a n b i s n i s . wo rd p re s s . c o m
Contac t me : muhammad.f irman177@gmail.com /@f irmanmhmd (Line)
PE1
20000
7.5
150000
2025
Disusun oleh : Muhammad Firman (Akuntansi FE UI 2012)
Earnings
1000000 1000000
Outstanding
10000
11000
EPS
100 90.90909
Incremental cash flow
PV of Incremental cash flow
Cost of switching
(Current Price * Current Sales) +
VC(Qnew - Qcurrent)
9%
13400
536000
277800
a.) Harga saham berkurang 1/2x jadi $7.5
EPS berkurang menjadi $0.5 karena jumlah saham beredar naik 2 kali
NPV of switching
258200
Kepemilikan tidak berubah
(PV of incremental cash flow - Cost of
Nilai saham
switching)
sebelum
Nilai saham setelah
1500
1500Karena NPV kebijakan tersebut positif, maka kebijakan layak
b.) Stock Dividend
Harga saham turun karena kenaikan saham outstanding 10%
EPS turun sebanyak
Kepemilikan Tetap
diterapkan
5.) a.1
Avg Inventory
Avg A/R
Avg A/P
$
12,750.00
$
8,375.00
$
10,680.00
Inventory
Period
A/R Period
A/P Period
Inventory
Turnover
A/R Turnover
A/P Turnover
Operating Cycle
Cash Cycle
54.59 days
26.47 days
45.73 days
$
6.69
$
13.79
$
7.98
81.06 (Inv Period + A/R Period)
(Operating Cycle - A/P
35.33 Period)
a.2
1. Meningkatkan efisiensi penggunaan Inventory dan pengumpulan A/R
2. Memperlama
durasi
pembayaran A/P
b.
Cash flow with current policy
Cash flow with new policy
121000
134400
M a t a k u l i a h l a i n y a n g b e l u m a d a d i P D F i n i a k a n s a y a u p d a t e d i w w w . a k u n t a n s i d a n b i s n i s . wo rd p re s s . c o m
Contac t me : muhammad.f irman177@gmail.com /@f irmanmhmd (Line)
PE1
2026