Chapter 1: An Overview of Financial Management
Learning Objectives:
 Recall the 3 basic ways businesses are organized
 Discuss the advantages and disadvantages of each type of business organization
 Understand what is double taxation
 Understand that the goal of financial management is to maximize shareholder’s wealth
 Explain and discuss the links between stock prices, intrinsic values, and market equilibrium
 Discuss the conflicts between managers and shareholders and the various techniques firms can use to
mitigate the conflicts
Forms of Business Organization
Form
Proprietorship
(Unincorporated business
owned by one individual)
Partnership
(Unincorporated business
owned by two or more
persons)
Corporation
(Incorporated business
owned by many
shareholders)
Limited Liability
Company/Partnership
(Hybrid between partnership
and corporation)











Advantages
Easily and inexpensively formed
Subject to few government regulations
Subject to lower income taxes than
corporations
No corporate income tax
Easy transfer of ownership
Unlimited life
Limited liability
- Only lose what they invest
Ease of raising capital
Limited liability like corporations
Taxed like partnerships
Votes in proportion of their ownership
interest






Disadvantages
Unlimited personal liability
Limited life of business
Difficult to raise capital
Cost of set-up and report filing
Double taxation (U.S.)
- Corporation’s earnings taxed
- Dividend earnings taxed again as
personal income
Still evolving. Requires hiring of a
(good) lawyer when establishing
Balancing Shareholder Value and the Interest of Society


Financial Management: How companies conduct their business in order to maximize its value
Management’s primary goal: Shareholder Wealth Maximization (i.e. maximizing intrinsic value)
 Decisions should be made to maximize the long-run value of the firm’s common stock (cash flow)
 vs Proprietor’s goal to maximize his own interest
 Not inconsistent with being socially responsible
Corporation focuses on creating shareholder value  Unresponsive to employee and customers + Hostile to community +
Indifferent to effects on environment  Hard to retain & recruit top-notch employees + Products boycotted + Face additional
lawsuits + Confronted with negative publicity  Reduction in shareholder’s value

Maximize firm’s expected profits ≠ Maximize shareholder’s wealth
 Managers can use accounting manipulations to maximize profits, which has no effect on the real cash
flow of the company
 Managers can seek to cut expenses (such as R&D), which maximizes current year profits but jeopardizes
future survivability of the company
© COPYRIGHT JIA HUI (JPOH008)
Intrinsic values, Stock Prices

An estimate of the “true” value based on the best available information (accurate risk
and return data) + Long Run Concept
 Can be estimated, but not measured precisely
Intrinsic Value
 Changes when there’s new information
 Investors try to estimate the intrinsic value and may come up with different estimates
 Depends on firm’s future performance
 Set by marginal investor based on perceived value of the stock
Stock Prices
 Information that they have may be inaccurate
 Depends on demand and supply in the market
 At market equilibrium, intrinsic value = stock price.
 Equilibrium is where investors are indifferent between buying and selling the stock
 Ideally, managers should avoid actions that reduces intrinsic value, even if it increases stock price in the
short run
 The difference is what makes the transactions occur
 Effective communication is required to keep intrinsic prices and actual prices close
Market price > Intrinsic Value
 Overvalued
 Not good to buy; may sell
Market Price < Intrinsic Value
 Undervalued
 Good to buy
Market Price = Intrinsic Value
 Market equilibrium
 No tendency to buy/sell
Important Business Trends
Increased
Globalization of
Business
Ever-Improving
Information
Technology
Corporate
Governance
-
Developments in communications technology
Allows company to have branches/operations in other countries
Increases income (e.g. IBM generates more than half of their sales & income
overseas)
Spurs globalization
Firms collect massive amount of data and use it for financial decisions (e.g.
considering and predicting results of a potential site for business)
Top managers operate and interface with stockholders
Active investors who control huge pools of capital (hedge funds and private equity
groups) are constantly looking for underperforming firms; and they quickly pounce on
laggards, take control, and replace managers
Business Ethics


Company’s attitude and conduct toward its employees, customers, community, and stockholders
Most firms have strong written codes of ethical behaviors + Conduct training programs to ensure that
employees understand proper behavior in different situations
 When conflicts arise involving profits and ethics, the right choice isn’t always clear
© COPYRIGHT JIA HUI (JPOH008)
Conflicts between Managers, Stockholders, and Bondholders

Managers vs
Stockholders: Agency
Problems
Stockholders vs
Bondholders
Managers inclined to act in their own best interests (which is not always the same as
the interest of stockholders)
 E.g. Managers pay themselves excessive salaries
 Solving Agency Problems:
 Reward managers based on long-run intrinsic value of the
company stock, not the stock’s price on an option exercise data
i.e. Options should be phased in over a number of years 
Managers have the incentive to keep stock price high over time
 Compensation must be based on stock’s market price because
intrinsic value is not observable
Reasonable
 Price used should be an average over time
compensation
 Some managers paid via stocks
packages
- Not the best solution
- Managers could receive stock on a set date, sell it and make
profit. Once profit is based on stock price on the exercised
date, it may lead to managers trying to increase stock price on
that specific date and not in the long run. (e.g. Projects with
good long-term perspectives rejected because it penalizes
profit and lower stock prices on the option exercise date)
Direct
 Majority of stocks owned by institutional investors, who have the
intervention by
clout to exercise considerable influence over firms’ operations
shareholders
 If firm’s stock is undervalued, corporate raiders may see it as a
bargain and attempt to capture the firm in a hostile takeover. If
raid is successful, target’s executive is likely to be managers 
Threat of hostile
Incentive for managers to maintain stock price.
takeovers
- Corporate raiders: Individuals who target a corporation for
take-over because it is undervalued
- Hostile takeover: Acquisition of a company over the
opposition of its management
Firing managers
who don’t
perform well
 Bondholders: Generally receives fixed payments regardless of how well the company
does
 Stockholders: Do better when the company does better
 Problems:
1) When taking on risky projects that may result in bankruptcy
2) Usage of additional debt
 More debt a firm use, the riskier the firm
© COPYRIGHT JIA HUI (JPOH008)
Chapter 5: Time Value of Money
Learning Objectives:
 Explain how time value of money works and why it is important in Finance
 Calculate the present value (PV) and future value (FV) of:
- A lump sum
- Annuity
- Uneven cash flow stream
- Perpetuity (only for PV)
 Differentiate between annuity due and ordinary annuity
 Explain the difference between nominal, periodic, and effective interest rates
- Understand how to compare alternative investments with different compounding periods
 Understand loan amortization and able to calculate the relevant outputs (e.g. payments, principal
outstanding)
- Construct a loan amortization schedule
Time Value of Money

Idea that money available today is worth more than the same amount in future because we can invest the
money
Short Forms
Meaning
PV
Present value, or beginning amount
FVN
Future value, or ending amount
CF
Cash flow
I
Interest rate earned per year
INT
Dollars earned during the year = Beginning amount x I
N
Number of periods
Future Value (FV)
Methods
Formula
Calculator
Finding FV from a cash flow or PV is called compounding
𝐹𝑉𝑁 = 𝑃𝑉 (1 + 𝐼)𝑁
 𝐹𝑉1 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑉 + 𝑃𝑉(𝐼) = 𝑃𝑉 (1 + 𝐼)
Key in N, I/YR, PV, PMT = 0
Solve for FV (Press “Alpha” + “Enter”)
Present Value (PV)
Methods
Finding PV is called discounting
Formula
𝑃𝑉 =
Calculator
𝐹𝑉𝑁
(1+𝐼)𝑁
; 𝑃𝑉 =
𝐶𝐹1
(1+𝐼)1
𝐶𝐹
𝐶𝐹
𝐶𝐹
2
𝑁
𝑡
∑𝑁
+ (1+𝐼)
𝑡=1 (1+𝐼)𝑡
2 + ⋯ + (1+𝐼)𝑁 =
Key in N, I/YR, FV, PMT = 0
Solve for PV (Press “Alpha” + “Enter”)
Annuities & Perpetuities


Annuities: Series of equal cash flows for fixed intervals for a specified number of periods
Perpetuities: An annuity that lasts forever
Cash flows occur at the end of the periods
 Calculator set to “End” mode
𝑃𝑀𝑇
𝐹𝑉 =
[(1 + 𝐼 )𝑁 − 1]
Solving for FV
Ordinary Annuity
𝐼
𝑃𝑀𝑇
1
Solving for PV
𝑃𝑉 =
[1 −
]
𝐼
(1 + 𝐼)𝑁
Cash flow occur at the beginning of period
 Calculator set to “Begin” mode
Annuity Due
Solving for FV
𝐹𝑉𝐴𝑑𝑢𝑒 = 𝐹𝑉𝐴𝑜𝑟𝑑 (1 + 𝐼)
Solving for PV
𝑃𝑉𝐴𝑑𝑢𝑒 = 𝑃𝑉𝐴𝑜𝑟𝑑 (1 + 𝐼)
© COPYRIGHT JIA HUI (JPOH008)
Perpetuity
Solving for PV
𝑃𝑀𝑇
𝐼
1
Because as N  ∞, [1 − (1+𝐼)𝑁]  1
𝑃𝑉 =
Uneven Cash Flows
PMT (Payment)
CF (Cash Flow)
Finding PV of
Unequal CF
Finding FV of
Unequal CF
Finding Rate of
Return (I/R)
Equal cash flows at regular intervals
Not part of an annuity
Methods:
1. Step-by-Step discounting
2. Calculator: Use NPV Function
- NPV (Rate, Initial outlay, {CF1, CF2, …, CFN}, {Cash flow counts})
- Rate: 10% key in as “10”
- No spacing
Method: Step-by-Step
Method: Use IRR Function
- IRR (PV, {CF1, CF2, …, CFN})
- E.g. IRR(-7250,{750,1000,850,6250})
- No spacing
Semiannual and Other Compounding Periods
Annual
Periodic Rate
Stated Annual Rate
Number of Periods
PV/FV
Number of Years
Semiannual
𝑆𝑡𝑎𝑡𝑒𝑑 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 (𝑖. 𝑒. 2)
(Number of Years)(Periods per year, i.e. 2)
No Change
Comparing Interest Rates
Nominal Interest
Rate (INOM)
Periodic Rate (IPER)








Effective Annual Rate
(EAR = EFF%)


Also called the quoted or stated rate
Annual rate, ignores compounding effects
- Assume INOM is interest rate per year
Periods must also be given
Unless otherwise stated, INOM always given
Amount of interest charged each period
𝐼
𝐼𝑃𝐸𝑅 = 𝑁𝑂𝑀
; where M = number of compounding periods per year
𝑀
Actual annual rate of interest, accounting for compounding
𝐼
𝐸𝐹𝐹% = [1 + 𝑁𝑂𝑀
]𝑀 − 1
𝑀
Using GC, go to “Finance” and “C”. Insert (Nominal rate, Compounding periods)
Important to consider EFF% because:
- Investments with different compounding intervals provide different effective
returns
- Allows comparison of investments with different compounding intervals
© COPYRIGHT JIA HUI (JPOH008)
Amortized Loans



Loan that is repaid in equal payments over its life
Outstanding Loan Principal = PV of all remaining payments
Interest paid declines with each payment as the balance declines

Constructing loan amortization schedule
𝑃𝑀𝑇
1
[1 − (1+𝐼)𝑁]
𝐼
Step 1:
Find the Required
Annual Payment

𝑃𝑉 =


Using GC, FV = 0 because the reason for making payments if to retire the loan
PMT = Principal + Interest
Step 2:
Find the Interest Paid
in Year 1
Step 3:
Find the Principal
Repaid in Year 1
Step 4:
Find the Ending
Balance after Year 1


𝐼𝑁𝑇𝑡 = (𝐵𝑒𝑔 𝐵𝑎𝑙𝑡 )(𝐼)
i.e. Replace t with 1

Principal = PMT – INT

End Bal = Beg Bal – Prin
Constructing a Table
Repeat steps 1 to 4 until end of loan
Year
Beg Bal
PMT
1
2
Total
-
INT
Prin
End Bal
-
© COPYRIGHT JIA HUI (JPOH008)
Chapter 2: Financial Markets and Institutions (except 2.7)
Chapter 3: Financial Statements, Cash Flow, and Taxes (except 3.7, 3.8)
Chapter 7: Interest Rates (except 7.6)
Learning Objectives:
 Identify the different types of financial markets and financial institutions and explain how these markets
and institutions enhance capital allocation
 List each of the key financial statements and identify the information they provide
 Understand the different in tax treatment for dividends and interest expense
 List the various factors that influence the interest rates
 Understand the term structure of interest
 Explain what the yield curve is and what determines its shape
Capital Allocation Process
In a well-functioning economy, capital flows efficiently from suppliers to demanders
 Suppliers: Individuals or Institutions with “excess funds”. In return, they are looking for a rate of return.
 Demanders: Those who need to “raise funds”. Willing to pay a rate of return.
- Without going through any financial institutions
Direct Transfer - Usually used by small firms
- Little capital is raised
Indirect
Transfers
through
- Investment banks are the intermediate (middleman)
Transferring of
Investment
Capital
Bankers
Indirect
- Capital made through a financial intermediary (such as a bank of
Transfers
mutual funds)
through a
- E.g. Saver deposits money into the bank & receives interests. Bank
Financial
lends the money to business.
Intermediary
Financial Markets
A financial market is where individuals and organizations wanting to borrow funds are brought together with
those having a surplus of funds
 i.e. A market place where buyers and sellers trade debt instruments (such as bonds) and equity instruments
(such as stocks), and also other assets
 Bonds: Promises a fixed dollar amount for every period
 Stocks: Gives uncertain dividend for every period
Physical: Tangible/Real, for products such as wheat, autos, real estate
Physical assets vs
Financial assets
Financial: Stocks, bonds, notes, mortgages
Spot: Assets are bought or sold for “on-the-spot” delivery
Spot markets vs
Futures markets
Future: Participants agree today to buy or sell an asset at some future date
Money: Markets for short-term, highly liquid debt securities (generally less than 1 year)
Money markets vs
Capital markets
Capital: Markets for intermediate- or long-term debt and corporate stocks
Primary: Markets in which corporations raise capital by issuing new securities
Primary markets vs
Secondary: Markets in which existing, already outstanding securities are traded among
Secondary markets
investors, i.e. Listed shares (shares that are already in the market)
Private: Transactions are negotiated directly between two parties
Private markets vs
Public markets
Public: Standardized contracts are traded on organized exchanges
Financial Institutions



Provides services for firm’s capital raising
Efficient and easier for large firms to raise capital through financial institutions
Regulated to ensure the safety of these institutions and to protect investors (except hedge funds and private
equity companies)
© COPYRIGHT JIA HUI (JPOH008)

Types of financial institutions:
 Traditional “department store of finance”
Commercial banks
 Serves a variety of savers and borrowers
 Underwrites and distributes new investment securities
Investment banks
 Helps businesses obtain financing
Financial services
 A firm that offers a wide range of financial services, including investment banking,
corporations
brokerage operations, insurance, and commercial banking
 Cooperative associations where members have a common bond
Credit unions
 E.g. employees of same firm
 Retirement plans funded by corporations or government agencies for their workers
Pension funds
 Invests primarily in bonds, stocks, mortgages and real estate
Life insurance
 Invests annual premiums collected
companies
 Organization that pool investor funds to purchase financial instruments
Mutual funds
 Reduces risk through diversification
Exchange traded
 Similar to mutual funds
funds
 Operated by mutual fund companies
 Similar to mutual funds
Hedge funds
 But typically have large minimum investments, and marketed primarily to go
institutions and individuals with high net worth
Private equity
 Similar to hedge funds
companies
 But buys and manage entire firms instead of stocks
The Stock Market


Most active secondary market
Most important to financial managers
- Prices of firms’ stocks established
- Knowledge of stock market is important to managing a business
Physical
- i.e. NYSE, American Stock Exchange
Location
- Formal organizations having tangible physical locations that
Exchange
conduct auction markets in designated (“listed”) securities
- i.e. Nasdaq
Types of Market
- Over-the-Counter Market: A large collection of brokers and
Procedures
Electronic
dealers, connected electronically by telephones and computers,
Dealer-based
that provides trading in unlisted securities
Markets
- Dealer Market: Includes all facilities required to conduct security
transactions not conducted on the physical location exchanges
© COPYRIGHT JIA HUI (JPOH008)
The Market for Common Stock
Closely Held
Corporations
Publicly Owned
Corporations
Type of Stock Market
Transactions

Corporation owned by a few individuals who are typically associated to a firm’s
management
 Stocks called: Closely held stocks
 Corporation that is owned by a large number of individuals not actively involved in
firm’s management
 Publicly held stock
1. Outstanding shares of established publicly owned companies that are traded: the
secondary market
2. Additional shares sold by established publicly owned companies
3. Initial public offerings made by privately held firms: the IPO market
- Going public: The act of selling stock to the public by a closely held corporation or
its principal stockholders
- Initial Public Offering (IPO) market: The market for stocks of companies that are in
the process of going public
 When the market is going strong, many companies go public to bring in new
capital and give their founders an opportunity to cash out some of their
shares (selling occurs in primary market)
 Essential to recognize that firms can go public without raising any additional
capital
Financial Statements and Reports
Annual Report
 Report issued annually by a corporation to stockholders
 Contains financial statements, and a verbal section of the management’s analysis of firm’s past operations and
future prospects
 Presented as a letter from the chairperson
Verbal Section
 Describes firm’s operating results during the past year and discusses new
developments that will affect future operations
 Statement of firm’s financial position at one point of time
Balance Sheet
 Shows what assets the company owns and who has claims on the
assets as of a date
Income
 Summarizes a firm’s revenues and expenses over a given period of
Statement
Key Financial
time
Statements
Statement of
 How much cash the firm began with, how much it ended with and
Cash Flows
what it did to increase/decrease its cash
Statement of
 Shows that amount of equity the stockholders’ had at the start of
Stockholders’
the year, that items that increase or decrease equity, and equity at
Equity
the end of the year
 Both balance sheet and income statement shows how the company performed in the past and this year
 Provides information about future prospects
The Balance Sheet


-
-
Statement of a firm’s financial position at a specific point in time
Total Assets = Total Liabilities and Equity
Total Assets
Total Liabilities and Equity
Current Assets/Working Capital
Current Liabilities
Less than one-year maturity
Cash and Equivalents
Accounts Receivable
Inventory
Long-Term (Fixed) Assets
-
-
Net plant and equipment
Intellectual property
Other long-term assets
-
-
Less than one-year maturity
Accrued wages and taxes
Accounts Payable
Notes Payable
Stockholders’ Equity
Common Stock + Retained Earnings
(must equal)
- Total Assets – Total Liabilities
Long-Term Debt
© COPYRIGHT JIA HUI (JPOH008)


Stockholders’ Equity: Amount that the shareholders paid the company when the shares were purchased and
the amount of earnings that the company has retained since its organization
Retained Earnings: Represent the cumulative total of all earnings kept by the company during its life

Other things to note:
Net Working Capital
Current Assets – Current Liabilities
Net Operating Working Capital
Current Assets – (Current Liabilities – Notes Payable)
- Accumulated Depreciation: Decrease in value of an asset over time
- Market Value: Value if put up on sale vs Book Value: Accounting numbers
The Income Statement


Report summarizing firm’s revenue, expenses and profits during a reporting period
Interest expense is tax deductible
 Other things to note:
Operating Income (or EBIT)
Earnings Before Taxes (EBT)
(i.e. Taxable Income)
Net Income
Earning Per Share (EPS)
(most important to shareholders)
Sales Revenue – Operating Costs
Earnings Before Income and Taxes – Interest Expense
Operating Income – Interest - Tax
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
Book Value Per Share (BVPS)
𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
- EBITDA: Earnings before interest, taxes, depreciation and amortization
- Amortization: Similar to depreciation, but used for intangible assets (i.e. copyrights, patents)
Statement of Cash Flows

Report that shows how items that affect the balance sheet and income statement affect the firm’s cash
flows
 Managers strive to maximize cash flows available to investors
 E.g.
Net Income
Depreciation and Amortization
Increase in Inventories
Operating Income
Increase in Accounts Receivable
Increase in Accounts Payable
Increase in Accrued Wages and Taxes
Net Cash provided by (used in) Operating Activities
Long-Term Investing Additions to Property, Plant and Equipment
Activities
Net Cash used in Investing Activities
Increase in Notes Payable
Increase in Bonds
Financing Activities
Payment of Dividends to Stockholders
Net Cash provided by Financing Activities
Net Decrease in Cash (Sum of First 3)
Summary
Cash and Equivalents at the Beginning of the Year
Cash and Equivalents at the End of the Year
 Note: if during the year a company has high cash flows from its operations, it does not necessarily mean that
cash on its balance sheet will be higher at the end of the year. This is especially so if there were negative
cash flows from its investing and/or financing activities.
i.e. If company used a lot of cash to purchase new equipment or to repurchase common stock, cash on the
balance sheet could decline despite strong operating performance.
Statement of Stockholders’ Equity

Statement that shows by how much a firm’s equity changed during the year and why it occurred
© COPYRIGHT JIA HUI (JPOH008)
Income Taxes
Individual
Corporations
Progressive Tax
Marginal Tax
Rate
Average Tax
Rate
Capital Gain or
Loss
Double Taxation
Tax system where tax rate is higher on higher incomes
Tax rate applicable to the last unit of a person’s income
Tax paid divided by taxable income
Profit (loss) from the sale of a capital asset for more (less) than its
purchase price. In U.S., capital gains are taxed
Interest Paid by Corporations: Tax deductible (paid out of pre-tax
income)
Dividends Paid by Corporations: Out of after-tax income
Dividends Received by Investors: Taxed in the U.S.
The Cost of Money
Affected by:
Production
Opportunities
Time Preference for
Consumption
Risk
(Expected) Inflation
Investment opportunities in productive (cash-generating) assets
Preference for current consumption as opposed to saving for future
Chance that an investment will provide a low/negative return
Amount by which prices increase over time
 Higher the EI, higher the required dollar return
The Determinants of Market Interest Rates
 𝑟 = 𝑟 ∗ + 𝐼𝑃 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃
 𝑟 = 𝑟𝑅𝐹 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃
r
r*
IP
rRF
DRP
LP
MRP
Required return on a debt security
- Nominal interest rate, takes into account expected inflation
Real risk-free rate of interest
- Interest rate of borrowing when there is zero expected inflation
Inflation premium
- Average expected inflation over life of debt security
Nominal rate on risk-free security
- i.e. U.S. Treasury bill (very liquid and free of most types of risks)
- r* + IP
Default risk premium
- Compensation for possible default that issuer will not pay principal and interests
on time and at stated amounts
- Difference between interest rate on a U.S. Treasury bond and a corporate bond of
equal maturity and marketability
Liquidity premium
- Compensation for possibility of difficulty of selling debt security quickly at market
value
Maturity risk premium
- Compensation for possible loss in value due to increase in interest rates over
maturity of debt security
- Affects longer term security more than shorter term
- Longer the maturity, higher the MRP

Different premiums added to different types of debt
IP
MRP
S-T Treasury
Added
L-T Treasury
Added
Added
S-T Corporate
Added
L-T Corporate
Added
Added
DRP
LP
Added
Added
Added
Added
© COPYRIGHT JIA HUI (JPOH008)
The Term Structure of Interest Rates
 Relationship between interest rates (or bond yields) and maturities
 Yield curve are graphs showing the relationship
“Normal” yield curve Upward sloping. Due to an increase in IP and increasing MRP
Downward sloping; “Abnormal” yield curve
Inverted yield curve
When IP is expected to decrease, and decreases more than increase in MRP
Yield curve where interest rates on intermediate-term maturities are higher than rates on
Humped yield curve
both short- and long-term maturities
What Determines the Shape of the Yield Curve





Treasury bond yield = rt* + IPt + MRPt
Corporate bond yield = rt* + IPt + MRPt + DRPt + LPt
Corporate bond yield spread = Corporate bond yield – Treasury bond yield = DRPt + LPt
- Spread widens as the corporate bond rating decreases
Corporate yield curves are higher than treasury securities
- Because higher risk of default
Constructing the Treasury Yield Curve:
Step 1: Finding the average
expected inflation rate
Step 2: Find the appropriate
maturity risk premium
Step 3: Adding the IP and MRP
to r* to find appropriate
nominal rates
-
∑𝑁 𝐼𝑁𝐹𝐿
𝐼𝑃𝑁 = 𝑡=1𝑁 𝑡
Sum of expected inflation from year 1 to year N divided by number of years
MRPt = 0.1% (t-1)
t = number of years to maturity
Treasury bond yield = rt* + IPt + MRPt
Macroeconomic Factors that Influence Interest Rate Levels
Federal Reserve
policy (Fed promotes
economy growth)




Government budgets
deficits or surpluses
International Factors
(Includes foreign
trade balance and
interest rates in
other countries)





Level of Business
Activities

Control of money supply & to keep inflation at bay
To stimulate the economy, Fed increases money supply
Buy and sell short-term securities:
- Initial effect: Short-term rates declines
- Larger money supply cause long-term rates to rise (even if short-term rates fall)
Govt spends more than it takes in as taxes  Deficit  Covered by additional
borrowing or printing money
- Additional borrowing  Increases demand for funds  i/r increases
- Printing money  Increased inflation  Increases i/r
- Hence, larger the deficit, higher the level of i/r, ceteris paribus
More imports than exports  Run a foreign trade deficit
Larger the trade deficit, higher the tendency to borrow
Foreigners will only hold U.S. debt if rates on U.S. securities are competitive with
other countries  U.S. i/r highly dependent on rates of other countries
- Interdependency limits the ability to use monetary policy to control economic
activity in U.S.
Inflation increases, i/r tend to increase
Recessions  Demand for money & rate of inflation tend to fall + Fed tend to
increase money supply to stimulate economy  Tendency for i/r to decline
Recessions: Short-term rates decline more sharply than long-term rates (in U.S.)
- Fed operates mainly in short-term sector  Strongest effect there
- Long-term rates reflect the average expected inflation rate over the next 20 to 30
years, and this expectation generally doesn’t change much
Interest Rates and Business Decisions

If short-term interest rates are lower than long-term rates, a borrower might still choose to finance with
long-term debt because:
- Interest costs remain the same throughout  Increase in i/r in the economy will not affect us
© COPYRIGHT JIA HUI (JPOH008)
Chapter 9: Bonds and Their Valuations
Learning Objectives:
 Calculating the bond prices and discuss what the relationship is between interest rates and bond prices
 Understand how a bond’s price changes over time as it approaches maturity
 Calculate a bond’s yield to maturity
 Understand the component of total return on bonds
 Explain the different types of risks that bond investors and issuers face
Who Issues Bonds?
Bonds: Long-term debt instrument (or contract)
(Borrower agrees to make payments of interest and principal on specific dates to holders of the bond)
Treasury Bonds
 Reasonable to assume govt makes good on its promised payments  No DRP
(issued by govt)
 Bonds’ prices do decline when i/r increases  Not completely riskless
 Exposed to default risk (often referred as “credit risk”)
- Issuing company runs into trouble  Unable to make promised interest and
Corporate Bonds
principal payments  Bondholders suffer losses
 Larger the risk, higher the i/r investors demand
 Exposed to some default risk
Municipal Bonds
 Interest earned in most munis exempted from federal tax and from state taxes (if
(issued by state)
holder is a resident)  Market interest rate on a muni is considerably lower than on a
corporate of equivalent risk
 Exposed to default risk
Foreign Bonds
 Additional risk when bonds are denominated in another currency
Key Characteristics of Bonds
Yield to Maturity
Par Value
Coupon Interest Rate
Maturity Date
Call Provisions
Sinking Funds
Other Features
Nominal rate of return earned on a bond held to maturity
Stated face value of the bond, paid at maturity
 Generally assumed to be $1,000 unless otherwise stated
Specified number of dollars of interest paid each year
Coupon
Payment
 Coupon i/r X Par Value
Coupon Interest Stated annual i/r on a bond
Rate
Fixed-Rate Bond Bond’s i/r fixed for its entire life
Floating-Rate
Bond whose interest fluctuates with shifts in general level of i/r
Bond
Zero Coupon
Pays no annual interest, but sold at discount below par
Bond
 Provides capital appreciation rather than interest income
Original Issue
Any bond originally offered at a price below its par value
Discount (OID)
Bond
Specified date on which the par value must be repaid
Provision that gives issuers the right to redeem the bonds under specified terms prior to
the normal maturity date
 Mainly in corporate and municipal bonds
 Usually issuer must pay bondholders an amount greater than par value if called
 Companies not likely to call bonds unless i/r declined significantly since bonds issuing
Provision in the bond contract that requires the issuer to retire a portion of the bond issue
each year
Convertible
Bond that is exchangeable into shares of common stock at a fixed price
Bond
Long-term option to buy a stated number of shares of common stock
Warrant
at a specified price
 Capital gain if stock’s price rises
© COPYRIGHT JIA HUI (JPOH008)
Putable Bond
Income Bond
Indexed Bond
Bond with provision that allows investors to sell it back to the company
prior to maturity at a prearranged price
Bond that pays interest only if it issuer earned enough money to pay
the interest
Bond that has interest payments based on inflation index to protect
holder from inflation

Zero Coupon Bond: 𝐹𝑉 = 𝑃𝑉 (1 + 𝐼)𝑁

Coupon Bond: 𝑃𝑉 =
𝑃𝑀𝑇
1
1000
[1 − (1+𝐼)𝑁] − (1+𝐼)𝑁
𝐼
= PV of Annuity + PV of Par Value
Bond Valuation
𝐶𝐹1
𝐶𝐹2
𝐶𝐹𝑁
𝑀
𝐶𝐹
𝑀
∑𝑁
 𝐵𝑜𝑛𝑑′ 𝑠 𝑉𝑎𝑙𝑢𝑒 = 𝑉𝐵 = (1+𝑟)
𝑡=1 (1+𝑟)𝑡 + (1+𝑟)𝑁
1 + (1+𝑟)2 + ⋯ + (1+𝑟)𝑁 + (1+𝑟)𝑁 =
r (or rd)
CF
N
M
Par Bond
Premium Bond
Discount Bond
Required rate of return of shareholders = YTM = Discount price
 Opportunity cost of debt capital
 r ≠ Coupon rate unless bond price is at par
Cash flow/Payment = Coupon rate X Par value
Number of years
Par value
YTM = Coupon Rate  Bond Price = Par Value
YTM < Coupon Rate  Bond Price > Par Value
YTM > Coupon Rate  Bond Price < Par Value
Bond Yields

Finding r (or rd):
𝐶𝐹1
𝐶𝐹2
𝐶𝐹𝑁
𝑀
- 𝑉𝐵 = (1+𝑟)
1 + (1+𝑟)2 + ⋯ + (1+𝑟)𝑁 + (1+𝑟)𝑁
-
Expected total return = YTM = (Expected CY) + (Expected CGY)
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡
 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 (𝐶𝑌) = 𝑃𝑟𝑖𝑐𝑒 =𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
𝑡
 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 𝑌𝑖𝑒𝑙𝑑 =
𝑃𝑟𝑖𝑐𝑒𝑡+1 −𝑃𝑟𝑖𝑐𝑒𝑡
𝑃𝑟𝑖𝑐𝑒𝑡
(= Percentage value; negative value means capital loss)
Changes in Bond Value Over Time
If required rate of return remains at 10%,
 Par bonds: No gain nor loss
 Premium bonds: Capital loss because bond value decrease over time  Compensated by high CY
 Discounts bonds: Capital gain because bond value increase over time  Low coupon rates hence low CY
Bonds with Semiannual Coupons
𝐼𝑁𝑇
𝑀
2
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝐵𝑜𝑛𝑑 (𝑉𝐵 ) = ∑
𝑟𝑑 𝑡 +
𝑟
(1 + 2𝑑 )2𝑁
𝑡=1 (1 + 2 )
2𝑁
1. Multiply the years by 2
2. Divide nominal rates by 2
3. Divide annual coupon by 2
© COPYRIGHT JIA HUI (JPOH008)
Assessing a Bond’s Riskiness
Interest Rate (or
Price) Risk
Reinvestment Risk



Risk of a decline in bond’s price due to an increase in i/r
 Bonds with longer maturity have higher i/r risk, ceteris paribus
 Longer maturity bonds are more sensitive to i/r changes
Risk that a decline in i/r will lead to a decline in income from a bond portfolio
 i/r falls, future CFs reinvested at lower rates  Reduces income
Which type of risk is more relevant to an investor depends on how long the investor plans to hold the bonds,
referred to as his investment horizon
Interest Rate Risk
Reinvestment Risk
Short-term Bonds
Low
High
Long-term Bonds
High
Low
Low Coupon Rates
High
Low
High Coupon Rates
Low
High
Low coupon means relatively larger portion of cash flows will only occur at maturity with repayment of
principal
High coupon means more of the cash flows occur in the early years due to higher coupon payment
 When i/r increases, low coupon bonds are penalized more (i.e. value decreases more) as a relatively
larger portion of cash flows are locked up in the bond
 In contrast, due to higher coupon payment of high coupon bonds, risk of reinvesting these high coupons
at a lower i/r is higher
Default Risk



If issuer defaults, investors receive less than the promised return
Influenced by issuer’s financial strength and the terms of the bond contract
Bond ratings reflect the probability of a bond issue doing into default
- Investment-Grade Bond:
Bond rated Triple-B and above; Many banks and institutional investors are permitted by law to only hold
investment-grade bonds
- Junk Bond:
High-risk, high-yield bond

Bond Rating Criteria:
1. Financial Ratios
2. Qualitative Factors: Bond Contract Terms
3. Miscellaneous Qualitative Factors
i.e. Sensitivity of firm’s earnings to strength of the economy
© COPYRIGHT JIA HUI (JPOH008)
Chapter 8: Risk and Rates of Return
Learning Objectives:
 Explain the difference between stand-alone risk and portfolio risk
 Understand how risk aversion affects a stock’s required rate of return
 Calculate the expected return and risk when holding an individual stock
 Calculate the coefficient of variation
 Discuss the difference between diversifiable risk and market risk, and explain how each type of risk
affects well-diversified investors
 Understand what the capital asset pricing model (CAPM) is and how it is used to estimate a stock’s
required rate of return
 Calculate a portfolio’s expected return and its risk
 Determine if a stock is undervalued or overvalued
 Explain how expected inflation and investors’ risk aversion can affect the security market line (SML)
The Risk-Return Trade-Off


To entice investors to take on more risk, have to provide them with higher expected returns
Most investors are risk averse
- Dislike risks, and require higher rate of return to encourage them to hold riskier securities
Risk Premium
Investment risk
Rate of Return
Difference between the return on a risky asset and a riskless asset
 Serves as a compensation for investors to hold riskier securities
Probability of earning a return that is different from expected
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒−𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
Stand-Alone Risk

The risk an investor faces if he only held one asset
Probability
Listing of all possible outcomes, and the probability of each occurrence
Distributions
𝑟̂ = 𝑃1 𝑟1 + 𝑃2 𝑟2 + ⋯ + 𝑃𝑁 𝑟𝑁 = ∑𝑁
𝑖=1 𝑃𝑖 𝑟𝑖
 N= Number of different states of economy
Expected rates of
 𝑟𝑖 = Stock’s expected return at i state of economy
return, 𝑟̂
 𝑃𝑖 = Probability of i state of the economy occurring
Rate of return to be realized from an investment
̂2
𝜎 = √∑𝑁
𝑖=1(𝑟𝑖 − 𝑟) 𝑃𝑖 where:
Standard deviation, σ



N= Number of different states of economy
𝑟𝑖 = Stock’s expected return at i state of economy
𝑃𝑖 = Probability of i state of the economy occurring
Used to measure volatility of stock’s returns
 Measures whether returns are likely to be close to the expected return
 Measures stand-alone risk
 Tighter the probability distribution, lower the S.D., lower the stand-alone risk
𝐶𝑉 =
Coefficient of
variation, CV

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
=
σ
𝑟̂
Shows risk per unit of return
 Useful when comparing investments with different expected returns
 Highest CV = Highest stand-alone risk
If risk remains the same when economy changes, it means that returns are independent of the economy.
- However, not completely risk free as it is still exposed to inflation and reinvestment risk.
© COPYRIGHT JIA HUI (JPOH008)
Risk in a Portfolio Risk
Expected Return on
Portfolio, 𝑟̂𝑝
𝑟̂𝑝



= 𝑤1 𝑟̂1 + 𝑤2 𝑟̂2 + ⋯ + 𝑤𝑁 𝑟̂𝑁 = ∑𝑁
𝑖=1 𝑤𝑖 𝑟̂𝑖
N= Number of different states of economy
𝑤𝑖 = Stock’s weight
𝑟𝑖 = Expected return on the ith stock
Portfolio’s expected return is a weighted average of the returns of portfolio’s component
assets.
Portfolio’s Standard
Deviation
̂2
σ𝑝 = √∑𝑁
𝑖=1(𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑎𝑣𝑔 − 𝑟𝑝 ) (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦)

σ𝑝 will be lower than σ𝑖 of individual stocks

There will be diversification benefits when combining stocks as long as the stocks are
not perfectly positively correlated stocks (i.e. ρ = 1.0)
- ρ is the correlation coefficient. Measures the degree of relationship between 2
variables
- Correlation: Tendency of 2 variables to move together
- When ρ = -1.0 (perfectly negatively correlated), all risks are diversified away 
No risk because no σ
Combining stocks in a portfolio generally lowers risk
Eventually, diversification benefits of adding more stocks dissipates (after about 10
stocks), and for large companies, σ𝑝 tends to converge to 20%
Portfolio’s Risk


Stand-alone risk
Diversifiable risk
Market risk
Sources of Risk
Decomposed into diversifiable and market risk
Portion of a security’s stand-alone risk that can be eliminated through proper
diversification
- Also called unsystematic/firm-specific risk
Portion of a security’s stand-alone risk that cannot be eliminated through diversification.
- Measured by beta
- Caused by market-wide risk factors that affect all stocks
- Also called systematic/undiversifiable risk
© COPYRIGHT JIA HUI (JPOH008)
CAPM: Capital Asset Pricing Model


Model based on proposition that any stock’s required rate of return is equal to the risk-free rate of return
plus a risk premium that reflects only the risk remaining after diversification
Primary conclusion: Relevant riskiness of a stock is its market risk as measured by beta

Security Market Line (SML): 𝑟𝑖 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )(𝑏𝑖 )
 Additional return over the risk-free rate needed to compensate investors for
Market Risk Premium
assuming an average amount of risk
(𝑟𝑀 − 𝑟𝑅𝐹 ) or (𝑅𝑃𝑀 )  Size depends on the perceived risk of the stock market and the investors’ degree of
risk aversion
 Measures a stock’s market risk
 Shows stock volatility relative to market
 It is the expected change in its return given a 1% change in the return of the market
portfolio

Beta (𝑏𝑖 )

Beta values:
1. Beta = 1.0  Just as risky as average stock
2. Beta > 1.0  Riskier than average
3. Beta < 1.0  Beta less risky than average
4. Beta = 0  Returns are independent of the economy
5. Stocks can have a negative beta, especially if returns move counter-cyclically with
market returns
Beta of a portfolio is the weighted average of each of the stock’s betas
𝑁
𝑏𝑝 = 𝑤1 𝑏1 + 𝑤2 𝑏2 + ⋯ + 𝑤𝑁 𝑏𝑁 = ∑ 𝑤𝑖 𝑏𝑖
𝑖=1

- 𝑤𝑖 : Fraction of the portfolio invested in the ith stock
- 𝑏𝑖 : Beta coefficient of the ith stock
Calculating beta:
- Run a regression of the security’s past returns against the past returns of the
market
- Slope of regression line is the beta coefficient of the security
Required rate of return

𝑅𝑃𝑖 = 𝑅𝑃𝑀 (𝑏𝑖 )

𝑟𝑖
Risk Premium for
Stock i (𝑅𝑃𝑖 )
The Relationship between Risk and Rates of Return
Expected Inflation
Changes in Risk
Aversion
Required returns
Expected returns
Realized returns
Factors that Change the SML
Expected rate of inflation increases  Premium added to real risk-free rate of return to
compensate investors for the loss of purchasing power
 Increase in rRF leads to equal increase in rates of return on all risky assets as the same
inflation premium is built into the required rates of return
 i.e. SML will move up parallel by the amount inflation increased by
Steeper the slope of the line, more the average investor requires as compensation for
bearing risk
 i.e. SML will become steeper when there’s greater risk aversion
Returns an investor requires given the riskiness of the stock and returns available on
other investments
Returns an investor expects to get in the future
 Only buy the stock when expected returns > required returns
 In equilibrium, expected and required returns should be the same
Returns an investor actually gets
© COPYRIGHT JIA HUI (JPOH008)
Chapter 10 & Appendix 10A: Stocks and their Valuation (except 10.7)
Chapter 2.7: Stock Market Efficiency
Learning Objectives:
 Understand the difference between stock price and intrinsic value
 Identify and explain the two models that can be used to estimate a stock’s intrinsic value: the discounted
dividend model and multiples of comparable firms method
 Calculate the intrinsic value of a stock with constant growth and non-constant growth
 Calculate the stock’s expected return, expected dividend yield and expected capital gains yield
 Understand the key features of preferred stock and calculate the estimated value of preferred stock or its
expected return
 Discuss the importance of market efficiency, and explain why some markets are more efficient than
others

2 sources of returns from stocks:
1. Stock price appreciation (profits from increase in share price – capital gains)
2. Dividends

𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒−𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑡𝑒𝑑
𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
(from previous topics)
Types of Common Stock
Usually firms only have one type of common stock. Firms might use classified stock to seek funds from outside
sources.
Common stock that is given a special designated class such as Class A or Class B to meet
special needs of the company
- Different classes may have different votes per share + one Class sold to public but
Classified stock
another class retained by company’s insiders
- Enables company’s founders to maintain control over the company without having to
own a majority of common stock
Stock owned by the firm’s founders that enables them to maintain control over the
Founders’ Share
company without having to own a majority of the stock
Stock Price versus Intrinsic Value


At equilibrium, we assume that a stock’s price = its intrinsic value
Stock’s price < Intrinsic value  Undervalued
- Goal when investing in common stock is to purchase undervalued stocks
Stock Price
Current market price, easily observed for publicly traded companies
Represents the “true” value of the company’s stock, and cannot be directly observed
 Have to be estimated
Intrinsic Value 𝑃̂𝑜
 Outsiders estimate intrinsic value to help determine which stocks are attractive to
buy/sell
The Discounted Dividend Model

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 = 𝑃̂𝑜 =
Dt
P0
𝑃̂𝑡
g
rs
𝑟̂𝑠
𝐷1
𝑃0
𝑃̂1 − 𝑃0
𝑃0
𝐷1
(1+𝑟𝑠 )1
𝐷
𝐷
𝐷
𝑡
+ (1+𝑟2 )2 + ⋯ + (1+𝑟∞)∞ = ∑∞
𝑡=1 (1+𝑟 )𝑡 = 𝑃𝑉 𝑜𝑓 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑠
𝑠
𝑠
Dividend stockholder expects to receive at the end of year t
 D0 is the last dividend paid
Actual market price of stock today
Intrinsic value at the end of year t
Expected growth rate in dividends
Required rate of return (Use CAPM to estimate)
Expected rate of return = Dividend yield expected + Expected capital gains yield
Dividend yield expected
Expected capital gains yield on stock
© COPYRIGHT JIA HUI (JPOH008)
Constant Growth Stocks (Gordon’s Model)


Stock whose dividends are expected to grow forever at a constant rate, g
𝐷 (1+𝑔)
𝐷
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝐺𝑟𝑜𝑤𝑡ℎ 𝑆𝑡𝑜𝑐𝑘 = 𝑃̂𝑜 = 0
= 1
𝐷𝑛+1
𝑟𝑠 −𝑔
𝑟𝑠 −𝑔
𝑟𝑠 −𝑔

i.e. 𝑃̂𝑛 =

g = (1 – Payout) (ROE)
- Payout ratio = Dividends/Net Income
- ROE: Return on Equity = Net Income/Total Common Equity
g = (Retention Ratio) (ROE)

; 𝑃̂𝑛+1 = 𝑃̂𝑛 (1 + 𝑔)

Constant growth model can only be used if:
1. rs > g
- g > rs, constant growth formula leads to negative stock price (which doesn’t make sense)
2. g is expected to stay constant forever

Calculating intrinsic value of a stock with constant growth:
1. Calculate the required rate of return rs using CAPM
2. Find the expected D1
3. Use the constant growth model
Note: Estimated intrinsic value depends on future dividends at the growth rate, which comes from estimation &
based on assumption
Valuing Non-Constant Growth Stocks
𝐷1
(1+𝑟𝑠 )1
𝐷
𝑃̂
𝐷

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑁𝑜𝑛𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑆𝑡𝑜𝑐𝑘 𝐺𝑟𝑜𝑤𝑡ℎ, 𝑃̂𝑜 =

𝐷
𝑃𝑉 𝑜𝑓 ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 𝑃̂𝑁 = 𝑁+1

Calculating intrinsic value of a stock with non-constant growth:
1. Find PV of each dividend during the period of non-constant growth and sum them
2. Find the expected stock price at the end of the non-constant growth period. Discount the price back to
present.
3. Add both components to find stock’s intrinsic value

For non-constant growth stocks:
- Expected dividend yield and capital gains yield are not constant
- Capital gains yield ≠ g
+ (1+𝑟2 )2 + ⋯ + (1+𝑟𝑁 )𝑁 + (1+𝑟𝑁 )𝑁
𝑠
𝑠
𝑠
𝑟𝑠 −𝑔
Multiples of Comparable Firms Method

𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒
𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒
𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
𝑆𝑎𝑙𝑒𝑠
I.e. Based on comparable firms, estimate the appropriate P/E. Multiply by expected earnings to back out an
estimate of the stock price
Preferred Stock


Hybrid security
- Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid
to common stockholders
- Companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy
Preferred stock entitles its owners to regular, fixed dividends payments. If payments last forever, then:
𝐷
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 = 𝑉𝑃 = 𝑟 𝑃 ; where:
𝑃

- DP = Preferred stock’s dividend per share and
- rp = required return on preferred stock
𝐷
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟̂𝑃 = 𝑃
𝑉𝑃
© COPYRIGHT JIA HUI (JPOH008)
Stock Market Equilibrium


At equilibrium, stock prices are stable and there is no general tendency for people to buy/sell
For a stock to be in equilibrium, two conditions must hold.
1. The current market stock price = intrinsic value (i.e. P0 = 𝑃̂𝑜 )
2. Expected returns = Required returns (i.e. rs= 𝑟̂𝑠 )
𝐷
𝑟̂𝑠 = 𝑃1 + 𝑔 = 𝑟𝑠 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )(𝑏)
0
-
𝑟̂𝑠 based on current stock prices, and estimating the expected dividends and expected capital gains
𝑟𝑠 determined by estimating risk and applying CAPM

If stock price is below intrinsic:
- Current price is “too low” and offers a bargain
- Buy orders > Sell orders
- Price bid up until expected return = required return

Equilibrium levels are based on the market’s estimate of intrinsic value and the market’s required rate of
return, which are both dependent on the attitudes of the marginal investor (who makes the transactions
occur)
Stock Market Efficiency
Market Price
Intrinsic Value
Equilibrium Price
Efficient Market


Current price of stock
Price at which stock would sell at if all investors had all knowable information about a
stock (based on expected future cash flows and its risk)
Price that balances buy and sell orders at any given time
A market in which prices are close to intrinsic values and stocks seem to be in equilibrium
 Does not require market price = intrinsic value at every point of time
 Just requires deviations between the two to be random
 Implication: Investors cannot “beat the market” except through good luck or better
information
Concepts of market efficiency are related to the assumptions about what information is available to
investors and reflected in the price
It is also possible that some markets are efficient, while other are not. Key factors are:
1. Size of the company
2. Communication between company and analysts/investors
- i.e. Larger companies are usually followed by many analysts + Good communication with investors
 Highly efficient
- Smaller companies are usually not followed by many analysts + Not much contact with investors
 Highly inefficient
© COPYRIGHT JIA HUI (JPOH008)
Chapter 11: The Cost of Capital
Learning Objectives:
 Understand what is capital budgeting
 Understand why a weighted average cost of capital (WACC) is needed for capital budgeting purposes
 Determine the sources of long-term capital
 Determine the weights of each capital component
 Calculate the cost of long-term debt and cost of preferred stock
 Calculate the cost of retained earnings and cost of new common stock
 Calculate the composite WACC of the firm
 Understand why the composite WACC needs to be adjusted to account for differential project risk
Basic Definitions


Capital Budgeting

Cost of Capital
Capital Structure
Target Capital
Structure
rd
rd (1-T)
rp
rs
re
wd, wp, we
WACC
















Analysis of potential projects (especially long-term decisions involving large
expenditures)
Steps to Capital Budgeting:
1. Estimate Cash Flows
2. Assess the riskiness of CFs and determine the appropriate risk-adjusted cost of
capital for discounting cash flows
3. Find NPV and/or IRR (MIRR)
- To determine profitability
Weighted average cost of each type of financing
- Required returns of debtholders and equity holders become firm’s cost of capital
- i.e. Cost of borrowing and cost of savings (investing savings elsewhere)
Investment must give a return that is at least equal to cost of capital
Mix of debt, preferred stock and common equity used to finance the firm’s asset
Proportion of each long-term capital used
Desired optimal mix of equity and debt financing
Often the optimal structure that maximizes stock price
Always use target capital structure rather than actual financing
Interest rate on firm’s new debt
Before-tax component cost of debt
After-tax component cost of debt
T is the firm’s marginal tax rate
Component cost of preferred stock
Component cost of common equity raised by retaining earnings
Component cost of common equity raised by issuing new stock
Adds flotation cost
Target weights of debt, preferred stock and common equity
Firm’s weighted average, or cost of capital
WACC = wdrd (1-T) + wprp + wcrs


Basic Concepts


Use target capital structure weights (affects the ‘w’s)
- Desired optimal mix of debt and equity
Use market value weights (not book value)
- Market value represents the actual amount of financing raised by the firm when
they sell
- Calculated based on current market conditions
Use marginal cost (affect the ‘r’s)
- Not historical cost
- WACC is recorded at a point in time  Reflects marginal cost of raising an
additional dollar of capital today
Use after-tax capital cost (affect ‘rd’ only)
- Only rd needs adjustment because interest is tax deductible
© COPYRIGHT JIA HUI (JPOH008)
Cost of Debt,
rd(1-T)



rd = Marginal cost of debt capital
YTM on outstanding long-term debt is often used as a measure of rd
- Good estimate because YTM reflects current market conditions. Hence good
proxy on the cost of new debt if the firm borrows from the market now
Interest is tax deductible  Need to adjust via (1-T)
1. 𝑟𝑝 =
𝐷𝑝
𝑃𝑝
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
= 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘
Cost of Preferred
Stock, rp

Cost of Retained
Earnings, rs
 rs = Dividend yield + Capital gains yield
 Assuming constant growth, CGY = Perpetual growth rate, g
3. Own-Bond-Yield-Plus-Risk-Premium: 𝑟𝑠 = 𝑟𝑑 + 𝑅𝑃
 RP = Risk premium for firm’s common equity
 NOT the same as CAPM RPM (risk premium of whole market portfolio)
rp = Marginal cost of preferred stock
- Return investors require on a firm’s preferred stock
 Preferred dividends not tax deductible  No adjustments
1. CAPM: 𝑟𝑠 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )𝑏
𝐷
2. DCF: 𝑟𝑠 = 𝑃1 + 𝑔
0

rs = Marginal cost of common equity using retained earnings
- There is a cost because earnings can be retained and reinvested or paid as
dividends
- Investors can buy other securities and earn returns
1. 𝑟𝑒 =
Cost of New
Common Stock, re

𝐷0 (1+𝑔)
𝑃0 (1−𝐹)
+ 𝑔, where F is the flotation cost
re = Marginal cost of common equity using new common stock
- re > rs because when issuing new stock, have to pay flotation cost
Factors that Affect the WACC
Factors the Firm
Cannot Control
Factors the Firm Can
Control
1. Interest rate in the economy
- i/r increases  Cost of debt increases (because firms pay more to borrow)
2. General level of stock prices
- General stock price decreases  Firm’s stock price decreases  Cost of equity
increases
3. Tax rates
- Affects cost of capital
- i.e. When tax rates on dividends and capital gains lowered relative to rates on
interest income  Stocks relatively more attractive than debt  Cost of equity
and WACC decreases
1. Changing its capital structure
2. Changing its dividend payout ratio
- Dividend policy affects amount of retained earnings available to firm  Need to
sell new stock & Incur flotation costs
3. Altering its capital budgeting decision rules (i.e. investment policy)
- Firms with riskier projects generally have higher WACC
© COPYRIGHT JIA HUI (JPOH008)
Adjusting the Cost of Capital for Risk


Projects should only be accepted if estimated returns > cost of capital (hurdle rate)
Different projects have different risks, even for the same firm
 Each project’s hurdle rate should reflect the risk of the project, not the risk associate with the firm’s
average project as reflected in the composite WACC
Hence, companies should not use the composite WACC as the hurdle rate for each of its projects, regardless of
riskiness. The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC
only represents the “hurdle rate” for a typical project with similar risk as the firm as a whole. As different projects
have different risks, the project’s WACC should be adjusted to reflect the project’s risk.
Some Other Problems with Cost of Capital Estimates
Depreciationgenerated Funds
Privately Owned
Firms





Measurement
Problems


Cost of Capital for
Projects of Differing
Risk
Capital Structure
Weights
Largest single source of capital
Opportunity cost as depreciation CF can be reinvested or returned to investors
Stock not traded
Tax issues
Difficult to obtain good input data for CAPM, risk premium for rs
 CAPM uses estimates on market risk premium + Estimates can differ
Different estimates of same variable
 i.e. Market rate
Different assumptions for target capital structure
 The optimal mix

Difficult to measure a project’s risk
 To adjust the cost of capital for capital budgeting projects with different risk

Difficult to establish target capital structure
© COPYRIGHT JIA HUI (JPOH008)
Chapter 12: The Basics of Capital Budgeting
Learning Objectives:
 Understand the difference between normal and non-normal cash flow streams
 Understand the different between mutually exclusive and independent projects
 Calculate and use the major capital budgeting decision criteria for mutually exclusive and independent
projects, which are the
1) Payback Period
2) Discounted Payback Period
3) Net Present Value (NPV)
4) Internal Rate of Return (IRR)
5) Modified IRR (MIRR)
 Discuss strengths and weaknesses of each method (MCQ)
 Understand and interpret the NPV profile
 Calculate and understand the importance of the crossover point
 Discuss the conflict between NPV and IRR when evaluating mutually exclusive projects
 Understand why NPV is superior to IRR and MIRR
 Understand the multiple IRRs problem
An Overview of Capital Budgeting
Analyzing Capital
Expenditure
Proposals
Normal vs NonNormal Cash Flow
Streams
Independent vs
Mutually Exclusive
Projects
1. Replacement: Needed to continue current operations
- Expenditures to replace worn-out or damaged equipment required in the
production of profitable products
2. Replacement: Cost reduction
- Expenditure to replace serviceable but obsolete equipment
3. Expansion of existing products or markets
- Expenditures to increase output of existing products or to expand retail outlets or
distribution facilities in markets now being served
- Requires explicit forecast of growth in demand
4. Expansion into new products or markets
- Investments related to new products or geographic areas
- Involve strategic decisions that could change the fundamental nature of the
business
5. Safety and/or environmental projects
- Expenditures necessary to comply with government orders, labour agreements,
or insurance policy terms
6. Other projects
- Includes items such as office buildings, parking lots and executive aircraft
7. Mergers
- One company buys another
One change in sign
Normal
 E.g. Cost (negative CF) followed by a series of positive CF
Two or more changes of sign
Non-Normal
 E.g. [Setting up a power plant] Cost (negative CF), then string
of positive CF, then cost to close project (negative CF)
Both projects can be accepted
Independent
 CF of one unaffected by acceptance of another
Only one project can be accepted
Mutually
Exclusive
 If one is accepted, the other has to be rejected
© COPYRIGHT JIA HUI (JPOH008)
Capital Budgeting Criteria: Payback Period
Length of time required to recover a project’s cost from investment’s CF
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦
𝑈𝑛𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
To find Payback
+
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
Choose the one with shorter payback
Mutually
Exclusive
 Shorter time to get back investment
Which to Accept?
Subjective benchmark (usually based on past projects)
Independent
 E.g. Only projects less than X years
1) Easy to calculate and understand
Strengths
2) Provides an indication of a project’s risk and liquidity
- Shorter payback considered less risky & more liquid
1) Ignores time value of money
2) Arbitrary benchmark set subjectively by management
3) Ignores CFs occurring after the payback period
Weaknesses
- Unlike NPV (tells us how much wealth a project adds), and the IRR (tells us how
much the project yields over the cost of capital)
- Payback only tells when we can recover our capital
- No necessary relation between a given payback and investor wealth maximization
Capital Budgeting Criteria: Discounted Payback Period
Length of time required for investment’s CF discounted at the investment’s cost of capital (WACC), to cover its
cost
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦
To Find Discounted
𝑈𝑛𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
Payback
+
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒆𝒅 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
Capital Budgeting Criteria: Net Present Value (NPV)
Method of ranking investment proposals using NPV, which is equal to the present value of the project’s free cash
flows (both inflow and outflow) discounted at the cost of capital
 Indicates how much shareholders’ wealth would increase if project is taken up
 Higher NPV = More value the project adds = Higher stock price = Higher increase in shareholders’ wealth
𝑁
To find NPV
𝑁𝑃𝑉 = ∑
𝑡=0
Using GC
Which to Accept?
Strengths
NPV Profiles
Crossover Rates
𝐶𝐹𝑡
(1 + 𝑟)𝑡
NPV (rate, initial outlay, {CFs}, {CF counts})
- No spacing
- Initial outlay = CF0
Mutually
Accept the project with highest positive NPV
Exclusive
Independent
Accept if NPV > 0
 Direct measure of value the project adds to shareholder wealth
 Does not discriminate size of projects (unlike IRR)
Graphical representation of project NPVs at various different costs of capital
 X-axis: Discount Rate (%)
 Y-axis: NPV ($)
1. Downward sloping NPV profiles
- As discount rate increases, NPV decreases (because of discounting in formula)
2. Projects have different slopes  NPV profiles cross
- Steeper slope has higher sensitivity to discount rates
- Steeper slope usually long-term project, where bulk of CF comes in later years
3. At crossover points, NPVA = NPVB
4. If mutually exclusive, choose the one that is higher before/after crossover point.
5. If independent, choose any before x-intercept (where NPV = 0)
Cost of capital at which the NPV profiles of two projects cross  Projects’ NPV equal
 Found by calculating the IRR of the differences in the project’s CF
© COPYRIGHT JIA HUI (JPOH008)
Capital Budgeting Criteria: Internal Rate of Return (IRR)
The discount rate that forces a project’s NPV = 0
i.e. PV of CF = Investment costs
𝑁
To find IRR
0= ∑
𝑡=0
Using GC
Which to Accept?
Strengths
Weaknesses
𝐶𝐹𝑡
(1 + 𝐼𝑅𝑅)𝑡
IRR (initial outlay, {CFs})
- No spacing
- Initial outlay = CF0
Mutually
Accept the project with highest IRR, provided IRR > Cost of Capital
Exclusive
Independent
Accept if IRR > Cost of Capital
 Useful to know rates of return on proposed investments
 Gives information concerning project’s safety margin
 (Managers) More intuitive and gives indication of benefits obtained relative to cost
 Suffers from Multiple IRR issue
- Need to suspect multiple IRRs problem is CFs are non-normal and if cash inflows
and outflows are of similar magnitude
- NPV profiles intersects x-axis at 2 points
- Use MIRR when there’s non-normal CF & there is more than one IRR value
 Assumes intermediate CFs reinvested at IRR
 Does not give accurate representation when comparing projects of different scales
Comparing NPV and IRR Methods
Independent Projects
Mutually Exclusive
Projects
Both methods lead to the same accept/reject decisions
Discount Rate > Leads to the same accept/reject decision
Crossover Rate
Discount Rate < Leads to different accept/reject decisions
Crossover Rate (Hence better to rely on NPV results because of reinvestment rate)
Conflict between NPV and IRR arises due to timing differences in CF and differences in project size
 Rate at which intermediate CF are reinvested becomes a critical issue
Timing Differences in
CFs
Differences in CF timing or project scale  Firms have different amounts to reinvest at
Difference in Project various years
Size
NPV assumes intermediate CFs are reinvested at cost of capital (i.e. WACC)
Reinvestment Rate
 More realistic
Assumption
IRR assumes intermediate CFs are reinvested at IRR
© COPYRIGHT JIA HUI (JPOH008)
Capital Budgeting Criteria: Modified Internal Rate of Return (MIRR)
The discount rate that causes the PV of a project’s terminal value to equal to PV of costs
 TV found by compounding inflows at cost of capital (r)
𝑃𝑉 (𝐶𝑎𝑠ℎ 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔) = 𝑃𝑉 (𝐶𝑎𝑠ℎ 𝑰𝒏𝒇𝒍𝒐𝒘𝒔)
To find MIRR
𝑁
∑
𝑡=0
Steps
𝑁−𝑡
∑𝑁
𝐶𝑂𝐹𝑡
𝑡=0 𝐶𝐼𝐹(1 + 𝑟)
=
(1 + 𝑟)𝑡
(1 + 𝑀𝐼𝑅𝑅)𝑁
1. To get FV of
TV inflows
2. To get PV of
TV inflows
3. Calculating
MIRR
Which to Accept?
Strengths
Weaknesses




Assume CFs reinvested at cost of capital
Discount at MIRR to t = 0
Equate initial investment (or PV cash outflow, whichever is applicable)
to discounted TV inflow
Calculate MIRR
Mutually
Accept the project with higher MIRR
Exclusive
Independent
Accept projects which MIRR > Cost of Capital
More realistic because it assumes reinvestment at cost of capital
Avoids multiple IRRs problem
Does not solve IRR’s problem when evaluating projects of different scale
NPV > MIRR > IRR
Conclusions on Capital Budgeting (Page 428)
NPV is the single best criterion because it provides a direct measure of value the project adds to shareholder
wealth. IRR and MIRR measures profitability expressed as a percentage of return, which is interesting to decision
makers. Furthermore, IRR and MIRR contain information concerning a project’s “safety margin”.
The modified IRR has all the virtues of IRR, but it incorporates a better reinvestment rate assumption and avoids
the multiple IRRs problem. So if decision makers want to know projects’ rates of return, the MIRR is a better
indicator than the regular IRR.
Payback and discounted payback provide indications of a project’s liquidity and risk. A long payback means that
investment dollars will be locked up for a long time and hence, the project is relatively illiquid. In addition, a long
payback means that cash flows must be forecasted far out into the future, and that probably makes the project
riskier than one with shorter paybacks.
© COPYRIGHT JIA HUI (JPOH008)
Chapter 3,7 & Chapter 13: Cash Flow Estimation and Risk Analysis (Exclude 13.7)
Chapter 20.2: Lease or Buy Decision
Chapter 14.6: The Optimal Capital Budget
Learning Objectives:
 Understand and identify what are relevant cash flows that should be included in cash flow estimation
- Discuss sunk costs, opportunity costs, and externalities
 Estimate relevant cash flows for expansion project and replacement projects
- Estimate initial cash flows
- Estimate operating cash flows
- Estimate terminal cash flows
 Understand and discuss the use of sensitivity analysis and scenario analysis in the capital budgeting
process and how they can measure project standalone risk
 Analyze the decision to lease versus borrow-and-buy
 Calculate the net advantage of leasing
 Understand what is the optimal capital budget and what is capital rationing
Free Cash Flow
Cash flow available to shareholders and debtholders less the need for re-investment to operate and produce
future cash flows (without harming the firm’s ability)
 𝐹𝐶𝐹 = [𝐸𝐵𝐼𝑇(1 − 𝑇) + 𝐷𝑒𝑝. & 𝐴𝑚𝑜𝑟𝑡. ] − [𝐶𝐴𝑃𝐸𝑋 + ∆𝑁𝑂𝑊𝐶]
 Positive FCF indicates firm is generating more than enough cash to finance its current investments in fixed
assets and working capital
Amount of cash that the firm generates from its current operations
EBIT(1-T) + Dep. &
EBIT (1-T)
Net operating profit after taxes
Amort.
Depreciation & Added back in because they are noncash expenses that reduce EBIT,
Amortization
but does not reduce the amount of cash the company has available
Amount of cash that the firm is investing in its fixed assets (capital expenditures) and
operating working capital in order to sustain its operating operations
Capital Expenditure
CAPEX
 Investment in gross fixed assets + Depreciation
 ∆Gross fixed assets -∆Net fixed assets
CAPEX + ∆NOWC
Net Operating Working Capital
 Current assets – Non-interest-bearing current liabilities
∆NOWC
 Current assets – (Accrued wages and taxes + Accounts payable)
 Current assets – (Current liabilities – Notes payable)
Conceptual Issues in Cash Flow Estimation


Free Cash Flow vs
Accounting Income
Timing of Cash Flows
Relevant Cash Flows
Cash is king in finance
Net income and operating income are not cash
- They are accounting numbers
- Includes non-cash items such as depreciation
- Under accrual-based accounting, revenues and expenses are booked when they
occur, not when cash is received/paid
 When evaluating projects, we are interested in cash flows that the project produces
In theory, capital budgeting analysis should deal with cash flows exactly when they occur
 Costly to estimate and analyze daily cash flows
 Difficult to accurately forecast daily cash flows
Hence, we generally assume all cash flows to occur at the end of the year
Incremental cash flows that will occur if and only if the project is accepted
 Difference between CF if project is accepted vs. CF if project is not accepted
 Calculate relevant cash flows for different types of projects:
- Expansion projects
- Replacement projects
- Lease vs. buy
© COPYRIGHT JIA HUI (JPOH008)
Irrelevant Cash Flows
By accepting the project, the firm forgoes a possible annual CF, which
Opportunity
Costs Associated is an opportunity cost to be charged to the project
with Assets the
 Relevant CF is the annual after-tax opportunity cost [Cost(1-T)]
Firm Owns
 This CF should be taken out from annual operating CF
Effect on other businesses of the firm or on the environment
 After-tax CF loss per year on the other business lines would be
a loss to this project
Externalities
Externalities can be positive (complements) or negative (substitutes)
 Cannibalization: When new business takes away the existing
business
Because when calculating NPV, we divide by the cost of capital
Interest Charges
 Hence, all financing charges (i.e. interest charges and
dividends) are included
Because sunk cost would be (or has already been) incurred regardless
Sunk Costs
of whether the project is accepted/rejected (NOT incremental)
Analysis of an Expansion Project – Determining Project Cash Flows
Estimating relevant cash flows
1. Find
∆NOWC
Initial Year Free Cash
2. Combing
Flow
∆NOWC
with CAPEX
Determining
Annual
Depreciation
Annual Operating
Expense
Cash Flows
OCF
Terminal Cash Flow
(Inflow due to
liquidation of
project)
1. Find AfterTax Salvage
Value
2. Combine
with NOWC
∆NOWC = ∆Current Assets – (∆Current Liabilities - ∆Notes Payable)
CAPEX includes: (Equipment) and (Shipping & Installation)
(Negative) because cash outflow
Depreciable basis = Equipment + Shipping & Installation
Do NOT subtract salvage value from depreciable basis unless
otherwise stated
Revenue – Cash Operating Cost – Depreciation Expense = EBIT
EBIT (Operating Income) – Tax = Operating Income (AT)
Operating Income (AT) + Depreciation Expense = Operating Cash Flow
Salvage Value – Tax (Salvage Value – Remaining Book Value)
= After-Tax Salvage Value
Recovery of NOWC + After-Tax Salvage Value = Terminal CF
In termination year, cash flow = operating cash flow for that year +
terminal CF
Use GC: NPV(Rate,Initial outlay,{CF1, CF2, …, CFN},{Cash flow counts})
At Termination
Find NPV
Replacement Analysis
Find cash flow differentials between new and old projects
 Replacing old assets with new ones
 Key is to find incremental cash flow
- i.e. The opportunity cost
Initial Investment/CF
Cost of new asset – After-tax cash inflow from sale of old asset at t=0
(t=0)
Operating Cash Flows Operating cash flows from new asset – Operating cash flows from old asset
Terminal Cash Flows
After-tax inflows from sale of new asset – After-tax inflows from sale of old asset at t=N
(t=N)
© COPYRIGHT JIA HUI (JPOH008)
Risk Analysis in Capital Budgeting
Stand-Alone Risk
Corporate (Within
Firm) Risk
Market (Beta) Risk
Risk an asset would have if it were a firm’s only asset and investors owned only one stock
 Measured by the variability of the asset’s expected returns
Project’s risk to the corporation as opposed to investors
 Takes account of the fact that the project is only one asset in the firm’s portfolio
of assets
 Some of the risk will be eliminated by diversification within the firm
 Measured by a project’s effect on uncertainty about the firm’s expected future
returns
Riskiness of project which considers both firm and stockholder diversification
 Measured by effects on the firm’s beta coefficient
Measuring Stand-Alone Risk
Most inputs into capital budgeting process are estimates
 Understand how uncertainties affect our decision to accept/reject a project using the procedures below
 Used to understand/measure stand-alone risk of project
Examines how sensitive NPV is to changes in each input variable
 Measures the percentage change in NPV that results from a given percentage
change in an input
Sensitivity Analysis
 All other variables are held constant at base value
 Key inputs include: Equipment cost; Change in net operating working capital; Unit
sales; Sales price; Variable cost per unit; Fixed operating cost; Tax rate; WACC
Possible alternative scenarios with different input values are proposed
 Change more than one variable at a time
Scenario Analysis
 Probabilities are assigned to each scenario
 Multiply each scenario’s probability by the NPV  Project’s expected NPV and
standard deviation/CV of NPV
Simulation techniques where the NPV for many scenarios are calculated
 Risk analysis technique in which probable future events are simulated by a
Monte Carlo
computer, generating estimated rates of return and risk indexes
Simulation
 Simulation is useful, but complex
 (Do not need to know the details for AB1201)
Leasing
To obtain the use of assets, companies can either buy or lease them
An arrangement whereby a firm sells asset and simultaneously leases
Sale and
the asset back for a specified period under specific terms
Leaseback
 Alternative to taking out a mortgage loan
A lease under which the lessor maintains and finances the property
 Lessor maintains and services leased equipment
 Cost for providing maintenance included in lease payments
 Frequently not fully amortized
- i.e. Payment required under lease contract is not sufficient
to recover full cost of equipment
Types of Leases
Operating
- Lessor expects to recover all investment costs through
Leases
subsequent renewal payments, through subsequent
leases, or through the sale of leased equipment
 Frequently contain cancellation clause
- Important for lessee, as equipment can be returned if it is
rendered obsolete or no longer needed by lessee’s
business
A lease that does not provide for maintenance services, is not
Financial Leases
cancellable, and is fully amortized over its life.
© COPYRIGHT JIA HUI (JPOH008)
Financial Statement
Effects
Lease vs. Borrowand-Buy
Other Factors that
Affect Leasing
Decisions
Leasing is often called off-balance-sheet financing
 Financing in which assets and liabilities involved (on the lease contract) do not
appear on the firm’s balance sheet
Financial Accounting Standard Board issued FAS 13, which requires firms to restate their
balance sheet to capitalize the lease:
(1) Report leased assets as fixed assets
(2) Show the present value of future lease payments as liabilities
1. Firm decides to acquire an asset
- Decision based on regular capital budgeting procedures
2. How to finance it (by lease or by loan)
 Calculate NPV under leasing compared against NPV of borrow-and-buy
- Already determined that acquiring an asset is a positive NPV project
- Funds to purchase the asset can be obtained by borrowing, by retained earnings,
or by issuing new stock
- Asset can also be leased (under FAS 13, lease would have the same capital
structure effect as a loan)
In lease analysis, recommended to use after-tax cost of borrowing
 E.g. Discount cash flows at 6% = 10%(1-0.4)
Net Advantage
NAL = PV Cost of Owning – PV Cost of Leasing
of Leasing
Have to include maintenance expense since it is being owned
 Depreciation is tax deductible
Cost of Owning
 Tax savings of (T)(Depreciation)
Analysis
 Maintenance is tax deductible
 Maintenance expense = (-Maintenance expense)(1-T)
Existence of large residual values on equipment is not likely to bias the
decision against leasing
- Estimated residual value are expected to be large, by right
Estimated
owning would be more advantageous than leasing
Residual Value
- However, if expected residual values are large, competition
among leasing companies will force leasing rates down to
where potential residual values will be fully recognized in the
lease contract rates
Leasing could have an advantage for (small) firms that are seeking
maximum degree of financial leverage
- Because some leases not shown on balance sheet, lease
Increase Credit
financing can give firm a stronger appearance in a superficial
Availability
credit analysis
- May only be true for smaller firms
- Large firms are required to capitalize major leases and report
them on balance sheet
© COPYRIGHT JIA HUI (JPOH008)
The Optimal Capital Budget
The amount of investments where the marginal cost of capital equals to the returns on the marginal project
 In theory, accept all positive NPV projects
 Capital rationing occurs where company chooses not to fund all positive NPV projects
- Not enough internally generated cash
- Increasing marginal cost of capital
 Raise expensive external equity (incur flotation cost)
 Increasing cost of debt and preferred stock as more capital is raised (as firms become riskier)



Optimal capital budget = $600,000
where rate of return of marginal project = marginal
cost of capital
Hence accept A, B, C if $600,000 is available, else
capital rationing
WACC increases with capital budgeting because as
we raise more capital, we would run out of retained
earnings
 Need to issue new common stock (which is
more expensive)
 Cost of debt and preferred stock increases as
likelihood of default increases as well
(Lecture 9, Slide 39)
© COPYRIGHT JIA HUI (JPOH008)
E-Learning: SME Financing & Careers in Finance
Finance for Small and
Medium-size Entities
(SMEs)
Major Financing
Sources for SMEs
Finance for SMEs refers to the funding of small- and medium-sized enterprises
Internal Funds Such as owner’s savings, company’s profit
Overdrafts &
Bank Short-Term To fund working capital
Loans
Bank Long-Term To finance asset purchasing, other business development and
Loans
investment purposes
Leasing & Hiring
Purchase
To purchase capital equipment such as plant, machinery
Agreements
Stock market
Equity &
To finance large and long-term projects or investments
Corporate Bond
Issues
Financial capital provided to early-stage, high-potential start-up
Venture Capital
companies
Financial capital from firms specializing in in investing and acquiring
Private Equity
equity ownership
Such as factoring and invoice discounting – to finance short-term
working capital
Asset-based
 Factoring: Financial transaction in which a business sells its
Finance
account receivable (i.e. invoices) to a third party (called a
factor) at a discount
For short-term working capital
 Trade Credit: Delays in paying for purchases of goods and
Trade Credit
services
 Often provided by suppliers
 Earnings internally generated by the business and/or supplied informally as trade
credit are the main source of financing for SMEs
 Commercial banks are the main formal suppliers of external finance to small- and
medium-sized business
 Most small business start-ups are largely funded by their owners out of their own
savings, money from families, friends, or private investors, etc.
 While medium-sized public companies can issue bond/stock in the stock market for
external finance, medium-sized private companies tend to be highly reliant on banks
and/or private equity financiers
 SMEs account for over 90% of all enterprises, they contribute to 60% of the total
value-added in the economy and employ 7 out of 10 of the country’s workforce
 Over 100 programs administered by various government agencies such as SPRING
Singapore, IE Singapore, etc. to help SMEs with their financing issues
 Government assistance
- Tax incentives such as Productivity & Innovation Credit (PIC)
- Grants such as Capability Development Grant (CDG)
 Loans such as government-backed loans for working capital, trade financing and
equipment financing, offered through participating financial institutions
- Local Enterprise Finance Schemes (LEFS)
- Loan Insurance Schemes (LIS)
- Micro Loan Program (MLP)
© COPYRIGHT JIA HUI (JPOH008)
Chapter 15: Capital Structure and Leverage
Learning Objectives:
 Understand the risk-return trade-off associated with the use of operating leverage and financial leverage
 Distinguish between business risk and financial risk
 Finding the optimal capital structure through maximizing stock price and minimizing WACC
- Distinguish between levered beta and unlevered beta
- Apply the Hamada Equation
- Understand the impact of increasing debt on EPS, cost of equity, cost of debt, and WACC
 Discuss capital structure theories and use them to explain the capital structure of the firms
- MM’s irrelevance theory
- Trade-off theory: Trades off tax benefit of debt vs. the bankruptcy costs of debt
- Signaling theory
- Using debt to constrain managers
Capital Structure
2 main sources of capital:
1) Debt – A firm promise to make fixed payments regularly. However, when the firm defaults on payment,
bankruptcy may occur
2) Equity – Equity holders receive whatever cash flows that is left over in the firm after paying the
debtholders
Percentage of debt, preferred stock, and common equity that is used to finance a firm’s
asset
Capital Structure
𝐷𝑒𝑏𝑡
 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦+𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘
Optimal Capital
Structure
Reasons Capital
Structure Changes
over Time
The mix of debt, preferred stock, and common equity that maximizes the stock’s intrinsic
value
 Capital structure that maximizes the intrinsic value also minimizes WACC
Actual debt ratio > Target: Firm can sell large stock issue and use proceeds to retire debt
Stock prices increases, Actual < Target: Issue bonds and use proceeds to repurchase stock
Deliberate
Deliberately raise new money in a manner to move the actual
Actions
structure towards the target
Interest rate changes due to changes in the general level of rates
and/or changes in the firm’s default risk could cause significant
Market Actions changes in its debt’s market value
 Changes in market value of debt and/or equity could result in
large changes in its measured capital structure
© COPYRIGHT JIA HUI (JPOH008)
Business and Financial Risk
Risks from viewpoint of the corporation
 Single more important determinant of capital structure
 Represents the amount of risk that is inherent in the firm’s operations even if it uses
no debt financing
 Uncertainty about future operating income (EBIT)
 Does not include financing effects
 Measured by standard deviation of the firm’s return on invested capital (or EBIT)
 EBIT = Sales – Operating Costs = Quantity*Price – Operating Cost
 𝑅𝑂𝐼𝐶 =
𝐸𝐵𝐼𝑇(1−𝑇)
𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟−𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Business Risk
Financial Risk
Competition
 Firm has monopoly  Little risk from competition  Stable
sales and prices  Lowers business risk
 Uncertainty about demand (sales)
 More stable the demand  Lower its business risk
 Uncertainty about output prices
Factors That
 Volatile markets  More business risk
Affect Business  Uncertainty about input costs
Risk
 Product, other types of liability
 Product obsolescence: Faster products becomes obsolete,
greater the business risk
 Foreign risk exposure: Exchange rate fluctuations + Political
risks
 Regulatory risk and legal exposure
 Operating Leverage
Extent to which fixed costs are used in a firm’s operations
 Generally, more fixed cost  More operating leverage 
More business risk
Operating
 A small sales decline causes a big EBIT decline
Leverage
 Higher fixed cost generally associated with:
- Highly automated, capital-intensive firms and industries
- Employ highly skilled workers who must be retained and
paid even during recessions
Although operating leverage comes with higher business risk, it also
Trade-Off
comes with higher expected EBIT
 Additional risk concentrated on common stockholders as a result of decision to
finance with debt
 More debt, more financial risk
 Because have to pay debtholders first, then stockholders
Financial
Use of debt and preferred stock, which incurs fixed financial charges
Leverage
Between profitability and risk when we increase debt levels
 Increases expected profitability to shareholders but also
increases the risk to shareholders
 In turn increases required rate of return of shareholders
Trade-Off
Hence when determining optimal capital structure that maximizes
stock price, need to consider both:
1) Increased profitability
2) Increased risk resulting from use of debt
© COPYRIGHT JIA HUI (JPOH008)
Determining the Optimal Capital Structure

Capital structure (mix of debt, preferred, and common equity) at which stock price is maximized
- Stock price is affected by future CF and risk of CF
- Trades off higher expected profitability against higher risk when we increase debt
 GOAL: Find the stock price at each level of debt
- The debt level that maximizes stock price is the optimal capital structure
- To find expected stock price (𝑃̂0 ) at each debt level, find EPS and appropriate 𝑟𝑠 at each debt level
When a firm uses no preferred stock, 𝑊𝐴𝐶𝐶 = 𝑤𝑑 𝑟𝑑 (1 − 𝑇) + 𝑤𝑐 𝑟𝑠
 Bondholders recognize that if firm has greater Debt/Capital ratio, it increases the
risk of financial distress  Higher interest rates
𝐷1
𝐷𝑃𝑆 𝐸𝑃𝑆
𝑃̂0 =
=
=
𝑟𝑠 − 𝑔
𝑟𝑠
𝑟𝑠
Assumption: If all earnings are paid out as dividends, growth rate, g = 0
 Recall: g = (1 – Dividend Payout)(ROE)
 Dividend payout = 1 if all paid as dividends
Determine
WACC and Capital

EPS = DPS if g = 0
Impact of
Structure Changes
Changing
 First calculate shares outstanding (Initial – Repurchased)
Capital
(𝑬𝑩𝑰𝑻−𝒓𝒅 𝑫)(𝟏−𝑻)
 𝑬𝑷𝑺 = 𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈
Structure on
Stock Price
 Higher financial leverage usually leads to higher EPS

The Hamada
Equation
The Optimal Capital
Structure
However, not always necessary to set optimal capital structure at
the debt/capital ratio where EPS is maximized
- Have to consider risk-return trade off
- Higher 𝑟𝑠 from higher financial risk
- 𝑏𝐿 = Levered beta (Beta used in CAPM): Determined by
𝐷
both business & financial risk [also known as equity beta]
𝑏𝐿 = 𝒃𝑼 [1 + (1 + 𝑡)( )]
- 𝑏𝑈 = Unlevered beta (What we need to find):
𝐸
Determined by business risk only [known as asset beta]
 Higher financial leverage  Higher financial risk faced by shareholders  Higher
required rate of return by shareholders  Higher cost of equity
 Beta in CAPM changes when capital structure changes
- Affects 𝑟𝑠 in 𝑃̂0
Firm’s optimal capital structure can be determined in two ways & both leads to the same
results:
1) Maximising stock price
2) Minimising WACC
 Recognise that inputs are “guesstimates”
Capital
 Capital structure decisions have a large judgmental content as a
Structure in
result of imprecise numbers
Reality
 Hence, we end up with capital structures varying widely among
firms
-
Capital Structure Theory
Modigliani-Miller Irrelevance Theory states that under a restrictive set of assumptions, a firm’s value should be
unaffected by its capital structure
 Suggests that it does not matter how a firm finances its operations  Hence capital structure is irrelevant
 Some assumptions are not realistic
- But by indicating these conditions, MM provided clues about what is required to make capital
structure relevant and hence, to affect the firm’s value
Deductibility of interest favours the use of debt financing
Tax Benefit of Debt
 Interest expense is tax deductible  Pay less taxes
 But distributions to shareholders, e.g. dividends, do not reduce taxes
© COPYRIGHT JIA HUI (JPOH008)
Bankruptcy Costs
Expected bankruptcy cost depends on:
 Probability of bankruptcy:
- How volatile is your future cash flow? Volatile, more likely to bankrupt
 Actual cost incurred when in bankruptcy
- Legal and accounting fees, liquidation of assets at fire-sales, loss of customers,
suppliers, employees, etc.
 Indirect costs due to threat of bankruptcy
- Customers and suppliers refuse to do business with the firm because they
think the firm may go bankrupt anytime
Firms trade off the tax benefits of debts against problems caused by potential bankruptcy
Trade-off Theory: Tax
Benefits vs
Bankruptcy Costs
Signalling Effects
Agency Costs
Pecking Order
Hypothesis
Under MM’s Irrelevance Theory, shareholders and managers have the same information
on firm’s prospects (symmetric information)
 Not the case in reality, where managers have more information than outside
shareholders (asymmetric information)
Signalling theory suggests firms use less debt than what trade-off theory suggests
 This unused debt capacity helps avoid stock sales, which depress stock price
because of signalling effects
 Firm with favourable prospects should instead raise any required new capital by
using new debt, even If this moved its debt ratio beyond the target level
In general, announcement of stock offering is generally taken as a signal that the firm’s
prospects as seen by the management are not bright & that managers think that the stock
is overvalued
 Investors would sell stocks
 Stock price falls
Debt can constrain managers
 To make sure that managers earn enough to cover the regular interest payments
 Failing to do may force firms into bankruptcy and managers lose their jobs as a
result
Essential because conflicts may arise between managers and shareholders  Agency
problems
 When there’s excess cash, managers tend to send the cash on pet projects or
perquisites
 Able to reduce excess cash by funnelling some of it back to shareholders through
higher dividends or stock repurchases
The sequence in which firms prefer to raise capital: first spontaneous credit, then retained
earnings, then other debt, and finally new common stock
 Logical because no flotation costs incurred to raise capital as spontaneous credit
or retained earnings & costs relatively low to issue new debt
 Flotation costs too high + Asymmetric information makes it even more
undesirable to finance new common stock
© COPYRIGHT JIA HUI (JPOH008)
Checklist for Capital Structure Decisions
Other factors that firms consider when making capital structure decisions
Firms whose sales are relatively stable can safely take on more debt and incur higher
fixed charges
Sales Stability
 E.g. Utility companies where they’ve stable demands
Holding other factors constant, a company is able to take on more debt if it has more cash
on the balance sheet
Asset Structure
 Net Debt = Total Debt – Cash and Equivalents
Firm with less operating leverage is better able to employ financial leverage because it will
Operating Leverage
have less business risk, ceteris paribus
Faster-growing firms must rely more heavily on external capital
 Flotation cost involved in selling common stock > When selling debt
Growth Rate
 At the same time, those firms often face higher uncertainty  Tends to reduce
willingness to use debt
Firms with very high rates of return on investment use relatively little debt
Profitability
 Profitable firms’ high rates of returns enable them to do most of their financing
with internally generated funds
Higher a firm’s tax rate, greater the advantage of debt because interest is deductible
Taxes
expense
If management currently has voting control but not in a position to buy more stocks, it
may choose debt for new financings
Control
 Management may use equity if firm’s financial situation is so weak that use of
debt subject it to serious risk of default
- However, if too little debt used, management runs the risk of takeover
Management can exercise own judgement on proper capital structure
Management
 Conservative managers tend to use less debt
Attitudes
 Aggressive managers tend to use relatively high percentage of debt in quest for
higher profits
Lender and Rating
Corporations often discuss their capital structures with lenders and rating agencies and
Agency Attitudes
give much weight to their advice
Conditions in the stock and bond markets undergo long- and short-run changes that can
have an important bearing on a firm’s optimal capital structure
Market Conditions
 E.g. During credit crunch, low-rated companies in need of capital were forced to
go to stock market or to short-term debt market regardless of their target capital
structure because there was no market for low rated bonds
Notes:
Factors affecting target capital structure:

Increasing in corporate tax rate
- Should use more debt
- More tax savings
 Increase in bankruptcy cost
- Less debt
 Higher business risk
- Higher uncertainty
- Low debt to ensure it can meet debt obligations
 Others such as management large debt
- Should use less debt
- Interest expense alr large
The optimal debt/capital ratio that maximizes stock price is generally less than debt/capital ratio that maximizes
EPS. Because at the capital structure that maximizes EPS, the risk is too high
As we shift from cheaper debt to more expensive equity, WACC would always increase
- False
- Depends on weightage of the components
- Cost of debt (less default risk) and equity falls when debt falls (because there is less debt  less risk)
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Chapter 16: Distributions to Shareholders (except 16.3a)
Course Wrap Up
Learning Objectives:
 Explain what is dividend policy
 Discuss the different dividend theories and explain whether dividend policy matters
- MM’s dividend irrelevance theory
- Bird-in-hand theory
- Tax advantages of capital gains
- Signalling theory
- Clientele effects
 Discuss what is Dividend Reinvestment Plan (DRIP) and its different forms
 Understand the difference between cash dividends and stock repurchases and discuss the trade-offs
 Differentiate between stock splits and stock dividends
Dividend Policy
Dividend policy has to do with the decision of whether to pay dividends vs retaining funds to reinvest, and also
the decision to pay back using cash dividends or repurchase shares
 Cash flow from operations
- Pay off debt holders
- For equity holders (assuming no preferred stock)
 Retain and reinvest in new projects = Capital Gain Yield (because expect dividends to increase)
 Pay out cash dividends = Dividend Yield
 Pay out as repurchase shares
 Target payout ratio is defined as the percentage of net income to be paid out as cash dividends
- Should be based on investors’ preferences for dividends vs capital gains
- Preference can be considered in terms with constant growth stock valuation model
𝐷
Optimal dividend policy should maximise stock price – 𝑃̂0 = 1
Constant Growth
Stock Valuation
Model


𝑟𝑠 −𝑔
Essential to strike a balance between current dividends and future growth that
maximises stock price
Increasing dividends has two opposing effects on stock price:
1) Increase 𝐷1  Upward pressure on stock price
2) Decrease 𝑔  Downward pressure on stock price (because lesser money
available for reinvestment)
Dividends versus Capital Gains: What Do Investors Prefer?
Dividend Irrelevance
Theory (Only In A
Perfect World)
Reasons Some
Investors Prefer
Dividends
(Bird-in-Hand
Theory)
Reasons Some
Investors Prefer
Capital Gains
(Tax Preference)
Proposed by Modigliani and Miller that stock price is determined only by the earning
power and risk of its assets (investments)
 Investors are indifferent between dividends and retention-generated capital gains
 Given MM’s assumption, investors can create their own dividend policy
- If they want cash, they can sell stock
- If they do not want cash, they can use dividends to buy stock
Implication: Any payout is okay
Investors may think dividends paid today are less risky than potential future gains, hence
investors prefer dividends
 Stocks with high dividends  Less risky  Shareholders require lower returns 
High stock price
Implication: Set a high payout  Firm value increases
Dividends will be taxed – Capital gains avoids transaction costs from reinvesting dividends
 Tax advantages of capital gains:
- Capital gains usually taxed at a lower rate than dividends, but this differs
depending on tax regimes
- Taxes of dividends due to in the year they are received, but taxes on capital
gains due when the stock is sold (TVM states that $ paid later worth lesser
today)
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
To that extent, dividends have a tax disadvantage relative to capital gains, hence
shareholders prefer capital gains
 Important to consider the tax regime that the company operates in
- In Singapore, there is no tax on capital gains and dividends
Implication: Set a low payout
Other Dividend Policy Issues
Information Content,
or Signalling,
Hypothesis
Clientele Effect
Investors view dividend changes as signals of management’s view of the future
 Since managers hate to cut dividends, they will not raise dividends unless they
think the raise is sustainable
- Dividend increase – Good future prospects (that profits are sustainable)
- Dividend decrease – Bad future prospects
 Hence a stock price increase at the time of a dividend increase could reflect
higher expectations for future EPS, not a preference for dividends
 Need to consider information conveyed to shareholders when company cuts or
increase dividends
Firm’s past dividend policy determines its current clientele of investors
 Different groups of investors, or clienteles, prefer different policies
Implication: Clientele effects impede changing dividend policy. Taxes and brokerage
costs hurt investors who have to switch companies.
Dividend Reinvestment Plans
DRIP: A plan that enables a stockholder to automatically reinvest dividends received back into the stock of the
paying firm
 I.e. Stockholders choose to receive cash dividends or have the company use the dividends to buy more
stock in the firm on behalf of the investor
 2 types of plans:
1) Open market
2) New stock
Cash is given to trustee  Trustee buys stock in open market  Stock allocated to
shareholders
 Economies of scale  Bulk purchase of stocks together  Lower brokerage fee
Open Market Plan
 Brokerage costs reduced by volume purchases
 Convenient, easy way to invest  Useful for investors
Company issues new stock  Stock allocated to shareholder
 Cash stays within the company  Conserves cash (Important for cash strapped
New Stock Plan
firms)
 Companies that need capital to use new stock plans
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Summary of Factors Influencing Dividend Policy
Constraints
Investment
Opportunities
Alternative Sources
of Capital
Effects of Dividend
Policy on rs
Debt contracts often limit dividend payments to earnings generated
after the loan was granted
Bond Indentures
 Also often stipulate that no dividends can be paid unless the
current ratio, times-interest-earned ratio, and other safety
ratios exceed stated minimum
Preferred Stock Typically, common dividends cannot be paid if the company has
Restrictions
omitted its preferred dividend
Legal restriction that dividend payments cannot exceed the balance
Impairment of
sheet item “retained earnings”
Capital Rule
 Designed to protect creditors
Availability of
Cash dividend can only be paid with cash
Cash
To prevent wealthy individuals from using corporations to avoid
Penalty Tax on
personal taxes
Improperly
 Firm will be subjected to heavy penalties if IRS can
Accumulated
demonstrate that a firm’s dividend payout ratio is deliberately
Earnings
being held down to help its stockholders avoid personal taxes
Number of
If a firm has a large number of profitable investment opportunities,
Profitable
this will tend to produce a low target payout ratio and vice versa if firm
Investment
has few good investment opportunities
Opportunities
Possibility of
Accelerating or The ability to accelerate or postpone projects permits a firm to adhere
Delaying
more closely to a stable dividend policy
Projects
Firm needs to finance a given level of investment, it can obtain equity
by retaining earnings or by issuing new common stock
Cos of Selling
 If flotation costs are high (re well above rs), making it better to
New Stock
set a low payout ratio and to finance through retention rather
than sale of new common stock
Ability to
If firm can adjust its debt ratio without raising its WACC sharply, it can
Substitute Debt pay the expected dividend, even in earnings fluctuate, by additional
for Equity
borrowing
If management is concerned on maintaining control, it may be
Control
reluctant to sell new stock
 Shareholders’ preference for dividends
1) Stockholders’ desire for current vs future income
2) The perceived riskiness of dividends vs capital gains
3) The tax advantage of capital gains
4) Information (Signalling) content of dividends
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Stock Dividends and Stock Splits
Stock Splits
Stock Dividends
Effect on Stock Prices
Firm increases the number of shares outstanding
 2-for-1 stock split = 100 shares  200 shares
Firm issues new shares in lieu of paying a cash dividend
Both increases the number of shares outstanding
 Stock prices fall so to keep investor’s wealth unchanged because firm did not raise
new funds
 Unless the stock dividend and split conveys information (on future prospects)
Stock splits/dividends may get us to an “optimal price range”, keeping the price in the
optimal range
1. On average, price of company’s stock rises shortly after it announces stock split or
dividends
2. One reason that it leads to higher prices is that investors often take stock split and
dividends as signals of higher future earnings (positive signal)
- Because only companies whose managements believe that things look good tend
to split their stocks
- Announcement of stock split is taken as a signal that earnings and cash dividends
are likely to rise
3. If company announces stock split or dividend its price will tend to rise. HOWEVER, if it
does not announce an increase in earnings or dividends within the next few years,
stock price generally will drop back down
4. By creating more shares and lowering stock price, stock splits may also increase
stock’s liquidity.
- Tends to increase the firm’s value
- Because by decreasing the price, investors can afford to purchase shates
Stock Repurchases
The Effects of Stock
Repurchases
Advantages of
Repurchases
Disadvantages of
Repurchases
Conclusions on Stock
Repurchases (TB)
When companies decide to pay out cash instead of retaining it, they can choose to pay
cash dividends or buy back their own stock from stockholders
 Shares outstanding reduced
 Shares bought back are held as treasury stock and can be resold in the future to
raise capital
Company EPS will increase  Drop in P/E/ ratio after repurchase
 May be viewed as a positive signal that the management thinks stock is undervalued
- Management has more information than investors
 Shareholders can choose to sell or hold
 Repurchases can be used to dispose off temporarily excess cash flows and avoid
setting high dividend payout
 Can be used to make large capital changes
 May be viewed as a negative signal that the firm has poor investment opportunities
 Cash dividends are dependable (regular basis) but repurchases are not
 Firm may have to bid up prices to complete purchase, thus pay too much for its own
stocks
 Because of the deferred tax on capital gains, repurchases have a tax advantage over
dividends as a way to distribute income to stockholders. This advantage is reinforced
by the fact that repurchases provide cash to stockholders who want cash but also
allow those who do not need current cash to delay its receipt. On the other hand,
dividends are more dependable and are thus better suited for those who need a
steady source of income.
 Because of signalling effects, companies should not pay fluctuating dividends – that
would lower investors’ confidence in the company and adversely affect its cost of
equity and its lower stock price. However, cash flows vary over time, as do investment
opportunities. To get around this problem, a company can set its dividend at a level
low enough to keep dividend payments from constraining operations and then uses
repurchases on a more or less regular basis to distribute excess cash. Such procedure
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
would provide regular, dependable dividends in addition to supplemental cash flows
to those stockholders who want it.
Repurchases are also useful when a firm wants to make a large, rapid shift in its
capital structure, to distribute cash from a one-time event such as the sale of a
division, or to obtain shares for use in an employee stock option plan.
Course Summary
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