Chapter
1
•Introduction To Corporate
Finance
•Edited by DBH Jan 06
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•
•
•
•
•
Corporate Finance and the Financial
Manager
Forms of Business Organization
The Goal of Financial Management
The Agency Problem and Control of the
Corporation
Financial Markets and the Corporation
1-2
Corporate Finance
• Some important questions that are
answered using finance
• What long-term investments should the firm
take on?
• Where will we get the long-term financing to
pay for the investment?
• How will we manage the everyday financial
activities of the firm?
1-3
Financial Manager
• Financial managers try to answer some or
all of these questions
• The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
• Treasurer – oversees cash management,
credit management, capital expenditures and
financial planning
• Controller – oversees taxes, cost accounting,
financial accounting and data processing
1-4
Financial Management Decisions
• Capital budgeting
• What long-term investments or projects should
the business take on?
• Capital structure
• How should we pay for our assets?
• Should we use debt or equity?
• Working capital management
• How do we manage the day-to-day finances of
the firm?
1-5
Forms of Business Organization
• Three major forms in the United States
• Sole proprietorship
• Partnership
• General
• Limited
• Corporation
• S-Corp
• Limited liability company
1-6
Sole Proprietorship
• Advantages
• Easiest to start
• Least regulated
• Single owner keeps all
the profits
• Taxed once as personal
income
• Disadvantages
• Limited to life of owner
• Equity capital limited to
owner’s personal
wealth
• Unlimited liability
• Difficult to sell
ownership interest
1-7
Partnership
• Advantages
•
•
•
•
Two or more owners
More capital available
Relatively easy to start
Income taxed once as
personal income
• Disadvantages
• Unlimited liability
• General partnership
• Limited partnership
• Partnership dissolves
when one partner dies
or wishes to sell
• Difficult to transfer
ownership
1-8
Corporation
• Advantages
• Limited liability
• Unlimited life
• Separation of
ownership and
management
• Transfer of ownership is
easy
• Easier to raise capital
• Disadvantages
• Separation of
ownership and
management
• Double taxation
(income taxed at the
corporate rate and then
dividends taxed at the
personal rate)
1-9
Goal Of Financial Management
• What should be the goal of a corporation?
•
•
•
•
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s
stock?
• Does this mean we should do anything and
everything to maximize owner wealth?
1-10
Why Shareholder Value?
Roberto Goizueta, Chairman, Coca-Cola Company, 1997
 Increasing share-owner value is the job
our economic system demands of us
 Shareholders put us in business
 Business distributes the lifeblood of
our economic system--goods and
services but also taxes, salaries,
philanthropy
1-11
Why Shareholder Value? (2)
• If we do our jobs, we can contribute to society
in very meaningful ways
• Companies are expected to do good deeds, but
also good work--work focused on our mission to
create value over time for owners
• Those owners include not only individual investors,
but university endowments, philanthropic
foundations, other non-profit organizations. The
more value created for them, the more good they
can do
1-12
Why Shareholder Value? (3)
• Focusing on creating value over the long term
keeps us from acting shortsighted
• The long haul means being of value to consumers,
customers, bottling partners, all other stakeholders
• Real conflict is not between shareholders and
stakeholders, but between the long-term and shortterm interests of both
• Coca-Cola has grown over 110 years because of
discipline to its mission (value over the long haul
for its owners)
1-13
Why Shareholder Value? (4)
 “A billion hours ago, human life appeared
on Earth. A billion minutes ago, Christianity
emerged. A billion seconds ago, the Beatles
changed music forever. A billion CocaColas ago was yesterday morning.”
-Roberto Goizueta
1-14
Why Shareholder Value? (5-end)
 “What must we do to make a billion Coca-
Colas ago be this morning? By asking this
question, we discipline ourselves to the long
term view...the best way to serve all our
stakeholders...is by creating value over time
for those who have hired us.”
1-15
The Agency Problem
• Agency relationship
• Principal hires an agent to represent his/her
interest
• Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
• Conflict of interest between principal and agent
• Management goals and agency costs
1-16
Managing Managers
• Managerial compensation
• Incentives can be used to align management
and stockholder interests
• The incentives need to be structured carefully
to make sure that they achieve their goal
• Corporate control
• The threat of a takeover may result in better
management
• Other stakeholders
1-17
Work the Web Example
• The Internet provides a wealth of
information about individual companies
• One excellent site is finance.yahoo.com
• Click on the web surfer to go to the site,
choose a company and see what
information you can find!
1-18
Financial Markets
• Cash flows to the firm
• Primary vs. secondary markets
• Dealer vs. auction markets
• Listed vs. over-the-counter securities
• NYSE
• NASDAQ
1-19
Chapter
1
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
1
•Financial Statements, Taxes,
and Cash Flows
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•
•
•
•
The Balance Sheet
The Income Statement
Taxes
Cash Flow
2-22
Balance Sheet
• The balance sheet is a snapshot of the
firm’s assets and liabilities at a given point in
time
• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
• Assets = Liabilities + Stockholders’ Equity
2-23
The Balance Sheet - Figure 2.1
2-24
Net Working Capital and Liquidity
• Net Working Capital
• Current Assets – Current Liabilities
• Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out
• Usually positive in a healthy firm
• Liquidity
•
•
•
•
Ability to convert to cash quickly without a significant loss in value
Liquid firms are less likely to experience financial distress
But liquid assets earn a lower return
Trade-off to find balance between liquid and illiquid assets
2-25
US Corporation Balance Sheet –
Table 2.1
2-26
Market Vs. Book Value
• The balance sheet provides the book value
of the assets, liabilities and equity.
• Market value is the price at which the
assets, liabilities or equity can actually be
bought or sold.
• Market value and book value are often very
different. Why?
• Which is more important to the decisionmaking process?
2-27
Example 2.2 Klingon Corporation
KLINGON CORPORATION
Balance Sheets
Market Value versus Book Value
Book
Market
Book
Market
Assets
Liabilities and
Shareholders’ Equity
NWC
NFA
$ 400
700
1,100
$ 600 LTD
1,000 SE
1,600
$ 500 $ 500
600 1,100
1,100 1,600
2-28
Income Statement
• The income statement is more like a video
of the firm’s operations for a specified period
of time.
• You generally report revenues first and then
deduct any expenses for the period
• Matching principle – GAAP – ex: to show
revenue when it accrues and match the
expenses required to generate the revenue
2-29
US Corporation Income Statement –
Table 2.2
2-30
Work the Web Example
• Publicly traded companies must file regular
reports with the Securities and Exchange
Commission
• These reports are usually filed electronically
and can be searched at the SEC public site
called EDGAR
• Click on the web surfer, pick a company and
see what you can find!
2-31
Taxes
• The one thing we can rely on with taxes is
that they are always changing
• Marginal vs. average tax rates
• Marginal – the percentage paid on the next
dollar earned
• Average – the tax bill / taxable income
• Other taxes
2-32
Example: Marginal Vs. Average
Rates
• Suppose your firm earns $4 million in
taxable income.
• What is the firm’s tax liability?
• What is the average tax rate?
• What is the marginal tax rate?
• If you are considering a project that will
increase the firm’s taxable income by $1
million, what tax rate should you use in your
analysis?
2-33
The Concept of Cash Flow
• Cash flow is one of the most important
pieces of information that a financial
manager can derive from financial
statements
• The statement of cash flows does not
provide us with the same information that
we are looking at here
• We will look at how cash is generated from
utilizing assets and how it is paid to those
that finance the purchase of the assets
2-34
Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash
Flow to Creditors + Cash Flow to
Stockholders
• Cash Flow From Assets = Operating Cash
Flow – Net Capital Spending – Changes in
NWC
2-35
Example: US Corporation – Part I
• Operating Cash Flow (I/S) = EBIT + depreciation
– taxes = $547
• Net Cap.Spending ( B/S and I/S) = ending net
fixed assets – beginning net fixed assets +
depreciation = $130
• Changes in Net Working Cap. (B/S) = ending
NWC – beginning NWC = $330
• Cash Flow From Assets = 547 – 130 – 330 = $87
2-36
Example: US Corporation – Part II
• Cash Flow to Creditors (B/S and I/S) =
interest paid – net new borrowing = $24
• Cash Flow to Stockholders (B/S and I/S) =
dividends paid – net new equity raised = $63
• CFFA = 24 + 63 = $87
2-37
Cash Flow Summary Table 2.5
2-38
Example: Balance Sheet and
Income Statement Information
• Current Accounts
• 2004: CA = 3625; CL = 1787
• 2003: CA = 3596; CL = 2140
• Fixed Assets and Depreciation
• 2004: NFA = 2194; 2003: NFA = 2261
• Depreciation Expense = 500
• Long-term Debt and Equity
• 2004: LTD = 538; Common stock & APIC = 462
• 2003: LTD = 581; Common stock & APIC = 372
• Income Statement
• EBIT = 1014; Taxes = 368
• Interest Expense = 93; Dividends = 285
2-39
Example: Cash Flows
• OCF = 1014 + 500 – 368 = 1146
• NCS = 2194 – 2261 + 500 = 433
• Changes in NWC = (3625 – 1787) – (3596 –
2140) = 382
• CFFA = 1146 – 433 – 382 = 331
• CF to Creditors = 93 – (538 – 581) = 136
• CF to Stockholders = 285 – (462 – 372) = 195
• CFFA = 136 + 195 = 331
• The CF identity holds.
2-40
Chapter
1
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
1
•Working With Financial
Statements
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Cash Flow and Financial Statements: A
Closer Look
• Standardized Financial Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement Information
3-43
Sample Balance Sheet
Numbers in millions
2003
2002
2003
2002
Cash
696
58 A/P
307
303
A/R
956
992 N/P
26
119
Inventory
301
361 Other CL
1,662
1,353
Other CA
303
264 Total CL
1,995
1,775
Total CA
2,256
1,675 LT Debt
843
1,091
Net FA
3,138
3,358 C/S
2,556
2,167
Total
Assets
5,394
5,033 Total Liab.
& Equity
5,394
5,033
3-44
Sample Income Statement
Numbers in millions, except EPS & DPS
Revenues
5,000
Cost of Goods Sold
2,006
Expenses
1,740
Depreciation
116
EBIT
1,138
Interest Expense
7
Taxable Income
Taxes
1,131
442
Net Income
689
EPS
3.61
Dividends per share
1.08
3-45
Sources and Uses
• Sources
• Cash inflow – occurs when we “sell” something
• Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets
• Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock
• Uses
• Cash outflow – occurs when we “buy” something
• Increase in asset account
• Cash and other current assets
• Decrease in liability or equity account
• Notes payable and long-term debt
3-46
Statement of Cash Flows
• Statement that summarizes the sources and
uses of cash
• Changes divided into three major categories
• Operating Activity – includes net income and
changes in most current accounts
• Investment Activity – includes changes in fixed
assets
• Financing Activity – includes changes in notes
payable, long-term debt and equity accounts as well as
dividends
3-47
Sample Statement of Cash Flows
Numbers in millions
Cash, beginning of year
58
Operating Activity
Financing Activity
Decrease in Notes Payable
Net Income
689
Decrease in LT Debt
Plus: Depreciation
116
Decrease in C/S (minus RE)
Decrease in A/R
36
Decrease in Inventory
60
Increase in A/P
Increase in Other CL
Less: Increase in CA
Net Cash from Operations
4
309
Dividends Paid
Net Cash from Financing
-93
-248
-94
-206
-641
Net Increase in Cash
638
Cash End of Year
696
-39
1,175
Investment Activity
Sale of Fixed Assets
Net Cash from Investments
104
104
3-48
Standardized Financial
Statements
• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to
compare financial information, particularly as the
company grows
• They are also useful for comparing companies of
different sizes, particularly within the same
industry
3-49
Ratio Analysis
• Ratios also allow for better comparison
through time or between companies
• As we look at each ratio, ask yourself what
the ratio is trying to measure and why is that
information is important
• Ratios are used both internally and
externally
3-50
Categories of Financial Ratios
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage
ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
3-51
Computing Liquidity Ratios
• Current Ratio = CA / CL
• 2256 / 1995 = 1.13 times
• Quick Ratio = (CA – Inventory) / CL
• (2256 – 1995) / 1995 = .1308 times
• Cash Ratio = Cash / CL
• 696 / 1995 = .35 times
• NWC to Total Assets = NWC / TA
• (2256 – 1995) / 5394 = .05
• Interval Measure = CA / average daily operating
costs
• 2256 / ((2006 + 1740)/365) = 219.8 days
3-52
Computing Long-term Solvency
Ratios
• Total Debt Ratio = (TA – TE) / TA
• (5394 – 2556) / 5394 = 52.61%
• Debt/Equity = TD / TE
• (5394 – 2556) / 2556 = 1.11 times
• Equity Multiplier = TA / TE = 1 + D/E
• 1 + 1.11 = 2.11
• Long-term debt ratio = LTD / (LTD + TE)
• 843 / (843 + 2556) = 24.80%
3-53
Computing Coverage Ratios
• Times Interest Earned = EBIT / Interest
• 1138 / 7 = 162.57 times
• Cash Coverage = (EBIT + Depreciation) /
Interest
• (1138 + 116) / 7 = 179.14 times
3-54
Computing Inventory Ratios
• Inventory Turnover = Cost of Goods Sold /
Inventory
• 2006 / 301 = 6.66 times
• Days’ Sales in Inventory = 365 / Inventory
Turnover
• 365 / 6.66 = 55 days
3-55
Computing Receivables Ratios
• Receivables Turnover = Sales / Accounts
Receivable
• 5000 / 956 = 5.23 times
• Days’ Sales in Receivables = 365 /
Receivables Turnover
• 365 / 5.23 = 70 days
3-56
Computing Total Asset Turnover
• Total Asset Turnover = Sales / Total Assets
• 5000 / 5394 = .93
• It is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets
• NWC Turnover = Sales / NWC
• 5000 / (2256 – 1995) = 19.16 times
• Fixed Asset Turnover = Sales / NFA
• 5000 / 3138 = 1.59 times
3-57
Computing Profitability Measures
• Profit Margin = Net Income / Sales
• 689 / 5000 = 13.78%
• Return on Assets (ROA) = Net Income /
Total Assets
• 689 / 5394 = 12.77%
• Return on Equity (ROE) = Net Income /
Total Equity
• 689 / 2556 = 26.96%
3-58
Computing Market Value
Measures
• Market Price = $87.65 per share
• Shares outstanding = 190.9 million
• PE Ratio = Price per share / Earnings per
share
• 87.65 / 3.61 = 24.28 times
• Market-to-book ratio = market value per
share / book value per share
• 87.65 / (2556 / 190.9) = 6.56 times
3-59
The DuPont Identity (1)
The DuPont Identity = Relationship of ROI and ROE:
ROI: Return on Investment (sometimes called ROA-return on assets):
Initially compares income as a percentage of total investment, a
basic measure of profitability
ROI = Net Income
Total Assets
The DuPont model divides this into two factors: profit margin & asset
turnover, illustrating both profitability of operations (profit margin) and
efficient use of assets (turnover)
ROI = Net Income
Sales
ROI = (Profit margin)
x
Sales
Total Assets
x (Asset Turnover)
3-60
The DuPont Identity (2)
Return on Equity = basic measure of profitability on assets actually
provided by owners of a firm:
Net Income
ROE =
Owner’s Equity
The DuPont identity combines ROI & ROE into a three part analysis:
ROE =
Net Income
Sales
Or ROE =
x
Sales
Total Assets
Return on Investment
x Total Assets
Owner’s Equity
x Equity Multiplier
Or ROE = Profit Margin x Asset Turnover x Equity Multiplier
3-61
The DuPont Identity (3)
Putting it all together gives the DuPont identity:
ROE = ROA x Equity multiplier
= Profit margin x Total asset turnover x Equity multiplier
Profitability (or the lack thereof!) thus has three parts:
• Operating efficiency (profit margin)
• Asset use efficiency (asset turnover)
• Financial leverage (equity multiplier)
3-62
The DuPont Identity (4)
The successful financial manager must be able to
make effective decisions influencing all three
elements:
 To survive at all, the firm must be effective in its use of revenues
to generate profits (operating efficiency--profit margin)
 To generate profitability, the firm must utilize its investment in
assets wisely to convert revenues to profit (asset turnoverefficiency)
 But if a firm can generate a return on assets greater than its net
borrowing costs, it can return profits to investors more effectively
by financial leverage—using borrowed money to generate
profits rather than tying up owners’ funds (equity multiplier)
3-63
Expanded DuPont Analysis –
Aeropostale Data
• Balance Sheet Data
•
•
•
•
•
Cash = 138,356
Inventory = 61,807
Other CA = 12,284
Fixed Assets = 94,601
EM = 1.654
• Computations
• TA = 307,048
• TAT = 2.393
• Income Statement Data
•
•
•
•
•
Sales = 734,868
COGS = 505,152
SG&A = 141,520
Interest = (760)
Taxes = 34,702
• Computations
•
•
•
•
NI = 54,254
PM = 7.383%
ROA = 17.668%
ROE = 29.223%
3-64
Aeropostale Extended DuPont Chart
ROE = 29.223%
ROA = 17.668%
Total Costs = - 680,614
+
EM = 1.654
x
PM = 7.383%
NI = 54,254
x

Sales = 734,868
Sales = 734,868
TAT = 2.393
Sales = 734,868

TA = 307,048
Fixed Assets = 94,601
COGS = - 505,152
SG&A = - 141,520
Cash = 138,356
Interest = - (760)
Taxes = - 34,702
Other CA = 12,284
+
Current Assets = 212,447
Inventory = 61,807
3-65
Why Evaluate Financial
Statements?
• Internal uses
• Performance evaluation – compensation and
comparison between divisions
• Planning for the future – guide in estimating
future cash flows
• External uses
•
•
•
•
Creditors
Suppliers
Customers
Stockholders
3-66
Benchmarking
• Ratios are not very helpful by themselves;
they need to be compared to something
• Time-Trend Analysis
• Used to see how the firm’s performance is
changing through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within
industries
• SIC and NAICS codes
3-67
Real World Example - I
• Ratios are figured using financial data from
the 2003 Annual Report for Home Depot
• Compare the ratios to the industry ratios in
Table 3.12 in the book
• Home Depot’s fiscal year ends Feb. 1
• Be sure to note how the ratios are computed
in the table so that you can compute
comparable numbers.
• Home Depot sales = $64,816 MM
3-68
Real World Example - II
• Liquidity ratios
• Current ratio = 1.40x; Industry = 1.8x
• Quick ratio = .45x; Industry = .5x
• Long-term solvency ratio
• Debt/Equity ratio (Debt / Worth) = .54x;
Industry = 2.2x.
• Coverage ratio
• Times Interest Earned = 2282x; Industry = 3.2x
3-69
Real World Example - III
• Asset management ratios:
• Inventory turnover = 4.9x; Industry = 3.5x
• Receivables turnover = 59.1x (6 days); Industry =
24.5x (15 days)
• Total asset turnover = 1.9x; Industry = 2.3x
• Profitability ratios
• Profit margin before taxes = 10.6%; Industry =
2.7%
• ROA (profit before taxes / total assets) = 19.9%;
Industry = 4.9%
• ROE = (profit before taxes / tangible net worth) =
34.6%; Industry = 23.7%
3-70
Potential Problems
• There is no underlying theory, so there is no way
to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes
comparison more difficult because of differences
in accounting regulations
• Varying accounting procedures, i.e. FIFO vs.
LIFO
• Different fiscal years
3-71
• Extraordinary events
Work the Web Example
• The Internet makes ratio analysis much
easier than it has been in the past
• Click on the web surfer to go to
www.investor.reuters.com
• Choose a company and enter its ticker symbol
• Click on Ratios and then Financial Condition
and see what information is available
3-72
Chapter
1
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
4
•Long-Term Financial
Planning and Growth
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•
•
•
•
•
What is Financial Planning?
Financial Planning Models: A First Look
The Percentage of Sales Approach
External Financing and Growth
Some Caveats Regarding Financial
Planning Models
4-75
Elements of Financial Planning
• Investment in new assets – determined by
capital budgeting decisions
• Degree of financial leverage – determined
by capital structure decisions
• Cash paid to shareholders – determined by
dividend policy decisions
• Liquidity requirements – determined by net
working capital decisions
4-76
Financial Planning Process
• Planning Horizon - divide decisions into short-run
decisions (usually next 12 months) and long-run
decisions (usually 2 – 5 years)
• Aggregation - combine capital budgeting
decisions into one big project
• Assumptions and Scenarios
• Make realistic assumptions about important variables
• Run several scenarios where you vary the assumptions
by reasonable amounts
• Determine at least a worst case, normal case and best
4-77
case scenario
Role of Financial Planning
• Examine interactions – help management see the
interactions between decisions
• Explore options – give management a systematic
framework for exploring its opportunities
• Avoid surprises – help management identify
possible outcomes and plan accordingly
• Ensure feasibility and internal consistency – help
management determine if goals can be
accomplished and if the various stated (and
unstated) goals of the firm are consistent with one4-78
Financial Planning Model
Ingredients
• Sales Forecast – many cash flows depend directly on the
level of sales (often estimated sales growth rate)
• Pro Forma Statements – setting up the plan as projected
financial statements allows for consistency and ease of
interpretation
• Asset Requirements – the additional assets that will be
required to meet sales projections
• Financial Requirements – the amount of financing
needed to pay for the required assets
• Plug Variable – determined by management decisions
about what type of financing will be used (makes the
balance sheet balance)
• Economic Assumptions – explicit assumptions about the 4-79
Example: Historical Financial
Statements
Gourmet Coffee Inc.
Balance Sheet
December 31, 2004
Assets 1000 Debt
400
Equity
Total
1000 Total
Gourmet Coffee Inc.
Income Statement
For Year Ended
December 31, 2004
Revenues
2000
Costs
1600
1000 Net Income
400
600
4-80
Example: Pro Forma Income
Statement
• Initial Assumptions
• Revenues will grow at
15% (2000*1.15)
• All items are tied
directly to sales and the
current relationships
are optimal
• Consequently, all other
items will also grow at
15%
Gourmet Coffee Inc.
Pro Forma Income
Statement
For Year Ended 2005
Revenues
2,300
Costs
1,840
Net Income
460
4-81
Example: Pro Forma Balance
Sheet
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
• Case I
• Dividends are the plug
variable, so equity
increases at 15%
• Dividends = 460 NI – 90
increase in equity = 370
• Case II
• Debt is the plug variable
and no dividends are paid
• Debt = 1,150 – (600+460) =
90
• Repay 400 – 90 = 310 in
debt
Assets
1,150 Debt
460
Equity
Total
1,150 Total
690
1,150
Gourmet Coffee Inc.
Pro Forma Balance Sheet
Case 1
Assets
1,150 Debt
Equity
Total
1,150 Total
90
1,060
1,150
4-82
Percent of Sales Approach
• Some items vary directly with sales, while others do not
• Income Statement
• Costs may vary directly with sales - if this is the case, then the
profit margin is constant
• Depreciation and interest expense may not vary directly with
sales – if this is the case, then the profit margin is not constant
• Dividends are a management decision and generally do not vary
directly with sales – this affects additions to retained earnings
• Balance Sheet
• Initially assume all assets, including fixed, vary directly with sales
• Accounts payable will also normally vary directly with sales
• Notes payable, long-term debt and equity generally do not
because they depend on management decisions about capital
structure
4-83
Example: Income Statement
Tasha’s Toy Emporium
Tasha’s Toy Emporium
Income Statement, 2004
Pro Forma Income Statement, 2005
% of Sales
Sales
5,500
Sales
5,000
Costs
3,300
Costs
3,000
2,200
EBT
2,000
60% EBT
Taxes
40%
Net Income
16%
Taxes (40%)
Net Income
800
1,200
Dividends
600
Add. To RE
600
24%
880
1,320
Dividends
660
Add. To RE
660
Assume Sales grow at 10%
Dividend Payout Rate = 50%
4-84
Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current
% of
Sales
Pro
Forma
Current % of
Sales
Liabilities & Owners’ Equity
ASSETS
Current Assets
Current Liabilities
Cash
$500
10%
A/R
2,000
40
Inventory
3,000
5,500
Total
Pro
Forma
$550
A/P
$900 18%
$990
2,200 N/P
2,500
n/a
2,500
60
3,300
Total
3,400
n/a
3,490
110
6,050 LT Debt
2,000
n/a
2,000
CS & APIC
2,000
n/a
2,000
RE
2,100
n/a
2,760
4,100
n/a
4,760
Owners’ Equity
Fixed Assets
Net PP&E
4,000
80
4,400
Total Assets
9,500
190
10,450
Total
Total L & OE
9,500
10,250
4-85
Example: External Financing
Needed
• The firm needs to come up with an
additional $200 in debt or equity to make
the balance sheet balance
• TA – TL&OE = 10,450 – 10,250 = 200
• Choose plug variable
•
•
•
•
Borrow more short-term (Notes Payable)
Borrow more long-term (LT Debt)
Sell more common stock (CS & APIC)
Decrease dividend payout, which increases the
Additions To Retained Earnings
4-86
Example: Operating at Less than Full
Capacity
• Suppose that the company is currently operating at 80%
capacity.
•
•
•
•
•
Full Capacity sales = 5000 / .8 = 6,250
Estimated sales = $5,500, so would still only be operating at 88%
Therefore, no additional fixed assets would be required.
Pro forma Total Assets = 6,050 + 4,000 = 10,050
Total Liabilities and Owners’ Equity = 10,250
• Choose plug variable
•
•
•
•
•
Repay some short-term debt (decrease Notes Payable)
Repay some long-term debt (decrease LT Debt)
Buy back stock (decrease CS & APIC)
Pay more in dividends (reduce Additions To Retained Earnings)
Increase cash account
4-87
Work the Web Example
• Looking for estimates of company growth
rates?
• What do the analysts have to say?
• Check out Yahoo Finance – click the web
surfer, enter a company ticker and follow the
“Analyst Estimates” link
4-88
In-class Case
• Break here and introduce Part I of the
Wally’s Widget Works case in class
• Class handout and separate PowerPoint
4-89
Growth and External Financing
• At low growth levels, internal financing
(retained earnings) may exceed the
required investment in assets
• As the growth rate increases, the internal
financing will not be enough and the firm will
have to go to the capital markets for money
• Examining the relationship between growth
and external financing required is a useful
tool in long-range planning
4-90
The Internal Growth Rate
• The internal growth rate tells us how much
the firm can grow assets using retained
earnings as the only source of financing.
• Using the information from Tasha’s Toy
Emporium
ROA

b
• ROA = 1200
/ 9500
= .1263
Internal
Growth
Rate

1
-ROA

b
• B = .5
.1263

.5


.0674
1

.1263

.5

6
.74
%
4-91
The Sustainable Growth Rate
• The sustainable growth rate tells us how
much the firm can grow by using internally
generated funds and issuing debt to
maintain a constant debt ratio.
• Using Tasha’s Toy Emporium
ROE

b
• ROE = 1200
/ 4100eGrowth
= .2927
Sustainabl
Rate

1
ROE

b
• b = .5
.
2927

.
5


.
1714
1

.
2927

.
5

17
.
14
%
4-92
Determinants of Growth
• Profit margin – operating efficiency
• Total asset turnover – asset use efficiency
• Financial leverage – choice of optimal debt
ratio
• Dividend policy – choice of how much to pay
to shareholders versus reinvesting in the
firm
4-93
Important Questions
• It is important to remember that we are
working with accounting numbers and 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 maximize owners’
wealth?
4-94
Quick Quiz
• What is the purpose of long-range planning?
• What are the major decision areas involved in
developing a plan?
• What is the percentage of sales approach?
• How do you adjust the model when operating
at less than full capacity?
• What is the internal growth rate?
• What is the sustainable growth rate?
• What are the major determinants of growth?
4-95
Chapter
4
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
A Time Value of Money Primer
•By David B. Hamm, MBA, CPA
•for Finance and Quantitative Methods
•Modules
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Simple Interest and Discount: (1)
In its most basic form, interest is calculated by multiplying
principal (amount invested) by rate (percent of interest)
multiplied by time (number of periods the interest is
calculated). This is called simple interest.
I=Prt
Example: A $1,000 deposit at 8% per year for three years'
simple interest: I = (1000)(.08)(3) = 240 A $1000 deposit at
8% simple interest for three years earns $240 interest.
Simple Interest/Discount (2)
The future value (FV) of a simple interest calculation is derived
by adding the original principal back to the interest earned.
$1,000 + $240 = $1,240
Expressed as a formula:
FV = P(1 + rt)
FV = (1000)+(1000)(.08)(3) = 1240
Simple Interest/Discount (3)
Note: usually simple interest is used in financial
institutions for interest periods of less than one year. If the
rate is expressed as an annual rate (normal practice), then
the time period (t) must be a fraction of a year. Example:
we invest $10,000 in an 8% , 90-day certificate of deposit.
Our total proceeds at the end of the CD period are:
FV = (10000)+(10000)(.08)(90/365) = $10,197.26
Simple Interest/ Discount (4):
Often, if a bank or other financial institution loans a sum for
a short term, the lender will prefer to calculate the interest
up front and loan out the discounted principal, or principal
minus interest to be earned. The interest to be paid up front
on a loan is called discount and the discounted principal, or
the actual amount loaned is called the present value (PV)
FV
PV = (1+rt)
Simple Interest/Discount (5):
Repeating the discount basic formula (simple interest):
FV
PV = (1+rt)
Example: If the bank loans out $10,000 for 90 days at 8%
simple interest, the PV is:
PV = 10000 / [1 + (.08)(90/365)]
= 10000/ 1.019726
= $9,806.56
Compound Interest (1):
However, if interest is left in the account to accumulate for a
longer period (usually longer than one year) common
practice (and usually state law!) requires that after interest is
earned and credited for a given period, the new sum of
principal + interest must now earn interest for the next
period, etc. This is compound interest. To distinguish from
simple interest, we use "n" to refer to the number of
"periods" in which the interest is compounded and added to
principal.
FV = P(1 + r)n
FV
PV = (1+r)n
Compound Interest (2):
Suppose we invest our original $1,000 for three years at 8%,
compounded quarterly: (The rate per quarterly period is 8%
/ 4 or 2%. The number of periods (n) is 3 x 4 = 12 quarterly
periods.)
FV = (1000)(1.02)12 = $1,268.24
If we wanted to know how much we'd have to invest now
(PV) at 8% compounded quarterly to earn $10,000 in three
years:
PV = 10000 / (1.02)12 = $7,884.93
Compound Interest (3):
Because raising interest factors to an exponent of "n" was
a difficult calculation before calculators, some
mathematicians used logarithmic functions to calculate the
exponent factor. Financial professionals acquired tables of
these functions so that either of the above problems could
be calculated simply by looking up a FV factor (or to
discount, a PV factor) based on the interest rate and
number of compounding periods and multiplying the
principal by the interest factor.
Compound Interest (4):
Now, computerized spreadsheets can build in these
financial functions and easily do the work for us. It
will be our assumption in this class that you will have
a computer present to calculate these financial
functions. Our discussion will be based on MS Excel,
but Quattro and Lotus and most other major
spreadsheets have similar function capability.
Basic Financial Functions in Excel
In the spreadsheet, it is often advisable to set up and
identify cells for your principal, your interest rate, and the
number of time periods. Setting up a simple template in
this fashion means you can easily update your template
for new calculations just by changing amounts in the
cells.
Principal
Rate (yr)
Yrs
-1000
8%
3
Quick note: In Excel, present value (PV) is assumed to be
a cash outlay, and is thus expressed as a negative value.
Functions in Excel (2):
The mathematical functions are accessed on the Excel
taskbar with the " fx" key.
Select "Financial" functions.
We will most commonly compute =FV (future value) or
=PV (present value). Each of the functions in Excel pops
up a simple menu to follow to identify data. If you have
annual rates or periods that need conversion to
semiannual, quarterly, or monthly compounding, the
function can multiply the number of periods or divide the
rate for you in the menu cell.
Functions in Excel (3):
1.
Try this problem in Excel:
Invest $1,000 (present value) at 8% annual interest
compounded quarterly for three years to see how
much we can receive (future value) (hint: use the
=FV function)
1. Invest $1,000 at 8% compounded quarterly for 3 years:
Principal
Rate
Nper
-1000
2%
12
(enter as negative)
(8% / 4 qtrs)
(3 yrs x 4 qtrs)
Fut. Val
$1,268.24 =FV
Functions in Excel (4):
2. Now the reverse—how much would we have to
invest now (present value) at 8% compounded
quarterly to receive $10,000 (future value) in three
years? (use the =PV function)
2. Discount investment required to realize $10,000 at 8% compounded
quarterly in 3 years
FV
Rate
Nper
Pres Val
10000
2%
12
(enter as positive amount)
(8% / 4 qtrs)
3 yrs x 4 qtrs)
($7,884.93) =PV
Again, Excel displays the PV amount as negative.
Consumer Loans (brief) (1):
Not so long ago, banks and finance companies frequently
calculated simple interest on consumer loans using the
add-on interest method:
Payment = P +I
n
Add principal + interest over the life of the loan and divide
by the number of payments.
Example: a $5,000 car loan at 8% simple interest for 3
years = $1,200 interest. Therefore ($5,000 +1,200) / 36
months = $172.22 monthly payment
Consumer Loans (2):
Problem: this was charging interest on the full $5,000 for
the whole life of the loan despite the principal being
partially paid down each month. The true annual interest
rate was therefore much higher than 8%. (Using a financial
function, the true APR (annual % rate) would be 14.55% for
the full 36 months.)
Current Federal and state consumer law requires that the
stated interest rate be reported not only as the simple rate,
but also as the true APR. Add-on loans, while still used,
are therefore much less popular or common today.
Revolving Credit-Credit Cards (1):
Some “revolving credit" accounts, such as some store
credit cards, calculate finance charges monthly based on
the unpaid balance from the previous month--the unpaid
balance method.
I = Prt
but P = previous balance + finance
charge + new charges - returns or payments.
Revolving Credit-Credit Cards (2):
Most bank credit cards use the average daily
balance
method which computes the number of days in
each
month from date of each transaction and divides
by
the number of days in the month to figure an
average
daily balance to be entered into the I = Prt
formula.
•
•
•
Add outstanding balance for account for each day
of the previous month
Divide Step 1 total by number of days in previous
month = average daily balance
Use I= prt to find finance charge, where P is
Annuities (1):
An annuity is an interest bearing account into which we
make, or we receive, payments of an equal amount
each period until the annuity ends.
If the payment is made on the last day of each period, it
is an ordinary annuity. (This is most typical and what
we will illustrate.)
If the payment is made on the first day of each period, it
is an annuity due. (not as common) MS Excel
identifies the two types as "0" or blank=ordinary;
"1" =annuity due.
Annuities (2):
Some annuities have no "fixed" ending date, but rather
continue for the life of the recipient. These are usually
called life annuities and the payment is calculated for a
number of periods based on life expectancy.
A perpetuity is an annuity with no ending date. (An
example of a perpetuity is an endowed scholarship,
where only interest is paid out as scholarship funds
and the endowment principal remains invested
"forever" or in perpetuity.)
Annuities (3):
A sinking fund is a fund in which a regular annuity
payment is made to accumulate to a future value to be
used for some future purpose, such as paying off a bond
issue or some other obligation.
Before calculators, polynomials and logarithmic
functions were used to calculate annuity tables for
financial use. Now, we can simply use spreadsheet
financial functions, usually using =PV, =FV, or =PMT in
Excel and now inserting payment information where
applicable.
Annuities (4):
Illustration: We need to accumulate a sinking fund of
$100,000 in ten years (120 months) to pay off a note
payable. If we can invest our funds at 8% compounding
monthly, how much must we deposit per month?
FV
PV
100,000
0
Rate
Nper
0.006667
8% / 12
120 10 yrs x 12
=PMT
($546.61)
Excel functions are available to find any of the above
variables, if we have the others.
Annuities (5):
Illustration (2): When Joe retires on his 65th birthday,
his retirement fund carries a balance of $240,000. If Joe
transfers this balance into a fund earning 8% to pay
him or his heirs $2,000 per month until the fund is
exhausted, how long can this annuity last?
FV
PV
Pmt
Rate
0
-240,000
2,000
0.006667
=NPER
242.2195
8% / 12
Approx 242 months—just over 20 years! (Assuming 8%
is consistent and there is no risk of loss of principal!)
Amortization (Mortgages) (1):
Finally, if we take out a long term loan, such as a mortgage,
or a car loan based on the true APR, the interest expense
is calculated for each month based on the unpaid balance
of the loan. A fixed monthly payment is computed from
which is first deducted the monthly interest, and the
balance is applied to reduce principal. The new interest is
then recalculated the next month based on the lower
principal. This generates a schedule of all loan payments,
interest and principal applied, and outstanding balance
called an amortization schedule.
Amortization (Mortgages) (2):
In the early months of an amortization schedule, much
(perhaps most) of the monthly payment goes toward
interest because the unpaid balance is so large. As the
principal is paid down, more and more of each payment is
applied toward principal.
Example: in a 30 year $100,000 home mortgage at 9%, the
required monthly payment is $804.63 (round up 1 cent)
PV
Nper
Rate
FV
=PMT
-100,000
360 (30 yrs)
0.0075 9% / 12
0
$804.623
Amortization (Mortgages) (3):
Of the $804.63 payment, the first month's interest is
$750.00 (100,000 x .09/12). Therefore only
804.63-750.00 = $54.63 goes toward principal.
But by the last month of the mortgage, only about $785.22
is left unpaid. Thus only $5.90 goes to interest and the last
loan payment is $791.12 to zero out the loan.
In fact it is not until payment #269 (22 years, 5 months into
the loan) when the interest portion of the payment is less
than the principal portion! Ultimately we would pay
$189,653.30 in interest on our $100,000 loan over the 30
years!
Amortization (Mortgages) (4):
We can build an amortization table using an Excel
spreadsheet to calculate the principal & interest portion
of all our payments:
Payment
No
start
1
2
3
= 9% / 12
Payment
Interest
Amount
Payment
$804.63
$804.63
$804.63
$750.00
$749.59
$749.18
=pyt - int = prev. - prin
Applied to
Unpaid
Principal
Balance
$100,000.00
$54.63
$99,945.37
$55.04
$99,890.33
$55.45
$99,834.88
This spreadsheet can be extended through all 360
monthly payments to total principal and interest paid
to the end of the mortgage
Chapter
9
•Net Present Value and Other
Investment Criteria
Revised by DBH, January 2006
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Good Decision Criteria
• We need to ask ourselves the following
questions when evaluating capital budgeting
decision rules
• Does the decision rule adjust for the time value
of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on
whether we are creating value for the firm?
9-126
Project Example Information
• You are looking at a new project and you
have estimated the following cash flows:
•
•
•
•
•
Year 0:
CF = -165,000
Year 1:
CF = 63,120; NI = 13,620
Year 2:
CF = 70,800; NI = 3,300
Year 3:
CF = 91,080; NI = 29,100
Average Book Value = 72,000
• Your required return for assets of this risk is
12%.
9-127
Payback Period
• How long does it take to get the initial cost
back in a nominal sense?
• Computation
• Estimate the cash flows
• Subtract the future cash flows from the initial
cost until the initial investment has been
recovered
• Decision Rule – Accept if the payback
period is less than some preset limit
9-128
Computing Payback For The
Project
• Assume we will accept the project if it pays
back within two years.
• Year 1: 165,000 – 63,120 = 101,880 still to
recover
• Year 2: 101,880 – 70,800 = 31,080 still to
recover
• Year 3: 31,080 – 91,080 = -60,000 project pays
back in year 3
• Do we accept or reject the project?
9-129
Decision Criteria Test - Payback
• Does the payback rule account for the time
value of money?
(No)
• Does the payback rule account for the risk
of the cash flows?
(No)
• Does the payback rule provide an indication
about the increase in value? (No)
• Should we consider the payback rule for our
primary decision rule?
(No)
9-130
Advantages and Disadvantages
of Payback
• Advantages
• Easy to understand
• Adjusts for
uncertainty of later
cash flows
• Biased towards
liquidity
• Disadvantages
• Ignores the time
value of money
• Requires an
arbitrary cutoff point
• Ignores cash flows
beyond the cutoff
date
• Biased against longterm projects, such 9-131
AAR and Discounted Payback
• Discounted payback is a variation on the payback
rule that does allow for the time value of money,
but still requires an arbitrary cutoff.
• Average Accounting Return (AAR) doesn’t even
measure cash flows, but only whether average
accounting income from the project = a set
percentage of return
• Neither effectively measures whether a long-term
investment has added value to the firm. For sake
of time, we will ignore these methods.
9-132
Net Present Value
• The difference between the market value of
a project and its cost
• How much value is created from
undertaking an investment?
• 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.
9-133
NPV – Decision Rule
• If the NPV is positive, accept the project
• A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
• Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal.
9-134
Computing NPV for the Project
• Using the formulas:
• NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 – 165,000 = 12,627.42
• Many financial calculators also have
templates for calculating NPV
• Easiest to calculate using a computerized
spreadsheet (See Excel, next slide):
• Do we accept or reject the project?
9-135
NPV using Excel
Year
Cash Flow
1
63,120.00
2
70,800.00
3
91,080.00
'=NPV at 12%
Original Investment
Net Present Value
177,627.41
-165,000.00
12,627.41
Since NPV is positive at 12%, we should accept the
investment.
9-136
Decision Criteria Test - NPV
• Does the NPV rule account for the time
value of money?
(Yes)
• Does the NPV rule account for the risk of
the cash flows?
(Yes)
• Does the NPV rule provide an indication
about the increase in value? (Yes)
• Should we consider the NPV rule for our
primary decision rule?
(Yes)
9-137
Internal Rate of Return
• This is the most important alternative to
NPV
• It is often used in practice and is intuitively
appealing
• It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere
9-138
IRR – Definition and Decision
Rule
• Definition: IRR is the return that makes the
NPV = 0
• Decision Rule: Accept the project if the
IRR is greater than the required return
9-139
Computing IRR For The Project
• If you do not have a financial calculator,
then this becomes a trial and error process
• Again many financial calculators have
templates for estimating IRR
• But IRR is most easily estimated using a
spreadsheet (See Excel, next slide)
• Do we accept or reject the project?
9-140
IRR using Excel
List all cash flows in sequence
Year 0 (Initital Inv.)
-$165,000.00
Year 1
63,120.00
Year 2
70,800.00
Year 3
91,080.00
= IRR @ est. 12%
16.13%
DBH suggestion: Use the required return as the “guess”
rate requested by the Excel function (in this case 12%)
Since 16.13% > 12% we would accept the project.
9-141
Decision Criteria Test - IRR
• Does the IRR rule account for the time value
of money?
(Yes)
• Does the IRR rule account for the risk of the
cash flows?
(Yes)
• Does the IRR rule provide an indication
about the increase in value? (Yes, by %)
• Should we consider the IRR rule for our
primary decision criteria? (Not primary,
see following slides)
9-142
Advantages of IRR
• Knowing a return is intuitively appealing
• It is a simple way to communicate the value
of a project to someone who doesn’t know
all the estimation details
• If the IRR is high enough, you may not need
to estimate a required return, which is often
a difficult task
9-143
Summary of Decisions For The
Project
Summary
Net Present Value
Accept
Payback Period
Reject
Discounted Payback Period
Reject
Average Accounting Return
Reject
Internal Rate of Return
Accept
9-144
NPV Vs. IRR
• NPV and IRR will generally give us the
same decision
• Exceptions
• Non-conventional cash flows – cash flow signs
change more than once
• Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
9-145
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 x-axis more than once, there will be
more than one return that solves the
equation
• If multiple IRR’s are calculated, none are
then reliable.
9-146
Another Example – Nonconventional Cash Flows
• Suppose an investment will cost $90,000
initially and will generate the following cash
flows:
• Year 1: 132,000
• Year 2: 100,000
• Year 3: -150,000
• The required return is 15%.
• Should we accept or reject the project?
9-147
Excel Output—Example #2
Year
Year
Year
Year
0
1
2
3
IRR
NPV fx 15%
Less inv.
NPV at 15%
-$90,000
$132,000
$100,000
-$150,000
10.11%
reject
$91,769.54
-$90,000.00
$1,769.54 accept
IRR says to reject, but NPV says to
accept. Go with NPV.
9-148
Summary of Decision Rules
• The NPV is positive at a required return of
15%, so you should Accept
• If you use the financial calculator or
spreadsheet, you would get an IRR of
10.11% which would tell you to Reject
• You need to recognize when there are nonconventional cash flows and look at the
NPV profile
9-149
IRR and Mutually Exclusive
Projects
• Mutually exclusive projects
• If you choose one, you can’t choose the other
• Example: You can choose to attend graduate
school at either Harvard or Stanford, but not
both
• Intuitively you would use the following
decision rules:
• NPV – choose the project with the higher NPV
• IRR – choose the project with the higher IRR
9-150
Example With Mutually Exclusive
Projects
Period
Project A Project
B
0
-500
-400
1
325
325
2
325
200
IRR
19.43%
22.17%
NPV
64.05
60.74
The required return
for both projects is
10%.
Which project
should you accept
and why?
Project A has a smaller
IRR but it is a larger
project, thus generating
greater value to the firm
IRR can’t measure that,
9-151
but NPV can.
Conflicts Between NPV and IRR
• NPV directly measures the increase in value
to the firm
• Whenever there is a conflict between NPV
and another decision rule, you should
always use NPV
• IRR is unreliable in the following situations
• Non-conventional cash flows
• Mutually exclusive projects
9-152
Profitability Index
• Measures the benefit per unit cost, based
on the time value of money
• A profitability index of 1.1 implies that for
every $1 of investment, we create an
additional $0.10 in value
• This measure can be very useful in
situations in which we have limited capital
9-153
Advantages and Disadvantages
of Profitability Index
• Advantages
• Closely related to
NPV, generally
leading to identical
decisions
• Easy to understand
and communicate
• May be useful when
available investment
funds are limited
• Disadvantages
• May lead to incorrect
decisions in
comparisons of
mutually exclusive
investments
9-154
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
9-155
Summary – Discounted Cash Flow
Criteria
• Net present value
•
•
•
•
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
• Internal rate of return
•
•
•
•
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually exclusive
projects
• Profitability Index
•
•
•
•
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
9-156
Summary – Payback Criteria
• Payback period
• Length of time until initial investment is recovered
• Take the project if it pays back in some specified period
• Doesn’t account for time value of money and there is an
arbitrary cutoff period
• Discounted payback period
• Length of time until initial investment is recovered on a
discounted basis
• Take the project if it pays back in some specified period
• There is an arbitrary cutoff period
9-157
Quick Quiz
• Consider an investment that costs $100,000 and
has a cash inflow of $25,000 every year for 5
years. The required return is 9% and required
payback is 4 years.
•
•
•
•
What is the payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
(4 yrs)
(-2,758.72)
( 7.93%)
(No)
• What decision rule should be the primary decision
method?
• When is the IRR rule unreliable?
9-158
Quiz using Excel
Year 0
-$100,000
Year 1
$25,000
Year 2
$25,000
Year 3
$25,000
Year 4
$25,000
Year 5
$25,000
IRR
NPV at 9%
-Original Inv.
NPV
7.93%
$97,241.28
-$100,000
($2,758.72)
Reject project!
9-159
Class Case
Pause here to work in-class NPV / IRR case
for Wally’s Widget Works:
9-160
Chapter
9
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
1
Chapter
0
•Making Capital Investment
Decisions
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Relevant Cash Flows
• The cash flows that should be included in a
capital budgeting analysis are those that will
only occur if the project is accepted
• These cash flows are called incremental
cash flows
• The stand-alone principle allows us to
analyze each project in isolation from the
firm simply by focusing on incremental cash
flows
10-163
Asking the Right Question
• You should always ask yourself “Will this
cash flow occur ONLY if we accept the
project?”
• If the answer is “yes”, it should be included in
the analysis because it is incremental
• If the answer is “no”, it should not be included
in the analysis because it will occur anyway
• If the answer is “part of it”, then we should
include the part that occurs because of the
10-164
project
Common Types of Cash Flows
• Sunk costs – costs that have accrued in the past
• Opportunity costs – costs of lost options
• Side effects
• Positive side effects – benefits to other projects
• Negative side effects – costs to other projects
• Changes in net working capital
• Financing costs
• Taxes
10-165
Pro Forma Statements and Cash
Flow
• Capital budgeting relies heavily on pro
forma accounting statements, particularly
income statements
• Computing cash flows – refresher:
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation when there
is no interest expense
• Cash Flow From Assets (CFFA) = OCF – net
capital spending (NCS) – changes in NWC
10-166
Table 10.1 Pro Forma Income
Statement
Sales (50,000 units at $4.00/unit)
Variable Costs ($2.50/unit)
Gross profit
Fixed costs
Depreciation ($90,000 / 3)
EBIT
Taxes (34%)
Net Income
$200,000
125,000
$ 75,000
12,000
30,000
$ 33,000
11,220
$ 21,780
OCF= EBIT + Depreciation - Taxes=
33,000 + 30,000 -11,220= 51,780
10-167
Original Investment (Year 0)
• Original capital investment for this project is
$90,000
• The project’s duration is three years.
• Investment will be depreciated straight-line (1/3
each year) for ease of calculation in this
example
• In addition, the project will tie up $20,000 of
working capital, but this working capital can
be recovered (freed up) at the end of the
project.
10-168
Table 10.5 Projected Total Cash
Flows
Year
0
OCF
1
$51,780
Change
in NWC
-$20,000
NCS
-$90,000
CFFA
-$110,000
2
$51,780
3
$51,780
+20,000
$51,780
$51,780
$71,780
10-169
Making The Decision
• Now that we have the cash flows, we can
apply the techniques that we learned in
chapter 9
• Enter the cash flows into Excel and compute
NPV and IRR
• Excel output, next page
• For this project, projected hurdle rate (required
return) is 20%
• Should we accept or reject the project? 10-170
Excel output for problem
Operating Cash Flows (OCF)
Year 0
$0
Change in Net Working
Capital (NWC)
-$20,000
Capital Spending
-$90,000
Cash Flow from Assets
-$110,000
Year 1
$51,780
Year 2
$51,780
Year 3
$51,780
$20,000
$51,780
$51,780
=NPV of CFFA's Year 1-3 @ 20%
Less original Investment
Net Present Value at 20%
=IRR of CFFA's, Years 0-3, use guess rate of 20%
Accept the project if we desire a return between 20 and 25.7%
$71,780
$120,647.69
-$110,000
$10,647.69
25.762%
10-171
More on Net Working Capital
• Why do we have to consider changes in
NWC separately?
• GAAP requires that sales be recorded on the
income statement when made, not when cash
is received
• GAAP also requires that we record cost of
goods sold when the corresponding sales are
made, whether or not we have actually paid
our suppliers yet
• Finally, we have to buy inventory to support 10-172
Depreciation
• The depreciation expense used for capital
budgeting should be the depreciation
schedule required by the IRS for tax
purposes
• Depreciation itself is a non-cash expense;
consequently, it is only relevant because it
affects taxes
• Depreciation tax shield = DT
• D = depreciation expense
• T = marginal tax rate
10-173
Computing Depreciation
• Straight-line depreciation
• D = (Initial cost – salvage) / number of years
• Very few assets are depreciated straight-line
for tax purposes
• MACRS (see text for classes and rates)
• Need to know which asset class is appropriate
for tax purposes
• Multiply percentage given in table by the initial
cost
• Depreciate to zero (assume no salvage value)10-174
After-tax Salvage
• If the salvage value is different from the
book value of the asset, then there is a tax
effect
• Book value = initial cost – accumulated
depreciation
• After-tax salvage = salvage – T(salvage –
book value)
10-175
Example: Replacement Problem
• Original Machine
• Initial cost = 100,000
• Annual depreciation
= 9,000
• Purchased 5 years
ago
• Book Value = 55,000
• Salvage today =
65,000
• Salvage in 5 years =
• New Machine
• Initial cost = 150,000
• 5-year life
• Salvage in 5 years =
0
• Cost savings =
50,000 per year
• 3-year MACRS
depreciation
10-176
• Required return = 10%
Replacement Problem –
Computing Cash Flows
• Remember that we are interested in
incremental cash flows
• If we buy the new machine, then we will sell
the old machine
• What are the cash flow consequences of
selling the old machine today instead of in 5
years?
10-177
Replacement Problem – Pro
Forma Income Statements
Year
Cost
Savings
1
2
3
4
5
50,000
50,000
50,000
50,000
50,000
New
49,500
67,500
22,500
10,500
0
Old
9,000
9,000
9,000
9,000
9,000
40,500
58,500
13,500
1,500
(9,000)
EBIT
9,500
(8,500)
36,500
48,500
59,000
Taxes
3,800
(3,400)
14,600
19,400
23,600
5,700
(5,100)
21,900
29,100
35,400
Depr.
Increm.
(40%)
NI
OCF= EBIT + Incremental Depr –Taxes on Project
Year 1: OCF= 9,500+ 40,500 -3,800 = 46,200 etc.
10-178
Replacement Problem – Incremental
Net Capital Spending
• Year 0
• Cost of new machine = 150,000 (outflow)
• After-tax salvage on old machine = 65,000 .40(65,000 – 55,000) = 61,000 (inflow)
• Incremental net capital spending = 150,000 –
61,000 = 89,000 (outflow)
• Year 5
• After-tax salvage on old machine = 10,000 .40(10,000 – 10,000) = 10,000 (outflow
because we no longer receive this)
10-179
Replacement Problem – Cash
Flow From Assets
Year
0
OCF
1
2
3
4
5
46,200
53,400
35,400
30,600
26,400
NCS
-89,000
-10,000
 In
NWC
0
0
CFFA
-89,000
46,200
53,400
35,400
30,600
16,400
10-180
Replacement Problem –
Analyzing the Cash Flows
• Now that we have the cash flows, we can
compute the NPV and IRR
• Enter the cash flows
• Use hurdle rate established (10%) for NPV and
as a “guess rate” for IRR
• Excel output, next page
• Should the company replace the
equipment?
10-181
Excel output for problem
Operating Cash Flows (OCF)
Year 0
$0
Net Capital Spending
-$89,000
Cash Flow from Assets
-$89,000
Year 1
$46,200
Year 2
$53,400
Year 3
$35,400
Year 4
$30,600
Year 5
$26,400
-$10,000
$46,200
=NPV, Years 1-5 @ 10%
Less original Investment
Net Present Value at 10%
=IRR of CFFA's, Years 0-5, use guess rate of 10%
$53,400
$35,400
$30,600
$16,400
$143,812.10
-$89,000
$54,812.10
36.28%
10-182
Pause here to work class case
10-183
1
Chapter
0
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
Project Analysis and Forecast Risk
•ADVANCE-Managerial Finance
•Class Notes for Chapter 11
•D.B. Hamm—updated Jan. 2006
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Evaluating NPV Estimates—The
Basic Problem
• Basic Problem—How reliable is our NPV estimate
for new project(s) under consideration?
• Projected vs. actual cash flows
• Forecasting risk—possibility that errors in projected
cash flows will lead to incorrect decisions
• Also called “estimation risk” (same)
• “What If” analysis may help us evaluate and
minimize forecasting/estimation risk
“What If” Analysis (overview)
• Scenario analysis
• Ask basic “What if?” questions and rework NPV
estimates
• Worst case—good start point—what is the minimum
NPV for the project?
• Best case—upper limit bound of project NPV
• Base case—most likely outcome assumed (probably
some midpoint between best & worst)
“What If” Analysis (continued)
• Sensitivity analysis—
• Impact on NPV and/or IRR when one variable is
changed (up or down) and other variables remain at
“base case”
• If our estimate of NPV or IRR is very sensitive (changes
significantly) to relatively small changes in some
component, forecasting risk for that variable is high
“What If” Analysis (slide 3):
• Simulation analysis
• Combine scenario and sensitivity analysis to calculate
impact of varying changes
• Use of a computer (spreadsheet or other software) is
essential
• Still may be impossible to forecast every possible
combination of variables, but should give us some
trends
Illustration:
Wally's Widget Works
New Project Estimate
Unit Sales
x Selling price per unit
Sales Revenue
-Variable Costs at $8 per unit
Contribution Margin
- Fixed costs (other than depr.)
- Depreciation
EBIT
Taxes @ 40%
Net Income
OCF (EBIT+ Depr-Taxes)
Pres. Value (4 yrs x above at 12%)
Less Original Investment
NPV
IRR
Base
6,000
$15
$90,000
-$48,000
$42,000
-$12,000
-$11,000
$19,000
-$7,600
$11,400
Scenario
Worst
4,500
$15
$67,500
-$36,000
$31,500
-$12,000
-$11,000
$8,500
-$3,400
$5,100
Best
7,500
$15
$112,500
-$60,000
$52,500
-$12,000
-$11,000
$29,500
-$11,800
$17,700
$22,400
$16,100
$28,700
$68,037
-$60,000
$8,037
18.22%
$48,901
-$60,000
($11,099)
2.89%
$87,172
-$60,000
$27,172
32.15%
Once our template is set up we may rerun with any variations
required
Break-Even Analysis (1):
• Fixed and Variable Costs
• VC varies with quantity produced/sold
• FC remains constant (in relevant range)
• Separate depreciation (D) for cash flow purposes
•
TC = VC + FC + D
• Or S = v x Q + FC+D
• Therefore S – VC – FC – D = 0
at break even point (“accounting break even”)
• Accounting break even occurs where net income
from project = 0
Break Even Analysis (2):
•
•
•
•
•
Since S – VC – FC – D = 0 at break even
And since S = p x Q (selling price x quantity)
And VC = v x Q (vc per unit x Q)
Then (p x Q)-(v x Q) – FC – D = 0
Finally accounting break even quantity is:
Q = FC + D
p -v
Accounting Break Even (illustration)
Selling price per unit = $20, variable cost = $11 per unit,
fixed costs other than depreciation = $60,000 and
depreciation = $20,000. Find accounting break even
quantity:
Q = FC
+D
/p -v
Q = 60,000 + 20,000 / 20 -11
Q = 80,000 / 9
Q = 8,889 units
Cash Flow Break Even:
Operating cash flow: OCF = EBIT + Depr – Taxes
In these illustrations we will assume Taxes = 0
(calculating break even on a pre-tax basis), so
OCF = EBIT + D
OCF =( S –VC – FC – D) + D
OCF = (P x Q)-(v x Q) – FC
OCF = Q (p-v) - FC
Q (break even) = FC (without depr.)
p–v
Cash flow break even occurs where project OCF = 0
Cash Flow B/E (illustration):
Using previous illustration:
Selling price per unit = $20, variable cost = $11 per unit,
fixed costs other than depreciation = $60,000 and
depreciation = $20,000. Find cash flow break even quantity
Q = FC / p – v
Q = 60,000 / 20 – 11
Q = 60,000 / 9
Q = 6,667 units
Note: B/E quantity for cash flow is less than required for
accounting break even, but project at cash b/e only can never
pay back its original investment. IRR = -100%
Financial Break Even:
• Financial break even occurs when NPV of
project = 0
• Discounted payback = project life
• Project NPV = 0
• Project IRR = required rate of return
• Formula for break even:
Q = FC + OCF*
p–v
*Where OCF results in a zero NPV
Financial B/E (illustration):
Our previous project seeks a 12% return over 5 years.
Original investment was $100,000. Required OCF per year
would therefore be OCF = 100,000 / 3.6048 (see table for PV
annuity factor @ 12% for 5 periods)
OCF = $27,741 ( 100,000 / 3.6048 rounded to nearest $1)
Q = FC + OCF / p – v
Q = 60,000 + 27,741 / 20 – 11
Q = 87,741 / 9
Q = 9,749 units (considerably more than cash flow b/e, even
more than accounting b/e, but this now factors recovery of
original capital investment at 12% over 5 yrs)
Problems (group case):
PAUSE FOR CLASS CASE:
Operating Leverage
Operating leverage is the degree to which a project
relies on fixed costs
Degree of operating leverage = % change in OCF
relative to % change in quantity sold
DOL = 1 + (FC/OCF)
Operating Leverage (illustration)
In the case just worked, OCF at base case = $30,000 and
FC=$40,000 (output is 14,000 units)
DOL = 1 + (40,000/30,000)
DOL = 1 + 1.3333
DOL = 2.333
Thus a 1% increase in units sold would generate a 2.33%
increase in OCF in the base case range. Vice versa, a 1%
decrease in sales = 2.33% decrease in OCF.
Operating Leverage (conclusion)
DOL will decline if Q increases substantially. At best
case scenario DOL = 1+(40,000/45,000) = 1.889
Conversely at worst case scenario DOL = 1 +(40,000 /
15,000)=3.667
This is because as fixed costs decline as a percent of
operating cash flow (quantities sold increases and OCF
therefore increases, but fixed costs stay constant), the
leverage effect diminishes. If fixed costs as a % of OCF
increases (as when sales decline, thus OCF declines, but
fixed costs don’t change), leverage effect increases.
End of Ch. 11 Presentation
1
Chapter
2
•Some Lessons from Capital
Market History
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Risk, Return and Financial
Markets
• We can examine returns in the financial
markets to help us determine the
appropriate returns on non-financial assets
• Lessons from capital market history
• There is a reward for bearing risk
• The greater the potential reward, the greater
the risk
• This is called the risk-return trade-off
12-204
Dollar Returns
• Total dollar return = income from investment
+ capital gain (loss) due to change in price
• Example:
• You bought a bond for $950 one year ago. You
have received two coupons of $30 each. You
can sell the bond for $975 today. What is your
total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 975 – 950 = 25
• Total dollar return = 60 + 25 = $85
12-205
Percentage Returns
• It is generally more intuitive to think in terms
of percentages than in dollar returns
• Dividend yield = income / beginning price
• Capital gains yield = (ending price –
beginning price) / beginning price
• Total percentage return = dividend yield +
capital gains yield
12-206
Example – Calculating Returns
• You bought a stock for $35 and you
received dividends of $1.25. The stock is
now selling for $40.
• What is your dollar return?
• Dollar return = 1.25 + (40 – 35) = $6.25
• What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%
12-207
The Importance of Financial
Markets
• Financial markets allow companies, governments
and individuals to increase their utility
• Savers have the ability to invest in financial assets
so that they can defer consumption and earn a
return to compensate them for doing so
• Borrowers have better access to the capital that is
available so that they can invest in productive
assets
• Financial markets also provide us with
information about the returns that are required for
12-208
various levels of risk
Average Returns (1926-2003)
Investment
Average Annual Return
Large-company stocks
12.4%
Small-company Stocks
17.5%
Long-term Corporate Bonds
6.2%
Long-term Govt. Bonds
5.8%
U.S. Treasury Bills
3.8% **
Inflation (same period)
3.1%
** Considered a “risk free” investment, but note average
return is only slightly over the rate of inflation
12-209
Risk Premiums
• The “extra” return earned for taking on risk
• Treasury bills are considered to be risk-free
• Risk-free in that there is “zero” risk of default,
but they still carry some price risk—govt.
bonds are traded in the market and prices may
fluctuate as the market fluctuates.
• The risk premium is the return over and
above the risk-free rate
12-210
Table 12.3 Average Annual Returns
and Risk Premiums
Investment
Average Return
Risk Premium**
Large stocks
12.4%
8.6%
Small Stocks
17.5%
13.7%
Long-term Corporate
Bonds
6.2%
2.4%
Long-term
Government Bonds
5.8%
2.0%
U.S. Treasury Bills
3.8%
0.0%
** Calculated as average return – the risk-free rate (T-bills)
12-211
Efficient Capital Markets
• Stock prices are in equilibrium or are “fairly”
priced
• If this is true, then you should not be able to
earn “abnormal” or “excess” returns
• If there are “excess-return” investments available, the
market will find them and bid the price up, adjusting
effective returns back to “normal”
• Efficient markets DO NOT imply that
investors cannot earn a positive return in
the stock market
12-212
What Makes Markets Efficient?
• There are many investors out there doing
research
• As new information comes to market, this
information is analyzed 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
12-213
Common Misconceptions about
Efficient Markets Hypothesis
• 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 there is not a bias in prices that can be
exploited to earn excess returns
• Market efficiency will not protect you from wrong
choices if you do not diversify – you still don’t
want to put all your eggs in one basket
12-214
1
Chapter
2
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
Managerial Finance:
Chapter 13—Return, Risk & the
Security Market Line
•OVU-ADVANCE
•Notes prepared by D. B. Hamm
•Updated January 2006
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Expected Return (1)
Most investments carry some degree of risk.
Generally only U.S. securities (specifically Tbills) are considered risk free [Rf] because
the Federal government can raise taxes or
borrow as necessary to avoid default.
Expected Return (2):
Suppose Investment A has probable returns as
follows:
• In the previous "go-go" market, it had earned
12%.
• In the recent market slump, it earned only 4%.
• If we project a 60% probability of renewed boom
and a 40% probability of bust, then the expected
return of A [ E(RA) ] is as follows:
E(RA) = (.60 x .12) + (.40 x .04)
= .072
+
.016
= .088 or 8.8%
Risk Premium:
Risk Premium is the difference between the
expected return on the proposed investment
and the risk free rate.
If U.S. security G is earning 4% then the risk
premium for investment A (from previous
slide, E(R) = 8.8%) is:
RiskA = E(RA) - Rf
= .088 - .04
= .048 or 4.8%
Variance & Standard Deviation
The Variance, or squared deviations from the expected
return gives us a measurement of how much risk
movement is in an investment. For Investment A:
2A = [prob1 x (return1 - E(RA)2] + [prob2 x (return2 - E(RA)2]
2A = [.60 x (.12
- .088)2] + [.40 x (.04
- .088)2]
= [.60 x .001024
] + [.40 x .002304
]
= [.00036864]
+ [.0009216]
= .00129024
The Standard deviation is the square root of the
variance. For A:
A = SQRT of .00129024 =+-0.03592 = + or - 3.59%
This gives some idea of the potential movement in Investment A
Investment Portfolios
A portfolio of investments enables us
to diversify and therefore minimize
the portion of risk that relates to
"surprises" or unexpected movement
in individual securities.
A portfolio won't remove risk related
to the market as a whole ("market
risk").
Portfolio Illustration
Suppose we mix a portfolio of 40% in Investment A
(previous) + 40% in Investment B, which may earn only
7% in a good market but booms to 14% in a recession,
and we put the other 20% in government investment G
earning 4%. Portfolio Expected Return for Portfolio "P"
:
E(RP) = [.40 x E(RA)] + [.40 x E(RB)] + [.20 x E(RG)]
Where E(RA) =8.8% , E(RB) =9.8% , and E(RG) =
4% (the risk-free rate)
E(RP) = ( .40 x .088) + (.40 x .098) + (.20 x .04)
E(RP) = .0824 or 8.24%
Portfolio Illustration (continued):
Note: The percentage weights are based on the
total dollars invested in each security. If we
invested $100,000 as follows: $40,000 in A, $40,000
in B, and $20,000 in G, then we would have the 40%40%-20% mix above.
The variance of this portfolio is 0.00000434062 and the
standard deviation is .0020736 or about + or - 2/10 of
1%. In other words, diversifying eliminated almost all of
the diversification risk or unexpected return.
Risk & Beta (1):
Total risk of any investment = both
• the market risk (which can't be diversified)
and
• the diversifiable risk, which can be
minimized or eliminated by diversification in a
portfolio.
•The market risk is called systematic and
the diversifiable risk is called unsystematic.
Total risk = Systematic risk + Unsystematic risk
(market risk)
(diversifiable risk)
Risk & Beta (2):
Total risk = Systematic risk + Unsystematic risk
(market)
(diversifiable)
The unsystematic risk is asset-specific and relates to
individual investments which can be minimized
through diversification. The systematic risk, or market
risk, can affect all market investments. A recession or
a war, for example, might impact all investments in a
portfolio. Since we can usually eliminate the
unsystematic risk, we focus primarily on the
systematic risk.
Expected return of any asset , or E(Rasset),
depends only on the asset's systematic risk. We
measure the systematic risk by the beta
Risk & Beta (3):
The Beta of an asset =
Covariance of asset returns with
The market index portfolio
Variance with the market portfolio
I don't want to figure that out--do you? There are people on this
planet who live for this stuff and do that for most publicly traded
assets. (Your facilitator is NOT one of them!) Therefore we will
assume the Beta is given for any investment we work with.
The general rule for  is as follows:
If  = 1.0 then the investment has "normal" market risk
If  < 1.0 then the investment has below normal market
risk
(for example U.S. securities'  = 0 or zero
risk)
If  > 1.0 then the investment has a greater than
Some Sample Betas (as of 1/31/07)
• Ford Motor Co (recent financial concerns, stock has
dipped from $13.17 to $8.08/share over 2 yrs) = 1.83
• Wal-Mart (solid, $47.19/sh)= 0.17
• GE (also solid, $36.11/sh) = 0.51
• CVS Corp. (near mkt average, $33.31/sh)= 0.94
• Microsoft (solid, but rolling out Windows Vista,
$30.41/sh) = 0.71
• Trump Entertainment Resorts (considerable fluctuation,
$17.57/sh) = 1.96
• NutriSystem, Inc. (also wildly fluctuates, $45.83/sh)=
2.06 (stock has recently endured a 12% drop)
Portfolio Beta:
If we have the Beta coefficient for each of the individual
investments in our portfolio, we can evaluate the overall
risk in our entire portfolio. Using the earlier example,
let's make the following assumptions:
40% +
40%
+ 20% = Portfolio P
Investment A
A = 1.40
Investment B Investment G
B = .90
G = 0 (risk free)
P = (.40 x 1.40) + (.40 x .90) + (.20 x 0)
= .56
+ .36
+ 0
= .92 (slightly below normal systematic risk)
(As we calculated earlier, the expected return E(R) on
portfolio P: E(RP) = 8.24%. Since the portfolio Beta is
slightly < 1, we assume its E(R) to be slightly < the
market rate)
The Security Market Line (SML)
When we mix a portfolio of assets, we find a
linear ( positive correlation) relationship
between the individual assets' expected
returns and their Betas.
Assets with a higher Beta generally have a
higher expected return to compensate for
the higher systematic (market) risk.
(General concept of risk vs. return--the
higher the potential return, the higher the
potential risk.)
The Security Market Line (SML) (2)
This linear relationship between expected
return and Beta is called the Security Market
Line (SML). The slope of the SML is as
follows:
E(RA) - Rf
Slope of SML for Asset A =
A
Or the difference between expected return
and risk free return divided by the beta
coefficient.
Security Market Line (SML) (3)
E(RA) - Rf
Slope of SML for Asset A =
A
.088 - .04
For our Investment A =
1.40
= .0343 or 3.4%
For our Investment B =
.098 - .04
.90
= .0644 or
6.4%
This is the reward-to-risk ratio. Here investment B is
more attractive, although neither is particularly high in
a “bull” market ( remember B was better in a “bear”
market).
Security Market Line (SML) (4)
In an organized market, this difference in
reward-to-risk would not persist because
buyers and sellers would bid up investment B
over investment A which would lower B's
return and increase A's return.
We therefore assume the reward to risk
ratio is the same for all assets in the
market and can therefore be plotted on the
SML.
Market Risk Premium
If we create a theoretical portfolio of all
securities in the market, which would
therefore have a Beta of the market
average M = 1.0 we can evaluate the
entire market risk premium as
Market Risk Premium = E(RM) - Rf
Risk premium = Expected market return – risk free
rate
Example:
If the “going” market rate were 11.5%
and the T-bill (risk free) rate were 4%, then the
market risk premium is the difference of 7.5%
Capital Asset Pricing Model (CAPM)
If we select any asset "i" in this market
and assume that trading in the market's
assets has "normalized" the expected
return so that it equals the same reward
to risk, then the equation for the SML of
any asset "i" in the market is
Expected return = risk free rate + (risk premium x Beta)
E(Ri) = Rf + [E(RM) - Rf] x i.
This is called the Capital Asset
Pricing Model or CAPM.
CAPM Illustration (1):
If the Rf = 4% and the E(RM)=11.5%
Suppose we select an asset "i" with a i =
.7 The expected return on this asset is
therefore (using CAPM)
E(Ri)= Rf + [E(RM) - Rf] x i
= .04 + [.115 - .04] x .7
= .04 + (.075 x .7)
= .04 + .0525
= .0925 or 9.25%
Because the Beta is low risk (less than market), the
expected return is less than the market rate.
CAPM Illustration (2):
Expected Return = risk free rate + (risk premium) x Beta
E(Ri)= Rf + [E(RM) - Rf] x I
(Where Rf= 4%, E(RM)= 11.5%)
If the  = 1.0 then the expected return = 11.5%
(the market rate)
If the  = 1.5 then the expected return = 15.25 %
If the  = 2.0 then the expected return = 19%
(this is double the market risk!)
If the  = .5 then the expected return = 7.75%
If the  = 0 then the expected return = 4%
(the risk-free rate)
CAPM (3):
• As long as we have the following variables:
• The risk free rate
• The current market rate
• The asset’s Beta
• Then we can estimate the expected return for any
asset (investment).
• If we have the E(R) of an asset and any two of the
above, we can work backward and find the missing
variable. Example-if we knew the return on an asset over
time, we could estimate what its Beta should be.
CAPM (conclusion):
Assumptions of the Capital Asset Pricing Model
(CAPM)
• The pure time value of money This is the risk- free rate,
or the rate you could expect to earn over time if you
accepted no (zero) risk (govt. securities)
• The reward for bearing systematic risk, or the risk
premium (asset rate in excess of the risk free rate)
• The amount of systematic risk in the market, or the
Beta value
Cartoon
Pause here for class case before going to chapter 15
Chapter
The Cost of Capital (Chapter 15)
•OVU-ADVANCE
•Managerial Finance
•D.B. Hamm, rev. Jan 2006
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
“Cost of Capital?”
• When we say a firm has a “cost of capital” of,
for example, 12%, we are saying:
• The firm can only have a positive NPV on a project
if return exceeds 12%
• The firm must earn 12% just to compensate
investors for the use of their capital in a project
• The use of capital in a project must earn 12% or
more, not that it will necessarily cost 12% to borrow
funds for the project
• Thus cost of capital depends primarily on the
USE of funds, not the SOURCE of funds
Weighted Average Cost of Capital
(overview)
• A firm’s overall cost of capital must reflect the
required return on the firm’s assets as a whole
• If a firm uses both debt and equity financing, the
cost of capital must include the cost of each,
weighted to proportion of each (debt and equity)
in the firm’s capital structure
• This is called the Weighted Average Cost of
Capital (WACC)
Cost of Equity
The Cost of Equity may be derived from the dividend
growth model as follows:
P = D / RE – g
Where the price of a security equals its dividend (D)
divided by its return on equity (RE) less its rate of
growth (g). We can invert the variables to find RE as
follows:
RE = D / P + g
But this model has drawbacks when considering that
some firms concentrate on growth and do not pay
dividends at all, or only irregularly. Growth rates may
also be hard to estimate. Also this model doesn’t
Cost of Equity (2):
Therefore many financial managers prefer the
security market line/capital asset pricing model
(SML or CAPM) for estimating the cost of equity:
RE = Rf + βE x (RM – Rf)
or Return on Equity = Risk free rate + (risk factor x
risk premium)
Advantages of SML: Evaluates risk, applicable to
firms that don’t pay dividends
Disadvantages of SML: Need to estimate both
Beta and risk premium (will usually base on past
data, not future projections.)
Cost of Debt
• The cost of debt is generally easier to
calculate
• Equals the current interest cost to borrow new funds
• Current interest rates are determined from the going
rate in the financial markets
• The market adjusts fixed debt interest rates to the
going rate through setting debt prices at a discount
(current rate > than face rate) or premium (current
rate < than face rate)
Weighted Average Cost of Capital
(WACC)
• WACC weights the cost of equity and the cost of
debt by the percentage of each used in a firm’s
capital structure
• WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
• (E/V)= Equity % of total value
• (D/V)=Debt % of total value
• (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The
after-tax rate must be considered because interest on
corporate debt is deductible
WACC Illustration
ABC Corp has 1.4 million shares common valued at $20
per share =$28 million. Debt has face value of $5
million and trades at 93% of face ($4.65 million) in the
market. Total market value of both equity + debt thus
=$32.65 million. Equity % = .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x
.74)=9.18% Tax rate is 40% Current yield on market
debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
Final notes on WACC
• WACC should be based on market rates and
valuation, not on book values of debt or
equity. Book values may not reflect the
current marketplace
• WACC will reflect what a firm needs to earn
on a new investment. But the new investment
should also reflect a risk level similar to the
firm’s Beta used to calculate the firm’s RE.
• In the case of ABC Co., the relatively low WACC of
8.81% reflects ABC’s β=.74. A riskier investment
should reflect a higher interest rate.
Cartoon
Pause for Class Case
Chapter
Financial Leverage (Chapter 17)
•OVU-ADVANCE
•Managerial Finance
•D.B. Hamm, Jan. 2006
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Equity vs Debt Financing (1)
• Since the WACC is the weighted average of cost
of equity + cost of debt, we can vary the WACC
by changing the mix of debt + equity
• If cost of debt < cost of equity, we can reduce WACC by
increasing the % of debt in the mix and vice versa
• The value of the firm (its earning’s potential) is
maximized when its WACC is minimized.
• A firm with a lower cost of capital can more easily return
profits to its owners
Debt vs Equity Financing (2):
• The optimal, or target capital structure is the
structure with the lowest possible WACC
• The Interest Tax Shield (deductibility of corp.
interest) is critical here, because it effectively
lowers the cost of debt.
• Therefore for many firms, the use of financial
leverage (debt financing) can lower WACC
and increase profitability
Debt vs. Equity Financing (3):
• Warning: choice between debt & equity can
not be based on interest rates, etc. alone.
Risk must be considered as well
• Systematic risk (see ch. 13) consists of two
factors which must be considered
• Business risk—risk inherent in firm’s operations
• Financial risk—risk inherent in using debt financing
• Remember debt is a multiplier:
• it can multiply returns if returns > cost of debt; but
• it can also multiply losses, or returns < cost of debt.
Pause for class case illustrating
Financial Leverage
Financial Leverage Considerations:
• If profits are down, dividends (the key cost of
equity financing) can often be deferred.
• Interest (cost of debt) must always be paid for
a firm to remain solvent
• Financial distress costs: costs incurred with
going bankrupt or costs that must be paid to
avoid bankruptcy
• According to the static theory of capital
structure, gains from the tax shield are offset
by the greater potential of financial distress
costs.
Optimal Capital Structure:
• Optimal capital structure is achieved by
finding the point at which the tax benefit of an
extra dollar of debt = potential cost of financial
distress. This is the point of:
•
•
•
•
Optimal amount of debt
Maximum value of the firm
Optimal debt to equity ratio
Minimal cost of WACC
• This will obviously vary from firm to firm and
takes some effort to evaluate. No single
equation can guarantee profitability or even
survival
Critical considerations:
• Firms with greater risk of financial distress must borrow
less
• The greater volatility in EBIT, the less a firm should
borrow (magnify risk of losses)
• Costs of financial distress can be minimized the more
easily firm assets can be liquidated to cover obligations
• A firm with more liquid assets may therefore have less
financial risk in borrowing
• A firm with more proprietary assets (unique to the firm,
hard to liquidate) should minimize borrowing