Finance Is One of The Most Difficult Subjects You Will Ever Love!
CORPORATE FINANCE
Presented by: Dr. Duong Thi Thuy An
ABOUT THE LECTURER
DR. DUONG THI THUY AN
PHONE: +84903163538
EMAIL: ANDTT@HUB.EDU.VN
2
Faculty of Finance
*Education: Ph.D. in Economics, Utrecht University
*Professional experience:
• 2004-2005: broker at ACB Securities
company
• 2005-2006: Financial Analyst at Thien Viet
securities company
• 2010-2011: Corporate consultant at
Vietinbank securities company
• 2012-2013: Head of Securities market
chair- Faculty of Finance-BUH
• 2016-2017: Export sale director Benelux
region- Nam Vinh Investment joint-stock
company.
• 2021-now: Head of Corporate Finance
chair-Faculty of Finance-BUH
*Leisure: gym, movies, dining out, travelling,
sewing.
Ho Chi Minh University of Banking
GRADE COMPONENTS
Diligence,
awarenes
s,attitude
10%
Final
exam
50%
Group
project
20%
Small quizes:
- Bonus: 0.25->1 point
+Top 3 best performances.
+ Add to the midterm test.
Midterm
test
20%
3
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Ho Chi Minh University of Banking
RECOMMENDED READING
• [1] Ross, S. A., Westerfield, R. W. and Jordan, B. D. (2019) Fundamentals of Corporate Finance. 12th ed.
New York: McGraw-Hill Education.
• [2] Brealey, R. A., Myers, S. C. and Allen, F. (2020) Principles of Corporate Finance. 13th ed. New York:
McGraw-Hill Education.
• [3].Tirole,J., (2006), The Theory of Corporate Finance , Princeton University Press.
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COURSE OUTLINE
Chapter 1: An Introduction to Corporate finance
Chapter 2: Time value of money
- Securities valuation
- Capital budgeting
Chapter 3: Financing and Cost of capital
Chapter 4: Financial leverage and capital structure
Chapter 5: Dividend policy
Chapter 6: Merger and acquisition
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CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
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KEY CONCEPTS AND SKILLS
Know
Know the basic types of financial management decisions and the
role of the financial manager
Know the financial implications of the different forms of business
organization
Know
Know the goal of financial management
1-7 Know
Understand
Understand the conflicts of interest that can arise between owners
and managers
Understand
Understand the various types of financial markets
Understand
Understand the various financial statements.
Compute
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Compute and, more importantly, interpret some financial ratios
Banking University of Ho Chi Minh City
CHAPTER OUTLINE
•
1.
2.
3.
4.
5.
•
Part 1:
Corporate Finance and the Financial Manager
Forms of Business Organization
The Goal of Financial Management
The Agency Problem and Control of the Corporation
Financial Markets and the Corporation
Part 2
Review: Some key financial indicators
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1-8
CORPORATE FINANCE
• Some important questions that are answered using finance:
• What long-term investments should the firm take on?
• Where will we get the long-term financing to pay for the investment?
• How will we manage the everyday financial activities of the firm?
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1-9
FINANCIAL MANAGER
• Financial managers try to answer some or all of these questions
• The top financial manager within a firm is usually the Chief Financial Officer
(CFO)
• Treasurer – oversees cash management, credit management, capital expenditures,
and financial planning
• Controller – oversees taxes, cost accounting, financial accounting and data processing
Video: Understanding Corporate Structure
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1-10
FINANCIAL MANAGEMENT DECISIONS
• Capital budgeting
• What long-term investments or projects should the business take on?
• Capital structure
• How should we pay for our assets?
• Should we use debt or equity?
• Working capital management
• How do we manage the day-to-day finances of the firm?
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1-11
CAPITAL BUDGETING DECISION
• Capital budgeting decision (investment decision, capital expenditure-capex) is the
process of planning and managing a firm’s long-term investments.
• The financial manager tries to identify investment opportunities that the value of the
cash flow generated by that investment exceeds the cost of that investment.
• The types of investment opportunities that would typically be considered depend in
part on the nature of the firm’s business
• Evaluating the size, timing, and risk of future cash flows is the essence of capital
budgeting.
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CAPITAL STRUCTURE DECISION
• Capital structure (or Financing decision) concerns ways in which the firm obtains and
manages the long-term financing it needs to support its long term investments. A firm’s
capital structure (or financial structure) is the specific mixture of long-term debt and
equity the firm uses to finance its operations.
• First, how much should the firm borrow? Second, what are the least expensive sources
of funds for the firm?
• Firms have a great deal of flexibility in choosing a financial structure. The question of
whether one structure is better than any other for a particular firm is the heart of the
capital structure issue.
• The financial manager has to decide exactly how and where to raise the money.
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WORKING CAPITAL MANAGEMENT
• Working capital include firm’s short-term assets and liabilities, such as inventory,
money owed to suppliers.
• Managing the firm’s working capital is a day-to-day activity that ensures that the firm
has sufficient resources to continue its operations and avoid costly interruptions
• Some questions of working capital management: How much cash and inventory should
we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to
whom will we extend them? (3) How will we obtain any needed short-term financing?
Will we purchase on credit or will we borrow in the short term and pay cash? If we
borrow in the short term, how and where should we do it?
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CONCEPT QUESTIONS
• What is the capital budgeting decision?
• What do you call the specific mixture of long-term debt and equity that a firm chooses
to use?
• Into what category of financial management does cash management fall?
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EXAMPLES OF RECENT INVESTMENT AND FINANCING DECISIONS BY
MAJOR PUBLIC CORPORATIONS.
Capital budgeting decision
Capital structure decision
Intel (U.S.)
Invests $7 billion in expanding semiconductor plant in Borrows $600 million from Chandler Industrial
Chandler, Arizona
Development Authority.
Amazon (U.S.)
Acquires self-driving start-up, Zoox, for over $1.2
Reinvests $33 billion that it generates from
billion
operations
Amazon (U.S.)
Announces plans to sell $2 billion of shares
Announces construction of new plant to build the
electric Cybertruck
Shell (U.K./Holland Starts production at a deep-water development in the Cuts dividend to preserve cash
Gulf of Mexico
GlaxoSmithKline Spends $6 billion on research and development for Raises $1 billion by an issue 8-year bonds
(U.K.)
new drugs.
Ørsted (Denmark) Completes a 230-MW wind farm in Nebraska
Arranges a borrowing facility with 14 international
banks
Spends $8 billion on advertising and marketing
Unilever
Pays a dividend and completes $200 million
(U.K./Holland)
program to buy back shares
Launches four new cruise ships
Carnival
Raises $770 million by sale of bonds; each bond can
be converted into about 19 shares
Corporation
(U.S./U.K.)
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FORMS OF BUSINESS ORGANIZATION-1
• Three major forms of business
• Sole Proprietorship
• Partnership
• General
• Limited
• Corporation
• Joint stock company
• Limited Liability Company
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1-17
SOLE PROPRIETORSHIP
• Advantages
•
•
•
•
Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income
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• Disadvantages
• Limited to life of owner
• Equity capital limited to owner’s
personal wealth
• Unlimited liability
• Difficult to sell ownership interest
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1-18
PARTNERSHIP
• Advantages
•
•
•
•
Two or more owners
More capital available
Relatively easy to start
Income taxed once as
personal income
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• Disadvantages
• Unlimited liability
• General partnership
• Limited partnership
• Partnership dissolves
when one partner dies
or wishes to sell
• Difficult to transfer
ownership
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1-19
CORPORATION
• Advantages
• Limited liability
• Unlimited life
• Separation of ownership
and management
• Transfer of ownership is
easy
• Easier to raise capital
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• Disadvantages
• Separation of ownership
and management
• Double taxation (income
taxed at the corporate
rate and then dividends
taxed at the personal
rate)
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1-20
GOAL OF FINANCIAL MANAGEMENT
• What should be the goal of a corporation?
•
•
•
•
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s stock?
• Does this mean we should do anything and everything to maximize owner
wealth?
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1-21
THE AGENCY PROBLEM
• Agency relationship
• Principal hires an agent to represent his/her interests
• Stockholders (principals) hire managers (agents) to run the company
• Agency problem
• Conflict of interest between principal and agent
• Management goals and agency costs
• the term agency costs refers to the costs of the conflict of interest between stockholders and
management. These costs can be indirect or direct.
• Direct agency costs come in two forms. The first type is a corporate expenditure that benefits
management but costs the stockholders. The second type of direct agency cost is an expense that arises
from the need to monitor management actions
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1-22
MANAGING MANAGERS
• Managerial compensation
• Incentives can be used to align management and stockholder interests
• The incentives need to be structured carefully to make sure that they achieve their
goal
• Corporate control
• The threat of a takeover may result in better management
• Other stakeholders
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1-23
WORK THE WEB EXAMPLE
• The Internet provides a wealth of information about individual companies
• One excellent site is cafef.vn
• Click on the web surfer to go to the site, choose a company and see what
information you can find!
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1-24
QUICK QUIZ
• What are the three types of financial management decisions and what
questions are they designed to answer?
• What are the three major forms of business organization?
• What is the goal of financial management?
• What are agency problems and why do they exist within a corporation?
• What is the difference between a primary market and a secondary market?
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1-25
ETHICS ISSUES
• Is it ethical for tobacco companies to sell a product that is known to be addictive and a
danger to the health of the user? Is it relevant that the product is legal?
• Should boards of directors consider only price when faced with a buyout offer?
• Is it ethical to concentrate only on shareholder wealth, or should stakeholders as a whole be
considered?
• Should firms be penalized for attempting to improve returns by stifling competition (e.g.,
Microsoft)?
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1-26
REVIEW:KEY FINANICAL INDICATORS
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FINANCIAL STATEMENTS ANALYSIS
• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare financial information,
particularly as the company grows.
• They are also useful for comparing companies of different sizes,
particularly within the same industry.
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3.2 RATIO ANALYSIS
• Ratios also allow for better comparison through time or between companies.
• As we look at each ratio, ask yourself:
•
•
•
•
•
How is the ratio computed?
What is the ratio trying to measure and why?
What is the unit of measurement?
What does the value indicate?
How can we improve the company’s ratio?
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CATEGORIES OF FINANCIAL RATIOS
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
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SHORT-TERM SOLVENCY OR LIQUIDITY RATIOS
• Short-term solvency ratios: provides information about a firm’s liquidity (liquidity
measures).
• Measure the firm’s ability to pay its bills over the short run without undue stress.
• These ratios focus on current assets and current liabilities
• Short-term creditors of interest.
• Book values and market values are likely to be similar
• Current assets and liabilities can change fairly rapidly
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SOME TERMINOLOGIES
• EPS = Earnings per Share=
Net income− preferred stock dividend
Average of outstanding shares
• DPS=Dividend per share
• BVPS= Book value per share=
Shareholder′ s equity−preferred stock
Average of outstanding shares
• EBIT = Earnings Before Interest and Taxes
• EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization
• EBT: Earning before tax
• EAT: Earning after tax= EBT (1-t)=(EBIT-I)(1-t)
t: corporate income tax rate
I: interest payment
Example: Prufrock corporation has 33 millions outstanding stocks, calculate EPS, BVPS.
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COMPUTING LIQUIDITY RATIOS
Prufrock corporation example:
• Current Ratio = CA / CL
• 708 / 540 = 1.31 times
• Quick Ratio = (CA – Inventory) / CL
• (708 - 422) / 540 = .53 times
• Cash Ratio = Cash / CL
• 98 / 540 = .18 times
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COMPUTING LONG-TERM LIQUIDITY RATIO (LEVERAGE RATIOS)
Prufrock corporation example:
• Total Debt Ratio = (TA – TE) / TA
• (3588 - 2591) / 3588 = 28%
• Debt/Equity = TD / TE
• (3588 – 2591) / 2591 = 38.5%
• Equity Multiplier = TA / TE = 1 + D/E
• 1 + .385 = 1.385
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ASSET MANAGEMENT (TURNOVER) RATIOS
Prufrock corporation example:
• Inventory Turnover = Cost of Goods
Sold / Inventory
• 1344 / 422 = 3.2 times
• Receivables Turnover = Sales /
Accounts Receivable
• 2311 / 188 = 12.3 times
• Total Asset Turnover = Sales / Total
Assets
• 2311 / 3588 = .64 times
• It is not unusual for TAT < 1, especially
if a firm has a large amount of fixed
assets.
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COMPUTING PROFITABILITY MEASURES
• Profit Margin = Net Income / Sales
• 363 / 2311 = 15.7%
• Return on Assets (ROA) = Net Income /
Total Assets
• 363 / 3588 = 10.1%
• Return on Equity (ROE) = Net Income /
Total Equity
• 363 / 2591 = 14.0%
• EBITDA Margin = EBITDA / Sales
• 967 / 2311 = 41.8%
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COMPUTING MARKET VALUE MEASURES
Prufrock corporation example: 33 million
share outstanding
• Market Capitalization = $88 per share x 33
million shares = 2904 million
• PE Ratio = Price per share / Earnings per share
• 88 / 11 = 8 times
• Market-to-book ratio = market value per share /
book value per share
• 88 / (2591 / 33) = 1.12 times
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USING FINANCIAL STATEMENTS
• Ratios are not very helpful by themselves: they need to be compared to something
• Time-Trend Analysis
• Used to see how the firm’s performance is changing through time
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes
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POTENTIAL PROBLEMS
• There is no underlying theory, so there is no way to know which ratios are
most relevant.
• Benchmarking is difficult for diversified firms.
• Globalization and international competition makes comparison more
difficult because of differences in accounting regulations.
• Firms use varying accounting procedures.
• Firms have different fiscal years.
• Extraordinary, or one-time, events
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End of Chapter
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1-42
CHAPTER 2
TIME VALUE OF MONEY
CHAPTER ORGANISATION
2.1
Future Value and Compounding
2.2
Present Value and Discounting
2.3
More on Present and Future Values
2.4
Present and Future Values of Multiple Cash Flows
2.5
Valuing Equal Cash Flows: Annuities and Perpetuities
2.6
Comparing Rates: The Effect of Compounding Periods
2.7
Loan Types and Loan Amortization
2.8
Applications of time value of money: Bond valuation
2.9
Applications of time value of money: Stock valuation
2.10
Applications of time value of money: Project evaluation: NPV, IRR, MIRR, DPP.
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CHAPTER OBJECTIVES
45
Distinguish
Distinguish between simple and compound interest.
Calculate
Calculate the present value and future value of a single amount for both
one period and multiple periods.
Calculate
Calculate the present value and future value of multiple cash flows.
Calculate
Calculate the present value and future value of annuities.
Compare
Compare nominal interest rates (NIR) and effective annual interest rates
(EAR).
Distinguish
Distinguish between the different types of loans and calculate the present
value of each type of loan.
Calculate
NPV, IRR, MIRR, DPP, stock and bond value
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TIME VALUE TERMINOLOGY
• Future value (FV) is the amount an investment is worth after one or more periods.
• Present value (PV) is the amount that corresponds to today’s value of a promised
future sum.
• The number of time periods between the present value and the future value is
represented by ‘t’.
• The rate of interest for discounting or compounding is
called ‘r’.
• All time value questions involve four values: PV, FV, r and t. Given three of them, it is
always possible to calculate the fourth.
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TIME VALUE TERMINOLOGY
• Compounding is the process of accumulating interest in an investment over time to
earn more interest.
• Interest on interest is earned on the reinvestment of previous interest payments.
• Discount rate is the interest rate that reduces a given future value to an equivalent
present value.
• Compound interest is calculated each period on the principal amount and on any
interest earned on the investment up to that point.
• Simple interest is the method of calculating interest in which, during the entire term of
the loan, interest is computed on the original sum borrowed.
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2.1 FUTURE VALUE OF A SINGLE CASH FLOW
• Suppose you invest $1,000 for one year at 5% per year. What is the future value in
one year?
• Interest = 1,000(.05) = 50
• Value in one year = principal + interest = 1,000 + 50 = 1,050
• Future Value (FV) = 1,000(1 + .05) = 1,050
• Suppose you leave the money in for another year. How much will you have two years
from now?
• FV = 1,000(1.05)(1.05) = 1,000(1.05)2 = 1,102.50
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FUTURE VALUES: GENERAL FORMULA
• FV = PV(1 + r)t
• FV = future value
• PV = present value
• r = period interest rate, expressed as a decimal
• t = number of periods
• Future value interest factor = (1 + r)t
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5C-49
EFFECTS OF COMPOUNDING
• Simple interest
• Compound interest
• Consider the previous example
• FV with simple interest = 1,000 + 50 + 50 = 1,100
• FV with compound interest = 1,102.50
• The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the
first interest payment
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5C-50
FUTURE VALUES – EXAMPLE 2
• Suppose you invest the $1,000 from the previous example for 5 years. How much
would you have?
• 5 N; 5 I/Y; 1,000 PV
• CPT FV = -1,276.28
• The effect of compounding is small for a small number of periods, but increases as the
number of periods increases. (Simple interest would have a future value of $1,250,
for a difference of $26.28.)
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5C-51
FUTURE VALUES – EXAMPLE 3
• Suppose you had a relative deposit $10 at 5.5% interest 200 years ago. How much
would the investment be worth today?
• 200 N; 5.5 I/Y; -10 PV
• CPT FV = -447,189.84
• What is the effect of compounding?
• Simple interest = 10 + 200(10)(.055) = 120.00
• Compounding added $447,069.84 to the value of the investment
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5C-52
FUTURE VALUE AS A GENERAL GROWTH FORMULA
• Suppose your company expects to increase unit sales of widgets by 15%
per year for the next 5 years. If you sell 3 million widgets in the current
year, how many widgets do you expect to sell in the fifth year?
• 5 N;15 I/Y; 3,000,000 PV
• CPT FV = -6,034,072 units (remember the sign convention)
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5C-53
QUICK QUIZ – PART I
• What is the difference between simple interest and compound interest?
• Suppose you have $500 to invest and you believe that you can earn 8%
per year over the next 15 years.
• How much would you have at the end of 15 years using compound interest?
• How much would you have using simple interest?
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FUTURE VALUES OF $100 AT 10%
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FUTURE VALUE OF $1 FOR DIFFERENT PERIODS AND RATES
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PRESENT VALUES
• How much do I have to invest today to have some amount in the future?
• FV = PV(1 + r)t
• Rearrange to solve for PV = FV / (1 + r)t
• When we talk about discounting, we mean finding the present value of some future
amount.
• When we talk about the “value” of something, we are talking about the present value
unless we specifically indicate that we want the future value.
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5C-60
PRESENT VALUE – ONE PERIOD EXAMPLE
• Suppose you need $10,000 in one year for the down payment on a new car.
If you can earn 7% annually, how much do you need to invest today?
• PV = 10,000 / (1.07)1 = 9,345.79
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PRESENT VALUES – EXAMPLE 2
• You want to begin saving for your daughter’s college education and you
estimate that she will need $150,000 in 17 years. If you feel confident
that you can earn 8% per year, how much do you need to invest today?
• N = 17; I/Y = 8; FV = 150,000
• CPT PV = -40,540.34 (remember the sign convention)
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PRESENT VALUES – EXAMPLE 3
• Your parents set up a trust fund for you 10 years ago that is now
worth $19,671.51. If the fund earned 7% per year, how much did
your parents invest?
• N = 10; I/Y = 7; FV = 19,671.51
• CPT PV = -10,000
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PRESENT VALUE OF $1 FOR DIFFERENT PERIODS AND RATES
64
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PRESENT VALUE – IMPORTANT RELATIONSHIP I
• For a given interest rate – the longer the time period, the lower
the present value
• What is the present value of $500 to be received in 5 years? 10 years?
The discount rate is 10%
• 5 years: N = 5; I/Y = 10; FV = 500
CPT PV = -310.46
• 10 years: N = 10; I/Y = 10; FV = 500
CPT PV = -192.77
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PRESENT VALUE – IMPORTANT RELATIONSHIP II
• For a given time period – the higher the interest rate, the smaller
the present value
• What is the present value of $500 received in 5 years if the interest rate
is 10%? 15%?
• Rate = 10%: N = 5; I/Y = 10; FV = 500
CPT PV = -310.46
• Rate = 15%; N = 5; I/Y = 15; FV = 500
CPT PV = -248.59
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QUICK QUIZ – PART II
• What is the relationship between present value and future value?
• Suppose you need $15,000 in 3 years. If you can earn 6% annually, how
much do you need to invest today?
If you could invest the money at 8%, would you have to invest more or
less than at 6%? How much?
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DISCOUNT RATE
• Often we will want to know what the implied interest rate is on an
investment
• Rearrange the basic PV equation and solve for r
• FV = PV(1 + r)t
• r = (FV / PV)1/t – 1
• If you are using formulas, you will want to make use of both the yx and the
1/x keys
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2.3 DETERMINING THE DISCOUNT RATE
• You currently have $100 available for investment for a 21-year period. At what
interest rate must you invest this amount in order for it to be worth $500 at maturity?
• r can be solved in one of three ways:
• Use a financial calculator
• Take the nth root of both sides of the equation
• Use the future value tables to find a corresponding value. In this example, you
need to find the r for which the FVIF after 21 years is 5 (500/100).
69
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DETERMINING THE DISCOUNT RATE
• To determine the discount rate (r) in this example, a financial calculator is used.
Enter:
21
N
Solve for →
100
I/Y
PV
- 500
FV
7.97
r = 7.97%
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DISCOUNT RATE – EXAMPLE 3
• Suppose you have a 1-year old son and you want to provide $75,000
in 17 years towards his college education. You currently have $5,000
to invest. What interest rate must you earn to have the $75,000 when
you need it?
• N = 17; PV = -5,000; FV = 75,000
• CPT I/Y = 17.27%
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QUICK QUIZ – PART III
• What are some situations in which you might want to know the implied
interest rate?
• You are offered the following investments:
• You can invest $500 today and receive $600 in 5 years. The investment is low
risk.
• You can invest the $500 in a bank account paying 4%.
• What is the implied interest rate for the first choice, and which investment should
you choose?
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5C-72
QUICK QUIZ – PART III
• What are some situations in which you might want to know the
implied interest rate?
• You are offered the following investments:
• You can invest $500 today and receive $600 in 5 years. The investment is
low risk.
• You can invest the $500 in a bank account paying 4%.
• What is the implied interest rate for the first choice, and which investment
should you choose?
Faculty of Finance
Ho Chi Minh University of Banking
5C-73
FINDING THE NUMBER OF PERIODS
• Start with the basic equation and solve for t (remember your logs)
• FV = PV(1 + r)t
• t = ln(FV / PV) / ln(1 + r)
• You can use the financial keys on the calculator as well; just remember the sign
convention.
Faculty of Finance
Ho Chi Minh University of Banking
5C-74
FINDING THE NUMBER OF PERIODS
• You have been saving up to buy a new car. The total cost will be $10,000. You
currently have $8000. If you can earn 6% on your money, how long will you have to
wait?
• To determine the number of periods (t) in this example, a financial calculator is used.
Enter:
6
N
Solve for →
I/Y
8000
PV
- 10 000
FV
3.83
t = 3.83 years
75
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Banking University of Ho Chi Minh City
NUMBER OF PERIODS – EXAMPLE 1
• You want to purchase a new car, and you are willing to pay
$20,000. If you can invest at 10% per year and you currently
have $15,000, how long will it be before you have enough
money to pay cash for the car?
• I/Y = 10; PV = -15,000; FV = 20,000
• CPT N = 3.02 years
Faculty of Finance
Ho Chi Minh University of Banking
5C-76
NUMBER OF PERIODS – EXAMPLE 2
• Suppose you want to buy a new house. You currently have $15,000, and
you figure you need to have a 10% down payment plus an additional 5%
of the loan amount for closing costs. Assume the type of house you want will
cost about $150,000 and you can earn 7.5% per year. How long will it be
before you have enough money for the down payment and closing costs?
Faculty of Finance
Ho Chi Minh University of Banking
5C-77
NUMBER OF PERIODS – EXAMPLE 2 CONTINUED
• How much do you need to have in the future?
• Down payment = .1(150,000) = 15,000
• Closing costs = .05(150,000 – 15,000) = 6,750
• Total needed = 15,000 + 6,750 = 21,750
• Compute the number of periods
• PV = -15,000; FV = 21,750; I/Y = 7.5
• CPT N = 5.14 years
• Using the formula
• t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
Faculty of Finance
Ho Chi Minh University of Banking
5C-78
QUICK QUIZ – PART IV
• When might you want to compute the number of periods?
• Suppose you want to buy some new furniture for your family room. You currently have
$500, and the furniture you want costs $600. If you can earn 6%, how long will you
have to wait if you don’t add any additional money?
Faculty of Finance
Ho Chi Minh University of Banking
5C-79
SUMMARY OF TIME VALUE CALCULATIONS
80
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Banking University of Ho Chi Minh City
COMPREHENSIVE PROBLEM
• You have $10,000 to invest for five years.
• How much additional interest will you earn if the investment provides a 5%
annual return, when compared to a 4.5% annual return?
• How long will it take your $10,000 to double in value if it earns 5%
annually?
• What annual rate has been earned if $1,000 grows into $4,000 in 20
years?
Faculty of Finance
Ho Chi Minh University of Banking
5C-81
2.4 FUTURE VALUE OF MULTIPLE CASH FLOWS
• You deposit $1000 now, $1500 in one year, $2000 in two years and $2500 in three
years in an account paying 10 per cent interest per annum. How much do you have
in the account at the end of the third year?
• You can solve by either:
• compounding the accumulated balance forward one year at a time
• calculating the future value of each cash flow first and then totaling them.
82
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SOLUTIONS
• Solution 1
• End of year 1:
• End of year 2:
• End of year 3:
($1 000  1.10) + $1 500 =
($2 600  1.10) + $2 000 =
($4 860  1.10) + $2 500 =
$2 600
$4 860
$7 846
• Solution 2
83
$1 000  (1.10)3
=
$1 331
$1 500  (1.10)2
=
$1 815
$2 000  (1.10)1
=
$2 200
$2 500  1.00
=
$2 500
Total
=
$7 846
Faculty of Finance
Banking University of Ho Chi Minh City
SOLUTIONS ON TIME LINES
Future value calculated by compounding forward one period at a time
0
1
2
3
$0
$1100
$2860
$5346
1000
$1000
1500
x 1.1
$2600
2000
x 1.1
$4860
Time
(years)
2500
x 1.1
$7846
Future value calculated by compounding each cash flow separately
0
1
2
3
Time
(years)
$1000
$1500
$2000
$2500
x 1.1
2200
x 1.12
1815
x
1.13
1331
Total future value
84
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$7846
Banking University of Ho Chi Minh City
PRESENT VALUE OF MULTIPLE CASH FLOWS
• You will deposit $1500 in one year’s time, $2000 in two years time and $2500 in
three years time in an account paying 10 per cent interest per annum. What is the
present value of these cash flows?
• You can solve by either:
•
•
85
discounting back one year at a time
calculating the present value of each cash flow first and then totaling them.
Faculty of Finance
Banking University of Ho Chi Minh City
SOLUTIONS
• Solution 1
• End of year 2:
• End of year 1:
• Present value:
($2500  1.10–1) + $2000=
$4273
($4273  1.10–1) + $1500=
$5385
($5385  1.10–1) =
$4895
• Solution 2
86
$2500  (1.10) –3
=
$1878
$2000  (1.10) –2
=
$1653
$1500  (1.10) –1
=
$1364
Total
=
$4895
Faculty of Finance
Banking University of Ho Chi Minh City
2.5 ANNUITIES
• Annuities: A sequence of payments required to be made or received at equal
intervals of time (payments are usually equal in value)
• Some examples of annuities include insurance premiums, rental payments, dividends
on government bonds and instalments for loans or mortgages
• It is assumed that payments and interest periods coincide (Simple Ordinary Annuity)
• A perpetuity is an annuity in which the cash flows continue forever.
87
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PRESENT VALUE OF AN ANNUITY
C = equal cash flow


1  1/ 1  r t 
PV  C  

r


• The discounting term is called the present value interest factor for annuities (PVIFA).
88
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• Example 1
You will receive $1000 at the end of each of the next ten years. The current
interest rate is 6 per cent per annum. What is the present value of this series of
cash flows?


1  1/1.06 
PV  $1 000  

0.06


 $1 000  7.3601
 $7 360.10
89
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10
• Example 2
You borrow $10 000 to buy a car and agree to repay the loan by way of equal
monthly repayments over four years. The current interest rate is 12 per cent per
annum, compounded monthly. What is the amount of each monthly repayment?

1  1/ 1.0148
$10 000  C  
0.01

C  $263.33
90
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Banking University of Ho Chi Minh City


FINDING THE RATE FOR AN ANNUITY
• You have a loan of $5000 repayable by instalments of $745.15 at the end of each
year for 10 years. What rate is implicit in this 10 year annuity?
• To determine the discount rate (r) in this example, a financial calculator is used.
Enter:
10
N
Solve for →
I/Y
5000
0
-745.15
PV
FV
PMT
8.00
r = 8%
91
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Banking University of Ho Chi Minh City
FINDING THE NUMBER OF PAYMENTS FOR AN ANNUITY
• You have $2000 owing on your credit card. You can only afford to make the minimum payment of $40
per month. The interest rate on the credit card is 1 per cent per month. How long will it take you to pay
off the $2000.
• To determine the number of payments (t) in this example, a financial calculator is used.
Enter:
N
Solve for →
1
2 000
I/Y
PV
0
FV
-40
PMT
69.66
t = 69.66 months ÷ 12 = 5.81 years
92
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Banking University of Ho Chi Minh City
FUTURE VALUE OF AN ANNUITY
• The compounding term is called the future value interest factor for annuities (FVIFA).
Refer to Table A 4.


1  r   1
FV  C 
t
r
93
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Banking University of Ho Chi Minh City
EXAMPLE—FUTURE VALUE OF AN ANNUITY
What is the future value of $1000 deposited at the
end of every year for 20 years if the interest rate is 6
per cent per annum?

(1.06)
FV  $1 000 
20
0.06
 $1 000  36.7856
 $36 785.60
94
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
1
ANNUITIES DUE
• An annuity for which the cash flows occur at the beginning of the period. Example: a
lease.
• Suppose an annuity due has five payments of $400 each, and the relevant discount
rate is 10 percent. The time line looks like this:
• Notice how the cash flows here are the same as those for a four-year ordinary
annuity, except that there is an extra $400 at Time 0. For practice, check to see that
the value of a four-year ordinary annuity at 10 percent is $1,267.95. If we add on
the extra $400, we get $1,667.95, which is the present value of this annuity due.
Annuity due value = Ordinary annuity value × (1 + r)
95
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PERPETUITIES
• The future value of a perpetuity cannot be calculated as the cash flows are infinite.
• The present value of a perpetuity is calculated as follows:
C
PV 
r
96
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GROWING ANNUITIES AND PERPETUITIES
• Annuities commonly have payments that grow over time. Suppose, for example, that
we are looking at a lottery payout over a 20-year period. The first payment, made
one year from now, will be $200,000. Every year thereafter, the payment will grow
by 5 percent, so the payment in the second year will be $200,000 × 1.05 =
$210,000. The payment in the third year will be $210,000 × 1.05 = $220,500, and
so on. What’s the present value if the appropriate discount rate is 11 percent?
• g is the growth rate
97
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2.6 COMPARING RATES
• The nominal interest rate (NIR) (stated interest rate, quoted interest rate) is the interest
rate expressed in terms of the interest payment made each period.
• The effective annual interest rate (EAR) is the interest rate expressed as if it was
compounded once per year.
• When interest is compounded more frequently than annually, the EAR will be greater
than the NIR.
• Annual percentage rate (APR) : The interest rate charged per period multiplied by
the number of periods per year.
98
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CALCULATION OF EAR
m
 NIR 
EAR  1 

1

m 

m = number of times the interest is compounded
99
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Banking University of Ho Chi Minh City
COMPARING EARS
• Consider the following interest rates quoted by three banks:
100
•
Bank A: 8.3%, compounded daily
•
Bank B: 8.4%, compounded quarterly
•
Bank C: 8.5%, compounded annually
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Banking University of Ho Chi Minh City
COMPARING EARS
EAR Bank A
 0.083 
 1 

365


365
 1  8.65%
4
 0.084 
EAR Bank B  1 
 1  8.67%

4 

1
EAR Bank C
101
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 0.085 
 1 

1

8.50%
1 

Banking University of Ho Chi Minh City
COMPARING EARS
• Which is the best rate? For a saver, Bank B offers the best (highest) interest rate. For
a borrower, Banks A and C offer the best (lowest) interest rates.
• The highest NIR is not necessarily the best.
• Compounding during the year can lead to a significant difference between the NIR
and the EAR, especially for higher rates.
102
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COMPLETE THE TABLE BELOW:
Nominal
rate
11.5%
15%
5%
7%
20%
103
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annual Compounding
periods
Daily
Monthly
Fortnightly
Quarterly
Semi annually
Quarterly
Daily
Semi annually
Quarterly
Daily
Banking University of Ho Chi Minh City
Effective rate
14.5%
14.8%
6%
8%
12%
COMPLETE THE TABLE BELOW:
Nominal
rate
11.5%
15%
13.58%
14.04%
5%
7%
20%
5.91%
7.77%
11.33%
104
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annual Compounding
periods
Daily
Monthly
Fortnightly
Quarterly
Semi annually
Quarterly
Daily
Semi annually
Quarterly
Daily
Banking University of Ho Chi Minh City
Effective rate
12.19%
16.08%
14.5%
14.8%
5.06%
7.19%
22.13%
6%
8%
12%
2.8 APPLICATION OF TIME VALUE OF MONEY:
BOND VALUATION
Faculty of Finance
Ho Chi Minh University of Banking
BOND TERMINOLOGY
• Coupon: The stated interest payment made on a bond.
• Face value: The principal amount of a bond that is repaid at the end of the term.
Also called par value.
• Coupon rate: The annual coupon divided by the face value of a bond.
• Maturity: The specified date on which the principal amount of a bond is paid.
• Yield to maturity (YTM): The rate required in the market on a bond.
106
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BOND CHARACTERISTICS
• A bond is a type of fixed income security. Its promise is to deliver known future cash
flows.
• Investor (bondholder) lends money (principal amount) to issuer for a defined period of
time, at a variable or fixed interest rate
• In return, bondholder is promised
• Periodic coupon payments (most of the times paid semiannually); and/or
• The bond’s principal (maturity value/par value/face value) at maturity.
107
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THE BOND PRICING FORMULA – 1
• Consider a bond paying coupons with frequency n.
• Cash flows: coupon C paid with frequency n up to year T, plus the principal M, paid at
T.
0
1
Purchase Coupon
Price
Cash Outflows
to the Investor
2
3
4
n
Coupon
Coupon
Coupon
Coupon +
Face Value
Cash Inflows
to the Investor
• How much is the stream of cash flows worth today? To answer this question we need to
calculate the present value of the cash flows.
• The present value (purchase price) is the price we are willing to pay today in order to
receive the stream of cash flows.
108
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THE BOND PRICING FORMULA-2
• Bond price is equal to present value of all the cash flows you receive if you hold to
maturity.
nT
• P: bond price;
𝐶
𝑀
𝑃=෍
y s+
y nT
(1 + )
s=1 (1 + 𝑛)
𝑛
• C: coupon payment (assumed constant);
• n: number of coupon payments per year;
• T: number of years to maturity;
• y: interest rate used to discount the cash flows; yield-to-maturity (YTM) or market
required yield;
• M: par value (or face value, or maturity value) of the bond.
109
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Ho Chi Minh University of Banking
Dr. Duong Thi Thuy An
THE BOND PRICING FOMULA-3
• Bond Price is equal to Present Value of all the cash flows you receive if you hold to
maturity
(2.2)
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ZERO COUPON BONDS
• Make no periodic interest payments (coupon rate = 0%)
• The entire yield-to-maturity comes from the difference between the purchase price
and the par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are good examples of zeroes
111
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Dr. Duong Thi Thuy An
THE BOND PRICING FOMULA-4
Three special cases of the bond pricing formula:
• A zero-coupon bond:
• An annuity (coupons only):
• A perpetuity bond (coupons only, infinite maturity):
112
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EXAMPLE
• Suppose the Xanth (pronounced “zanth”) Co. were to issue a bond with 10 years to
maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to
maturity of 8 percent. Based on our preceding discussion, the Xanth bond will pay $80
per year for the next 10 years in coupon interest. In 10 years, Xanth will pay $1,000 to
the owner of the bond. What would this bond sell for?
113
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COMPUTING YIELD TO MATURITY
• Yield to Maturity (YTM) is the rate implied by the current bond price
• Finding the YTM requires trial and error if you do not have a financial
calculator and is similar to the process for finding r with an annuity
• If you have a financial calculator, enter N, PV, PMT, and FV, remembering
the sign convention (PMT and FV need to have the same sign, PV the
opposite sign)
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Ho Chi Minh University of Banking
7-114
YTM WITH ANNUAL COUPONS
• Consider a bond with a 10% annual coupon rate, 15 years to maturity and
a par value of $1,000. The current price is $928.09.
• Will the yield be more or less than 10%?
• N = 15; PV = -928.09; FV = 1,000; PMT = 100
• CPT I/Y = 11%
Faculty of Finance
Ho Chi Minh University of Banking
7-115
YTM WITH SEMIANNUAL COUPONS
• Suppose a bond with a 10% coupon rate and semiannual coupons, has a
face value of $1,000, 20 years to maturity and is selling for $1,197.93.
•
•
•
•
•
Is the YTM more or less than 10%?
What is the semiannual coupon payment?
How many periods are there?
N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is this the YTM?)
YTM = 4%*2 = 8%
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Ho Chi Minh University of Banking
7-116
TABLE 7.1
Faculty of Finance
Ho Chi Minh University of Banking
7-117
CURRENT YIELD VS. YIELD TO MATURITY
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains yield
• Example: 10% coupon bond, with semiannual coupons, face value of 1,000, 20 years to
maturity, $1,197.93 price
• Current yield = 100 / 1,197.93 = .0835 = 8.35%
• Price in one year, assuming no change in YTM = 1,193.68
• Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -.0035 = -.35%
• YTM = 8.35 - .35 = 8%, which is the same YTM computed earlier
Faculty of Finance
Ho Chi Minh University of Banking
7-118
GRAPHICAL RELATIONSHIP BETWEEN PRICE AND YIELD-TO-MATURITY (YTM)
1500
1400
1300
Bond Price
1200
1100
1000
900
800
700
600
0%
2%
4%
6%
8%
10%
YTM
Yield-to-maturity (YTM)
7-119
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12%
14%
BOND PRICES: RELATIONSHIP BETWEEN COUPON AND YIELD
• If YTM = coupon rate, then par value = bond price
• If YTM > coupon rate, then par value > bond price
• Why? The discount provides yield above coupon rate
• Price below par value, called a discount bond
• If YTM < coupon rate, then par value < bond price
• Why? Higher coupon rate causes value above par
• Price above par value, called a premium bond
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Ho Chi Minh University of Banking
7-120
BOND CHARACTERISTICS AND REQUIRED RETURNS
• The coupon rate depends on the risk characteristics of the bond
when issued
• Which bonds will have the higher coupon, all else equal?
•
•
•
•
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
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Ho Chi Minh University of Banking
7-121
COMPREHENSIVE PROBLEM
• What is the price of a $1,000 par value bond with a 6% coupon rate paid
semiannually, if the bond is priced to yield 5% and it has 9 years to
maturity?
• What would be the price of the bond if the yield rose to 7%.
• What is the current yield on the bond if the YTM is 7%?
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7-125
2.9 APPLICATION OF TIME VALUE OF MONEY:
STOCK VALUATION
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STOCK CHARACTERISTICS
• Cash Flows for Stockholders
• If you buy a share of stock, you can receive cash in two ways
• The company pays dividends
• You sell your shares, either to another investor in the market or back to the
company
• As with bonds, the price of the stock is the present value of these expected cash
flows
• Preferred stock: receive a fix dividend over time.
127
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9/7/2023
COMMON STOCK-VALUE
• Face value (par value)
• Book value: The net asset value of a company, calculated by total assets minus
intangible assets (patents, goodwill) and liabilities. It is the total value of the company's
assets that shareholders would theoretically receive if a company were liquidated
• Market value: The current quoted price at which investors buy or sell a share of common
stock at a given time
• Intrinsic value: The actual value of a company or an asset based on an underlying
perception of its true value including all aspects of the business, in terms of both tangible
and intangible factors. This value may or may not be the same as the current market
value
1
2
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DIVIDEND CHARACTERISTICS
• Dividends are not a liability of the firm until a dividend has been declared by
the Board
• Consequently, a firm cannot go bankrupt for not declaring dividends
• Dividends and Taxes
• Dividend payments are not considered a business expense; therefore, they are not
tax deductible
• The taxation of dividends received by individuals depends on the holding period
• Dividends received by corporations have a minimum 70% exclusion from taxable
income
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8-129
FEATURES OF PREFERRED STOCK
• Dividends
• Stated dividend that must be paid before dividends can be paid to common
stockholders
• Dividends are not a liability of the firm, and preferred dividends can be
deferred indefinitely
• Most preferred dividends are cumulative – any missed preferred dividends
have to be paid before common dividends can be paid
• Preferred stock generally does not carry voting rights
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9/7/2023
The Dividend discount model (DDM)
Infinite holding period:

Dt
V0  
t 1 (1  r) t
(2)
Dt
:dividend of period t
Vo: Present value of a stock
r: required rate of return on the stock
131
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DDM -SINGLE HOLDING PERIOD
• Buy a stock and hold for one year
D1
P1
D1  P1
V0 


1
1
1
(1  r)
(1  r)
(1  r)
• P1 :the expected price per share at t=1
• D1:the expected dividend per share for year 1, assumed to be paid at the end of the year at t=1
• Example: suppose that you expect Carrefour SA (NYSE Euronext Paris: CA) to pay a €1.10
dividend next year. You expect the price of CA stock to be €53.55 in one year. The required
rate of return for CA stock is 9 percent. What is your estimate of the value of CA stock?
Discounting the expected dividend of €1.10 and the expected sales price of €53.55 at the
required return on equity of 9 percent, we obtain
1
3
D  P1
1.1  53.55
V0  1

 50.14
1
1
(1  r )
(1  0.09)
Faculty of Finance
Ho Chi Minh University of Banking
Dr. Duong Thi Thuy An
DDM-MULTIPLE HOLDING PERIODS
• Buy a stock and hold for n periods:
n
V0  
t 1
Dt
Pn
t  (1  r) n
(1  r)
Example: For the next five years, the annual dividends of a stock are expected to be $2.00, $2.10,
$2.20, $3.50, and $3.75. In addition, the stock price is expected to be $40.00 in five years. If the
required return on equity is 10 percent, what is the value of this stock?
• The present values of the expected future cash flows can be written out as:
V0=
• Calculating and summing these present values gives a stock value of Po 1.818 +1.736 +1.653 +2.391
+2.328 +24.837 = $34.76.
• The five dividends have a total present value of $9.926 and the terminal stock value has a present
value of $24.837, for a total stock value of $34.76.
1
3
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Ho Chi Minh University of Banking
DIVIDEND CONSTANT GROWTH MODEL (GORDON MODEL)
• Dividends are expected to grow at a constant percent per period.
• P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
• P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + …
• With a little algebra and some series work, this reduces to:
D 0 (1  g)
D1
P0 

R -g
R -g
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DGM – EXAMPLE 1
• Suppose Big D, Inc., just paid a dividend of $0.50 per share. It is
expected to increase its dividend by 2% per year. If the market requires
a return of 15% on assets of this risk, how much should the stock be
selling for?
• P0 = .50(1+.02) / (.15 - .02) = $3.92
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DGM – EXAMPLE 2
• Suppose TB Pirates, Inc., is expected to pay a $2 dividend in one year. If the
dividend is expected to grow at 5% per year and the required return is 20%, what is
the price?
• P0 = 2 / (.2 - .05) = $13.33
• Why isn’t the $2 in the numerator multiplied by (1.05) in this example?
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CONSTANT GROWTH MODEL (GORDON MODEL)
Example:
1. Suppose that an annual dividend of € 5 has just been paid (Do= € 5). The expected long - term
growth rate is 5% and the required return on equity is 8 percent.
Answer: The Gordon growth model value per share is Vo =Do(1 +g )/( r – g ) =(€ 5 *1.05)/(0.08 –
0.05) =€ 5.25/0.03= € 1752
2. A manufacturer of paper and plastic packaging has a sustainable increases in the level of earnings
with increases in dividends, payout ratio is 40 - 60 %. Most recent quarterly dividend was $0.26
.The forecasted dividend growth rate is 6.0 %per year, r= 10.1 %.
a) Calculate the Gordon growth model value for the above stock.
b) The current market price of stock is $30.18. Using your answer to question 1, judge whether the
stock is fairly valued, undervalued, or overvalued.
1
3
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GORDON GROWTH MODEL- NO GROWTH (PREFERRED STOCK)
• If dividends are expected at regular intervals forever, then this is a
perpetuity and the present value of expected future dividends can be
found using the perpetuity formula
Po=D/r
• Stocks that have earnings and dividends that are expected to remain
constant  Preferred Stock
• Example: Suppose stock is expected to pay a $0.50 dividend every
quarter and the required return is 10% with quarterly compounding.
What is the price?
• P0 = .50 / (.1 / 4) = $20
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Ho Chi Minh University of Banking
QUICK QUIZ – PART I
• What is the value of a stock that is expected to pay a constant dividend of $2 per
year if the required return is 15%?
• What if the company starts increasing dividends by 3% per year, beginning with the
next dividend? The required return stays at 15%.
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USING THE GORDON GROWTH MODEL TO FIND R
• Start with the DGM:
D 0 (1  g)
D1
P0 

R -g
R -g
D 0 (1  g)
D1
R
g
g
P0
P0
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FINDING THE REQUIRED RETURN - EXAMPLE
• Suppose a firm’s stock is selling for $10.50. It just paid a $1
dividend, and dividends are expected to grow at 5% per year.
What is the required return?
• R = [1(1.05)/10.50] + .05 = 15%
• What is the dividend yield?
• 1(1.05) / 10.50 = 10%
• What is the capital gains yield?
• g =5%
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TABLE 8.1 - STOCK VALUATION SUMMARY
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8-142
COMPREHENSIVE PROBLEM
• XYZ stock currently sells for $50 per share. The next
expected annual dividend is $2, and the growth rate is 6%.
What is the expected rate of return on this stock?
• If the required rate of return on this stock were 12%, what
would the stock price be, and what would the dividend yield
be?
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8-143
2.10 PROJECT EVALUATION-NPV, IRR, MIRR,
DPP
144
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NET PRESENT VALUE (NPV)
• Net present value is the difference between an investment’s market value (in today’s
dollars) and its cost (also in today’s dollars).
• Net present value is a measure of how much value is created by undertaking an
investment.
• Estimation of the future cash flows and the discount rate are important in the
calculation of the NPV.
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NET PRESENT VALUE
Steps in calculating NPV:
• The first step is to estimate the expected future cash flows.
• The second step is to estimate the required return for projects of this risk level.
• The third step is to find the present value of the cash flows and subtract the initial
investment.
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NPV ILLUSTRATED
0
1
Initial outlay
($1100)
Revenues
Expenses
$1000
500
Cash flow
– $1100.00
$500 x
$500
2
Revenues
Expenses
Cash flow $1000
1
1.10
+454.55
$1000 x
1
1.102
+826.45
+$181.00 NPV
147
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$2000
1000
NPV
• An investment should be accepted if the NPV is positive and rejected if it is negative.
• NPV is a direct measure of how well the investment meets the goal of financial
management—to increase owners’ wealth.
• A positive NPV means that the investment is expected to add value to the firm.
148
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PAYBACK PERIOD
• The amount of time required for an investment to generate cash flows to recover its
initial cost.
• Steps of caculating payback period:
• Estimate the cash flows.
• Accumulate the future cash flows until they equal the initial investment.
• The length of time for this to happen is the payback period.
• An investment is acceptable if its calculated payback is less than some prescribed
number of years.
149
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PAYBACK PERIOD ILLUSTRATED
Initial investment = –$1000
Year
1
2
3
Year
1
2
3
Cash flow
$200
400
600
Accumulated
Cash flow
$200
600
1200
Payback period = 2 2/3 years
150
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ADVANTAGES OF PAYBACK PERIOD
• Easy to understand.
• Adjusts for uncertainty of later cash flows.
• Biased towards liquidity.
151
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DISADVANTAGES OF PAYBACK PERIOD
• Time value of money and risk ignored.
• Arbitrary determination of acceptable payback period.
• Ignores cash flows beyond the cut-off date.
• Biased against long-term and new projects.
152
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DISCOUNTED PAYBACK PERIOD
• The length of time required for an investment’s discounted cash flows to equal its
initial cost.
• Takes into account the time value of money.
• More difficult to calculate.
• An investment is acceptable if its discounted payback is less than some prescribed
number of years.
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EXAMPLE—DISCOUNTED PAYBACK
Initial investment = —$1000
R = 10%
PV of
Year
Cash flow
Cash flow
1
$200
$182
154
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2
400
331
3
700
526
4
300
205
Banking University of Ho Chi Minh City
EXAMPLE—DISCOUNTED PAYBACK (CONTINUED )
Accumulated
Year
discounted cash flow
1
$182
2
513
3
1039
4
1244
Discounted payback period is just under three years
155
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ORDINARY AND DISCOUNTED PAYBACK
Initial investment = –$300
R = 12.5%
Cash Flow
Accumulated Cash Flow
Year
Undiscounted
Discounted
Undiscounted
Discounted
1
2
3
4
5
$ 100
100
100
100
100
$ 89
79
70
62
55
$ 100
200
300
400
500
$89
168
238
300
355
• Ordinary payback?
• Discounted payback?
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ADVANTAGES AND DISADVANTAGES OF DISCOUNTED PAYBACK
• Advantages
• Disadvantages
- Includes time value of money
- May reject positive NPV investments
-
Easy to understand
-
Does not accept negative estimated NPV investments
- Arbitrary determination of acceptable payback
period
-
Biased towards liquidity
- Ignores cash flows beyond the cutoff date
- Biased against long-term and new products
157
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ACCOUNTING RATE OF RETURN (ARR)
• Measure of an investment’s profitability.
average net profit
ARR 
average book value
• A project is accepted if ARR > target average accounting return.
158
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EXAMPLE—ARR
Year
1
2
3
$440
$240
$160
Expenses
220
120
80
Gross profit
220
120
80
Depreciation
80
80
80
140
40
0
35
10
0
$105
$30
$0
Sales
Taxable income
Taxes (25%)
Net profit
Assume initial investment = $240
159
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EXAMPLE—ARR ( CONTINUED )
$105  $30  $0
Average net profit 
3
 $45
Initial investment  Salvage value
2
$240  $0

2
 $120
Average book value 
160
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EXAMPLE—ARR ( CONTINUED )
Average net profit
Average book value
$45

$120
 37.5%
ARR 
161
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DISADVANTAGES OF ARR
• The measure is not a ‘true’ reflection of return.
• Time value is ignored.
• Arbitrary determination of target average return.
• Uses profit and book value instead of cash flow and market value.
162
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ADVANTAGES OF ARR
• Easy to calculate and understand.
• Accounting information almost always available.
163
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INTERNAL RATE OF RETURN (IRR)
• The discount rate that equates the present value of the future cash flows with the
initial cost.
• Generally found by trial and error.
• A project is accepted if its IRR is > the required rate of return.
• The IRR on an investment is the required return that results in a zero NPV when it is
used as the discount rate.
164
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EXAMPLE—IRR
Initial investment = –$200
Year
Cash flow
1
2
3
$ 50
100
150
n Find the IRR such that NPV = 0
0 = –200 +
50
100
(1+IRR)1
50
200 =
165
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(1+IRR)1
+
(1+IRR)2
100
+
(1+IRR)2
Banking University of Ho Chi Minh City
150
+
(1+IRR)3
150
+
(1+IRR)3
EXAMPLE—IRR (CONTINUED )
Trial and Error
Discount rates
NPV
0%
$100
5%
68
10%
41
15%
18
20%
–2
IRR is just under 20%—about 19.44%
166
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NPV PROFILE
Net present value
120
100
80
Year
Cash flow
0
1
2
3
4
– $275
100
100
100
100
60
40
20
0
– 20
– 40
Discount rate
2%
6%
10%
14%
18%
IRR
167
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22%
PROBLEMS WITH IRR
• More than one negative cash flow  multiple IRR.
• Project is not independent  mutually exclusive investments. Highest IRR does not
indicate the best project.
Advantages of IRR
• Popular in practice
• Does not require a discount rate
168
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MULTIPLE RATES OF RETURN
Assume you are considering a project for
which the cash flows are as follows:
169
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Year
Cash flows
0
–$252
1
1431
2
–3035
3
2850
4
–1000
Banking University of Ho Chi Minh City
MULTIPLE RATES OF RETURN
n What’s the IRR? Find the rate at which
the computed NPV = 0:
at 25.00%:
NPV =
0
at 33.33%:
NPV =
0
at 42.86%:
NPV =
0
at 66.67%:
NPV =
0
n Two questions:
u
u
170
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1. What’s going on here?
2. How many IRRs can there be?
Banking University of Ho Chi Minh City
IRR AND NON-CONVENTIONAL CASH FLOWS
• When the cash flows change sign more than once, there is more than one IRR.
• When you solve for IRR you are solving for the root of an equation and when you
cross the x axis more than once, there will be more than one return that solves the
equation.
• If you have more than one IRR, you cannot use any of them to make your decision.
171
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MULTIPLE RATES OF RETURN
NPV
$0.06
$0.04
IRR = 25%
$0.02
$0.00
($0.02)
IRR = 33.33%
IRR = 66.67%
IRR = 42.86%
($0.04)
($0.06)
($0.08)
0.2
172
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0.28
0.36
0.44
0.52
Discount rate
Banking University of Ho Chi Minh City
0.6
0.68
THE MODIFIED INTERNAL RATE OF RETURN (MIRR)
• Controls for some problems with IRR
• Calculate the net present value of all cash outflows using the borrowing rate.
• Calculate the net future value of all cash inflows using the investing rate.
• Find the rate of return that equates these values.
• Benefits: single answer and specific rates for borrowing and reinvestment
• Three methods:
1.Discounting approach = Discount future outflows to present and add to CF0
2. Reinvestment approach = Compound all CFs except the first one forward to end
3. Combination approach = Discount outflows to present; compound inflows to end
• MIRR will be unique number for each method
• Discount (finance) /compound (reinvestment) rate externally supplied
173
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MIRR- EXAMPLE
Project cash flows:
• Time 0: -$500 today; Time 1: + $1,000; Time 2: -$100
• Use combined method and RRR = 11%
• PV (outflows) = -$500 + -$100/(1.11)2 = -$581.16
• FV (inflow) = $1,000 x 1.11 = $1,110
• MIRR: N=2; PV=-581.16; FV=1,110; CPT I/Y = MIRR = 38.2
174
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MIRR VS IRR
• Different opinions about MIRR and IRR.
• MIRR avoids the multiple IRR problem.
• Managers like rate of return comparisons, and MIRR is better for this than IRR.
• Problem with MIRR: different ways to calculate with no evidence of the best method.
• Interpreting a MIRR is not obvious.
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Ho Chi Minh University of Banking
8-175
IRR, NPV AND MUTUALLY-EXCLUSIVE PROJECTS
Net present value
Year
0
160
140
120
100
80
60
40
20
0
1
2
3
4
Project A:
– $350
50
100
150
200
Project B:
– $250
125
100
75
50
Crossover Point
– 20
– 40
– 60
– 80
– 100
Discount rate
0
2%
6%
10%
14%
IRR A
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18%
IRRB
22%
26%
PROFITABILITY INDEX (PI)
• Expresses a project’s benefits relative to its initial cost.
PV of inflows
PI 
Initial cost
• Accept a project with a PI > 1.0.
177
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EXAMPLE—PI
Assume you have the following information on Project X:
Initial investment = –$1100
Required return = 10%
Annual cash revenues and expenses are as follows:
Year
1
2
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Revenues
Expenses
$1000
2000
Banking University of Ho Chi Minh City
$500
1000
EXAMPLE—PI (CONTINUED )
500 1 000
NPV 

 1100
2
1.10 1.10
 $181
181  1100
PI 
1100
 1.1645
179
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Net Present Value Index
= 181
1100
= 0.1645
EXAMPLE—PI (CONTINUED )
Is this a good project? If so, why?
• This is a good project because the present value of the inflows exceeds the outlay.
• Each dollar invested generates $1.1645 in value or $0.1645 in NPV.
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ADVANTAGES AND DISADVANTAGES OF PI
Advantages
Disadvantages
• Closely related to NPV, generally
leading to identical decisions.
• May lead to incorrect decisions in
comparisons of mutually exclusive
investments.
• Easy to understand.
• May be useful when available
investment funds are limited.
181
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CAPITAL BUDGETING IN PRACTICE
• We should consider several investment criteria when making decisions.
• NPV and IRR are the most commonly used primary investment criteria.
• Payback is a commonly used secondary investment criteria.
182
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• An investment project costs $15,000 and has annual cash flows of $4,300 for six
years. What is the discounted payback period if the discount rate is zero percent?
What if the discount rate is 5 percent? If it is 19 percent?
Faculty of Finance
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A project that provides annual cash flows of $28,500 for nine years costs $138,000
today. Is this a good project if the required return is 8 percent? What if it’s 20 percent?
At what discount rate would you be indifferent between accepting the project and
rejecting it
Faculty of Finance
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CHAPTER 3
FINANCING AND COST OF
CAPITAL
3.1. FINANCING
Reading: [1]: Chapter 15
[2]: Chapter 14,15
KEY CONCEPTS AND SKILLS
• Understand the venture capital market and its role in financing new businesses
• Understand how securities are sold to the public and the role of investment bankers
• Understand initial public offerings and the costs of going public
• Understand how rights are issued to existing shareholders and how the rights are valued
Faculty of Finance
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15-187
CHAPTER OUTLINE
• The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital
• Selling Securities to the Public: The Basic Procedure
• Alternative Issue Methods
• Underwriters
• IPOs and Underpricing
• New Equity Sales and the Value of the Firm
• The Cost of Issuing Securities
• Rights
• Dilution
• Issuing Long-Term Debt
• Shelf Registration
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15-188
VENTURE CAPITAL
• Private financing for relatively new businesses in exchange for equity
• Usually entails some hands-on guidance
• The company should have an “exit” strategy
• Sell the company – VC benefits from proceeds from sale
• Take the company public – VC benefits from IPO
• Many VC firms are formed from a group of investors that pool capital
and then have partners in the firm decide which companies will receive
financing
• Some large corporations have a VC division
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15-189
CHOOSING A VENTURE CAPITALIST
• Look for financial strength
• Choose a VC that has a management style that is compatible with your own
• Obtain and check references
• What contacts does the VC have?
• What is the exit strategy?
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15-190
SELLING SECURITIES TO THE PUBLIC
• Management must obtain permission from the Board of Directors
• Firm must file a registration statement with the SEC
• The SEC examines the registration during a 20-day waiting
period
• A preliminary prospectus, called a red herring, is distributed
during the waiting period
• If there are problems, the company is allowed to amend the
registration and the waiting period starts over
• Securities may not be sold during the waiting period
• The price is determined on the effective date of the registration
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15-191
TABLE 15.1 - I
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15-192
TABLE 15.1 - II
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15-193
UNDERWRITERS
• Services provided by underwriters
•
•
•
•
Formulate method used to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter
• Syndicate – group of investment bankers that market the securities and share the risk
associated with selling the issue
• Spread – difference between what the syndicate pays the company and what the
security sells for initially in the market
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15-194
FIRM COMMITMENT UNDERWRITING
• Issuer sells entire issue to underwriting syndicate
• The syndicate then resells the issue to the public
• The underwriter makes money on the spread between the
price paid to the issuer and the price received from investors
when the stock is sold
• The syndicate bears the risk of not being able to sell the entire
issue for more than the cost
• Most common type of underwriting in the United States
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15-195
BEST EFFORTS UNDERWRITING
• Underwriter must make their “best effort” to sell the securities at
an agreed-upon offering price
• The company bears the risk of the issue not being sold
• The offer may be pulled if there is not enough interest at the offer
price. In this case, the company does not get the capital, and they
have still incurred substantial flotation costs
• Not as common as it previously was
Faculty of Finance
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15-196
DUTCH AUCTION UNDERWRITING
• Underwriter accepts a series of bids that include number of shares and
price per share
• The price that everyone pays is the highest price that will result in all shares
being sold
• There is an incentive to bid high to make sure you get in on the auction but
knowing that you will probably pay a lower price than you bid
• The Treasury has used Dutch auctions for years
• Google was the first large Dutch auction IPO
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15-197
GREEN SHOES AND LOCKUPS
• Green Shoe provision
• Allows the syndicate to purchase an additional 15% of the issue from the
issuer
• Allows the issue to be oversubscribed
• Provides some protection for the underwriters as they perform their price
stabilization function
• Lockup agreements
• Restriction on insiders that prevents them from selling their shares of an
IPO for a specified time period
• The lockup period is commonly 180 days
• The stock price tends to drop when the lockup period expires due to
market anticipation of additional shares hitting the street
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15-198
IPO UNDERPRICING
• May be difficult to price an IPO because there isn’t a current market
price available
• Private companies tend to have more asymmetric information than
companies that are already publicly traded
• Underwriters want to ensure that, on average, their clients earn a good
return on IPOs
• Underpricing causes the issuer to “leave money on the table”
Faculty of Finance
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15-199
WORK THE WEB EXAMPLE
• How have recent IPOs done?
• Click on the web surfer to go to Hoovers and follow the “IPO Central” link
• Look at the IPO Scorecard and Money Left on the Table to see how much underpricing
there has been in recent issues
• What other information can you find on IPOs at this site?
Faculty of Finance
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15-200
NEW EQUITY ISSUES AND PRICE
• Stock prices tend to decline when new equity is issued
• Possible explanations for this phenomenon
• Signaling and managerial information
• Signaling and debt usage
• Issue costs
• Since the drop in price can be significant and much of the drop may
be attributable to negative signals, it is important for management
to understand the signals that are being sent and try to reduce the
effect when possible
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15-201
ISSUANCE COSTS
• Spread
• Other direct expenses – legal fees, filing fees, etc.
• Indirect expenses – opportunity costs, i.e., management time spent working on
issue
• Abnormal returns – price drop on existing stock
• Underpricing – below market issue price on IPOs
• Green Shoe option – cost of additional shares that the syndicate can purchase
after the issue has gone to market
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15-202
RIGHTS OFFERINGS: BASIC CONCEPTS
• Issue of common stock offered to existing shareholders
• Allows current shareholders to avoid the dilution that can occur with a new stock issue
• “Rights” are given to the shareholders
• Specify number of shares that can be purchased
• Specify purchase price
• Specify time frame
• Rights may be traded OTC or on an exchange
Faculty of Finance
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THE VALUE OF A RIGHT
• The price specified in a rights offering is generally less than the current market price
• The share price will adjust based on the number of new shares issued
• The value of the right is the difference between the old share price and the “new” share
price
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RIGHTS OFFERING EXAMPLE
• Suppose a company wants to raise $10 million. The subscription price is $20,
and the current stock price is $25. The firm currently has 5,000,000 shares
outstanding.
• How many shares must be issued?
• How many rights will it take to purchase one share?
• What is the value of a right?
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DILUTION
• Dilution is a loss in value for existing shareholders
• Percentage ownership – shares sold to the general public without a rights offering
• Market value – firm accepts negative NPV projects
• Book value and EPS – occurs when market-to-book value is less than one
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TYPES OF LONG-TERM DEBT
• Bonds – public issue of long-term debt
• Private issues
• Term loans
• Direct business loans from commercial banks, insurance companies, etc.
• Maturities 1 – 5 years
• Repayable during life of the loan
• Private placements
• Similar to term loans but with longer maturity
• Easier to renegotiate than public issues
• Lower costs than public issues
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SHELF REGISTRATION
• Permits a corporation to register a large issue with the SEC and sell it in small
portions over a two-year period
• Reduces the flotation costs of registration
• Allows the company more flexibility to raise money quickly
• Requirements
•
•
•
•
Company must be rated investment grade
Cannot have defaulted on debt within last three years
Market value of stock must be greater than $150 million
No violations of the Securities Act of 1934 in the last three years
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QUICK QUIZ
• What is venture capital, and what types of firms receive it?
• What are some of the important services provided by underwriters?
• What type of underwriting is the most common in the United States, and how does it
work?
• What is IPO underpricing, and why might it persist?
• What are some of the costs associated with issuing securities?
• What is a rights offering, and how do you value a right?
• What are some of the characteristics of private placement debt?
• What is shelf registration?
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ETHICS ISSUES
• Brokers have been known to sell securities based on sales scripts
that have little to do with the information provided in the
prospectus. Also, investors often make investment decisions before
receiving (or reading) the prospectus. Who is at greater fault in
this case?
• Traditionally, IPO share allocations have been reserved for the
underwriting syndicates’ best customers. What ethical implications
exist.
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COMPREHENSIVE PROBLEM
• A company wants to raise $20 million. The subscription price is $40, and the
current stock price is $50. The firm currently has 5,000,000 shares
outstanding.
• How many shares must be issued?
• How many rights will it take to purchase one share?
• What is the value of a right?
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CHAPTER SUMMARY
• This chapter has looked at how corporate securities are issued. The following are the
main points:
1. The costs of issuing securities can be quite large. They are much lower (as a percentage)
for larger issues.
2. The direct and indirect costs of going public can be substantial. However, once a firm is
public, it can raise additional capital with much greater ease.
3. Rights offerings are cheaper than general cash offers. Even so, most new equity issues in
the United States are underwritten general cash offers
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SELF-REVIEW
• In the aggregate, debt offerings are much more common than equity offerings and
typically much larger as well. Why?
• Why are the costs of selling equity so much larger than the costs of selling debt?
• Why do noninvestment-grade bonds have much higher direct costs than investmentgrade issues?
• Why is underpricing not a great concern with bond offerings?
Faculty of Finance
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End of Chapter
Faculty of Finance
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3.2.COST OF CAPITAL
KEY CONCEPTS AND SKILLS
• Know how to determine a firm’s cost of equity capital
• Know how to determine a firm’s cost of debt
• Know how to determine a firm’s overall cost of capital
• Understand pitfalls of overall cost of capital and how to manage them
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LEARNING OBJECTIVES
217
Determine
Determine a firm’s cost of equity capital.
Determine
Determine a firm’s cost of debt.
Determine
Determine a firm’s overall cost of capital and how to use it to
value a company.
Explain
Explain how to correctly include flotation costs in capital
budgeting projects.
Describe
Describe some of the pitfalls associated with a firm’s overall
cost of capital and what to do about them.
Faculty of Finance
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CHAPTER OUTLINE
1. The Cost of Capital: Some Preliminaries
2. The Cost of Equity
3. The Costs of Debt and Preferred Stock
4. The Cost of retained earnings.
5. The Weighted Average Cost of Capital
6. Divisional and Project Costs of Capital
7. Flotation Costs and the Weighted Average Cost of Capital
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1. WHY COST OF CAPITAL IS IMPORTANT
• We know that the return earned on assets depends on the risk of those
assets
• The return to an investor is the same as the cost to the company
• Our cost of capital provides us with an indication of how the market
views the risk of our assets
• Knowing our cost of capital can also help us determine our required
return for capital budgeting projects
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REQUIRED RETURN
• The required return is the same as the appropriate discount rate and is
based on the risk of the cash flows
• We need to know the required return for an investment before we can
compute the NPV and make a decision about whether or not to take the
investment
• We need to earn at least the required return to compensate our investors
for the financing they have provided
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2. COST OF EQUITY
• The cost of equity is the return required by equity investors given the risk of the cash
flows from the firm
• Business risk: The equity risk that comes from the nature of the firm’s operating activities
• Financial risk: The equity risk that comes from the financial policy (the capital structure)
of the firm
• There are two major methods for determining the cost of equity
• Dividend growth model
• SML, or CAPM
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THE DIVIDEND GROWTH MODEL APPROACH
• Start with the dividend growth model formula and rearrange to solve for RE
D1
P0 
RE  g
D1
RE 
g
P0
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DIVIDEND GROWTH MODEL EXAMPLE
• Suppose that your company is expected to pay a dividend of $1.50 per
share next year. There has been a steady growth in dividends of 5.1%
per year and the market expects that to continue. The current price is
$25. What is the cost of equity?
1.50
RE 
 .051  .111  11.1%
25
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EXAMPLE: ESTIMATING THE DIVIDEND GROWTH RATE
• One method for estimating the growth rate is to use the historical
average
•
•
•
•
•
•
Year
2005
2006
2007
2008
2009
Dividend
1.23
1.30
1.36
1.43
1.50
Percent Change
-
(1.30 – 1.23) / 1.23 = 5.7%
(1.36 – 1.30) / 1.30 = 4.6%
(1.43 – 1.36) / 1.36 = 5.1%
(1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
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ADVANTAGES AND DISADVANTAGES OF DIVIDEND GROWTH MODEL
• Advantage – easy to understand and use
• Disadvantages
• Only applicable to companies currently paying dividends
• Not applicable if dividends aren’t growing at a reasonably constant rate
• Extremely sensitive to the estimated growth rate – an increase in g of 1% increases
the cost of equity by 1%
• Does not explicitly consider risk
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THE SML APPROACH
• Use the following information to compute our cost of equity
• Risk-free rate, Rf
• Market risk premium, E(RM) – Rf
• Systematic risk of asset, 
RE  R f   E ( E ( RM )  R f )
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EXAMPLE - SML
• Suppose your company has an equity beta of .58, and the current riskfree rate is 6.1%. If the expected market risk premium is 8.6%, what is
your cost of equity capital?
• RE = 6.1 + .58(8.6) = 11.1%
• Since we came up with similar numbers using both the dividend growth
model and the SML approach, we should feel good about our estimate
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ADVANTAGES AND DISADVANTAGES OF SML
• Advantages
• Explicitly adjusts for systematic risk
• Applicable to all companies, as long as we can estimate beta
• Disadvantages
• Have to estimate the expected market risk premium, which does vary over time
• Have to estimate beta, which also varies over time
• We are using the past to predict the future, which is not always reliable
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EXAMPLE – COST OF EQUITY
• Suppose our company has a beta of 1.5. The market risk premium is expected to be
9%, and the current risk-free rate is 6%. We have used analysts’ estimates to
determine that the market believes our dividends will grow at 6% per year and our
last dividend was $2. Our stock is currently selling for $15.65. What is our cost of
equity?
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3. COST OF DEBT
• The cost of debt is the required return on our company’s debt
• We usually focus on the cost of long-term debt or bonds
• The required return is best estimated by computing the yield-to-maturity on the
existing debt
• We may also use estimates of current rates based on the bond rating we expect
when we issue new debt
• The cost of debt is NOT the coupon rate
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EXAMPLE: COST OF DEBT
• Suppose we have a bond issue currently outstanding that has 25 years
left to maturity. The coupon rate is 9%, and coupons are paid
semiannually. The bond is currently selling for $908.72 per $1,000 bond.
What is the cost of debt?
• N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT I/Y = 5%; YTM = 5(2) = 10%
1

1
 (1  r) t
Bond Value  C 
r


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

FV

t
(1

r)


Banking University of Ho Chi Minh City
COST OF PREFERRED STOCK
• Reminders
• Preferred stock generally pays a constant dividend each period
• Dividends are expected to be paid every period forever
• Preferred stock is a perpetuity, so we take the perpetuity formula,
rearrange and solve for RP
• R P = D / P0
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EXAMPLE: COST OF PREFERRED STOCK
• Your company has preferred stock that has an annual dividend of $3. If the current price
is $25, what is the cost of preferred stock?
• RP = 3 / 25 = 12%
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COST OF RETAINED EARNINGS (1)
• New common equity is raised in two ways: (1) by retaining some of the current year’s
earnings and (2) by issuing new common stock.
• Retained earnings refers to that part of the current year’s earnings not paid as dividends
(hence, available for reinvestment in the business this year)
• Cost of Retained Earnings (rs) The rate of return required by stockholders on a firm’s
common stock.
• Cost of New Common Stock (re) The cost of external equity; based on the cost of retained
earnings, but increased for flotation costs necessary to issue new common stock
• The firm needs to earn at least as much on any earnings retained as the stockholders could
earn on alternative investments of comparable risk.
• If the firm cannot invest retained earnings to earn at least rs , it should pay those funds to
its stockholders and let them invest directly in stocks or other assets that will provide that
return
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COST OF RETAINED EARNINGS (2)- MEASURES
• CAPM APPROACH
• BOND-YIELD-PLUS-RISK-PREMIUM APPROACH
• DIVIDEND-YIELD-PLUS-GROWTH-RATE, OR DISCOUNTED CASH FLOW (DCF),
APPROACH
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COST OF RETAINED EARNINGS (2)- MEASURES-CAPM APPROACH
• Step 1: Estimate the risk-free rate, rRF. We generally use the 10-year Treasury bond rate
as the measure of the risk-free rate, but some analysts use the short-term Treasury bill
rate.
• Step 2: Estimate the stock’s beta coefficient, bi , and use it as an index of the stock’s risk.
• Step 3: Estimate the market risk premium. Recall that the market risk premium is the
difference between the return that investors require on an average stock and the riskfree rate.
• Step 4: Substitute the preceding values in the CAPM equation to estimate the required
rate of return :
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COST OF RETAINED EARNINGS (2)- MEASURES-CAPM APPROACH
• Example: Assume that in today’s market, rRF 5 5.6%, the market risk premium is RPM
55.0%, and Allied’s beta is 1.48. Using the CAPM approach, Allied’s cost of equity is
estimated to be 13.0%:
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COST OF RETAINED EARNINGS (3)- MEASURES
BOND-YIELD-PLUS-RISK-PREMIUM APPROACH
• This measure is usually used when reliable inputs for the CAPM approach are not
available
• Empirical studies suggest that the risk premium on a firm’s stock over its own bonds
generally ranges from 3 to 5 percentage points (evidence from Roger G. Ibbotson for
US stock market)
rs=bond yield + risk premium
Example: Allied’s bonds yield 10%, its cost of equity might be estimated as follows
rs= Bond yield + Risk premium= 10.0% + 4.0% =14.0%
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COST OF RETAINED EARNINGS (2)- MEASURES-DIVIDEND-YIELD-PLUS-GROWTH-RATE, OR DISCOUNTED CASH FLOW (DCF), APPROACH
• According to DCF model, assume P0 is the current stock price, Dt is the dividend expected to
be paid at the end of Year t,rs is the required rate of return. Current stock price is
If dividends are expected to grow at a constant rate, the above equation reduces to:
solve for rs :
investors expect to receive a dividend yield, D1/P0, plus a capital gain, g, for a total
expected return of rs
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4. THE WEIGHTED AVERAGE COST OF CAPITAL
• We can use the individual costs of capital that we have computed to get
our “average” cost of capital for the firm.
• This “average” is the required return on the firm’s assets, based on the
market’s perception of the risk of those assets
• The weights are determined by how much of each type of financing is
used
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CAPITAL STRUCTURE WEIGHTS
• Notation
• E = market value of equity = # of outstanding shares times price per share
• D = market value of debt = # of outstanding bonds times bond price
• V = market value of the firm = D + E
• Weights
• wE = E/V = percent financed with equity
• wD = D/V = percent financed with debt
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EXAMPLE: CAPITAL STRUCTURE WEIGHTS
• Suppose you have a market value of equity equal to $500 million and a market
value of debt equal to $475 million.
• What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%
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TAXES AND THE WACC
• We are concerned with after-tax cash flows, so we also need to consider the effect of
taxes on the various costs of capital
• Interest expense reduces our tax liability
• This reduction in taxes reduces our cost of debt
• After-tax cost of debt = RD(1-TC)
• Dividends are not tax deductible, so there is no tax impact on the cost of equity
• WACC = wERE + wDRD(1-TC)
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EXTENDED EXAMPLE – WACC - I
• Debt Information
• Equity Information
•
•
•
•
•
• $1 billion in outstanding debt
(face value)
• Current quote = 110 (a
percent of par value)
• Coupon rate = 9%,
semiannual coupons
• 15 years to maturity
50 million shares
$80 per share
Beta = 1.15
Market risk premium = 9%
Risk-free rate = 5%
• Tax rate = 40%
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EXTENDED EXAMPLE – WACC - II
• What is the cost of equity?
• RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
• N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268
• RD = 3.927(2) = 7.854%
• What is the after-tax cost of debt?
• RD(1-TC) = 7.854(1-.4) = 4.712%
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EXTENDED EXAMPLE – WACC - III
• What are the capital structure weights?
•
•
•
•
•
E = 50 million (80) = 4 billion
D = 1 billion (1.10) = 1.1 billion
V = 4 + 1.1 = 5.1 billion
wE = E/V = 4 / 5.1 = .7843
wD = D/V = 1.1 / 5.1 = .2157
• What is the WACC?
• WACC = .7843(15.35%) + .2157(4.712%) = 13.06%
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EASTMAN CHEMICAL I
• Click on the web surfer to go to Yahoo Finance to get information on Eastman
Chemical (EMN)
• Under Profile and Key Statistics, you can find the following information:
•
•
•
•
# of shares outstanding
Book value per share
Price per share
Beta
• Under analysts estimates, you can find analysts estimates of earnings growth (use as
a proxy for dividend growth)
• The Bonds section at Yahoo Finance can provide the T-bill rate
• Use this information, along with the CAPM and DGM to estimate the cost of equity
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EASTMAN CHEMICAL II
• Go to FINRA to get market information on Eastman Chemical’s bond issues
• Enter Eastman Ch to find the bond information
• Note that you may not be able to find information on all bond issues due to the
illiquidity of the bond market
• Go to the SEC site to get book valve information from the firm’s most recent 10Q
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EASTMAN CHEMICAL III
• Find the weighted average cost of the debt
• Use market values if you were able to get the information
• Use the book values if market information was not available
• They are often very close
• Compute the WACC
• Use market value weights if available
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EXAMPLE: WORK THE WEB
• Find estimates of WACC at www.valuepro.net
• Look at the assumptions
• How do the assumptions impact the estimate of WACC?
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TABLE 14.1 COST OF EQUITY
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TABLE 14.1 COST OF DEBT
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TABLE 14.1 WACC
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5. DIVISIONAL AND PROJECT COSTS OF CAPITAL
• Using the WACC as our discount rate is only appropriate for projects that
have the same risk as the firm’s current operations
• If we are looking at a project that does NOT have the same risk as the firm,
then we need to determine the appropriate discount rate for that project
• Divisions also often require separate discount rates
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USING WACC FOR ALL PROJECTS - EXAMPLE
• What would happen if we use the WACC for all projects regardless of
risk?
• Assume the WACC = 15%
Project
A
B
C
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Required Return
20%
15%
10%
IRR
17%
18%
12%
Banking University of Ho Chi Minh City
THE PURE PLAY APPROACH
• Find one or more companies that specialize in the product or service that
we are considering
• Compute the beta for each company
• Take an average
• Use that beta along with the CAPM to find the appropriate return for a
project of that risk
• Often difficult to find pure play companies
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SUBJECTIVE APPROACH
• Consider the project’s risk relative to the firm overall
• If the project has more risk than the firm, use a discount rate greater than the WACC
• If the project has less risk than the firm, use a discount rate less than the WACC
• You may still accept projects that you shouldn’t and reject projects you should accept, but
your error rate should be lower than not considering differential risk at all
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SUBJECTIVE APPROACH - EXAMPLE
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Risk Level
Discount Rate
Very Low Risk
WACC – 8%
Low Risk
WACC – 3%
Same Risk as Firm
WACC
High Risk
WACC + 5%
Very High Risk
WACC + 10%
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6. FLOTATION COSTS
• The required return depends on the risk, not how the money is raised
• However, the cost of issuing new securities should not just be ignored
either
• Basic Approach
• Compute the weighted average flotation cost
• Use the target weights because the firm will issue securities in these percentages
over the long term
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NPV AND FLOTATION COSTS - EXAMPLE
• Your company is considering a project that will cost $1 million. The project will generate after-tax cash
flows of $250,000 per year for 7 years. The WACC is 15%, and the firm’s target D/E ratio is .6 The
flotation cost for equity is 5%, and the flotation cost for debt is 3%. What is the NPV for the project
after adjusting for flotation costs?
• fA = (.375)(3%) + (.625)(5%) = 4.25%
• PV of future cash flows = 1,040,105
• NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281
• The project would have a positive NPV of 40,105 without considering flotation costs
• Once we consider the cost of issuing new securities, the NPV becomes negative
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QUICK QUIZ
• What are the two approaches for computing the cost of equity?
• How do you compute the cost of debt and the after-tax cost of debt?
• How do you compute the capital structure weights required for the WACC?
• What is the WACC?
• What happens if we use the WACC for the discount rate for all projects?
• What are two methods that can be used to compute the appropriate discount rate
when WACC isn’t appropriate?
• How should we factor flotation costs into our analysis?
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ETHICS ISSUES
• How could a project manager adjust the cost of capital
(i.e., appropriate discount rate) to increase the likelihood
of having his/her project accepted?
• Is this ethical or financially sound?
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COMPREHENSIVE PROBLEM
• A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years
to maturity, a $1,000 face value, and a $1,100 market price.
• The company’s 100,000 shares of preferred stock pay a $3 annual dividend, and
sell for $30 per share.
• The company’s 500,000 shares of common stock sell for $25 per share and have a
beta of 1.5. The risk free rate is 4%, and the market return is 12%.
• Assuming a 40% tax rate, what is the company’s WACC?
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•
•
•
•
•
•
•
•
•
•
•
MV of debt = 10,000 x $1,100 = $11,000,000
Cost of debt = YTM: 8 N; -1,100 PV; 60 PMT; 1,000 FV; CPT I/Y = 4.48%
MV of preferred = 100,000 x $30 = $3,000,000
Cost of preferred = 3/30 = 10%
MV of common = 500,000 x $25 = $12,500,000
Cost of common = .04 + 1.5 x (.12 - .04) = 16%
Total MV of all securities = $11M + $3M + $12.5M = 26.5M
Weight of debt = 11M/26.5M = .4151
Weight of preferred = 3M/26.5M = .1132
Weight of common = 12.5M/26.5M = .4717
WACC = .4151 x .0448 x (1 - .4) + .1132 x .10 + .4717 x .16 = .0979 = 9.8%
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End of Chapter
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CHAPTER 4: FINANCIAL LEVERAGE AND
CAPITAL STRUCTURE
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KEY CONCEPTS AND SKILLS
Understand
Understand the effect of financial leverage on cash flows and the
cost of equity
Understand
Understand the impact of taxes and bankruptcy on capital structure
choice
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CHAPTER OUTLINE
The Capital Structure Question
The Effect of Financial Leverage
Capital Structure and the Cost of Equity Capital
M&M Propositions I and II with Corporate Taxes
Bankruptcy Costs
Optimal Capital Structure
The Pie Again
The Pecking-Order Theory
Observed Capital Structures
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CAPITAL RESTRUCTURING
• We are going to look at how changes in capital structure affect the value of the firm,
all else equal
• Capital restructuring involves changing the amount of leverage a firm has without
changing the firm’s assets
• The firm can increase leverage by issuing debt and repurchasing outstanding shares
• The firm can decrease leverage by issuing new shares and retiring outstanding debt
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CHOOSING A CAPITAL STRUCTURE
• What is the primary goal of financial managers?
• Maximize stockholder wealth
• We want to choose the capital structure that will maximize stockholder
wealth
• We can maximize stockholder wealth by maximizing the value of the firm
or minimizing the WACC
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THE EFFECT OF LEVERAGE
• How does leverage affect the EPS and ROE of a firm?
• When we increase the amount of debt financing, we increase the fixed interest
expense
• If we have a really good year, then we pay our fixed cost and we have more left
over for our stockholders
• If we have a really bad year, we still have to pay our fixed costs and we have less
left over for our stockholders
• Leverage amplifies the variation in both EPS and ROE
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EXAMPLE: FINANCIAL LEVERAGE, EPS AND ROE – PART I
• We will ignore the effect of taxes at this stage
• What happens to EPS and ROE when we issue debt and buy back shares
of stock?
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CAPITAL STRUCTURE SCENARIOS FOR THE TRANS AM CORPORATION
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EXAMPLE: FINANCIAL LEVERAGE, EPS AND ROE – PART II
• Variability in ROE
• Current: ROE ranges from 6.25% to 1.75%
• Proposed: ROE ranges from 2.5% to 27.5%
• Variability in EPS
• Current: EPS ranges from $1.25 to $3.75
• Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS increases when financial leverage is
increased
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BREAK-EVEN EBIT
• Find EBIT where EPS is the same under both the current and proposed
capital structures
• If we expect EBIT to be greater than the break-even point, then leverage
may be beneficial to our stockholders
• If we expect EBIT to be less than the break-even point, then leverage is
detrimental to our stockholders
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EXAMPLE: BREAK-EVEN EBIT
EBIT
EBIT − 400,000
=
400,000
200,000
400,000
EBIT =
EBIT − 250,000
200,000
EBIT = 2(EBIT − 250,000)
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Financial Leverage: EPS and EBIT for the Trans Am Corporation
$6.00
$5.00
Break-even Point:
EPS = $2; EBIT = $800,000
EPS
$4.00
Current
$3.00
Proposed
$2.00
$1.00
$0.00
$500,000
$1,000,000
EBIT
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$1,500,000
CONCLUSIONS
• 1. The effect of financial leverage depends on the company’s EBIT. When EBIT is
relatively high, leverage is beneficial.
• 2. Under the expected scenario, leverage increases the returns to shareholders, as
measured by both ROE and EPS.
• 3. Shareholders are exposed to more risk under the proposed capital structure
because the EPS and ROE are much more sensitive to changes in EBIT in this case.
• 4. Because of the impact that financial leverage has on both the expected return to
stockholders and the riskiness of the stock, capital structure is an important
consideration.
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EXAMPLE: HOMEMADE LEVERAGE AND ROE
• Current Capital Structure
• Proposed Capital Structure
• Investor borrows $500 and uses $500 of
her own to buy 100 shares of stock
• Investor buys $250 worth of stock (25
shares) and $250 worth of bonds paying
10%.
• Payoffs:
• Recession: 100(0.60) - .1(500) = $10
• Expected: 100(1.30) - .1(500) = $80
• Expansion: 100(2.00) - .1(500) = $150
• Mirrors the payoffs from purchasing 50
shares of the firm under the proposed
capital structure
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• Payoffs:
• Recession: 25(.20) + .1(250) = $30
• Expected: 25(1.60) + .1(250) = $65
• Expansion: 25(3.00) + .1(250) = $100
• Mirrors the payoffs from purchasing 50
shares under the current capital structure
Ho Chi Minh University of Banking
CAPITAL STRUCTURE THEORY
• Modigliani and Miller (M&M)Theory of Capital Structure
• Proposition I – firm value
• Proposition II – WACC
• The value of the firm is determined by the cash flows to the firm and the
risk of the assets
• Changing firm value
• Change the risk of the cash flows
• Change the cash flows
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CAPITAL STRUCTURE THEORY UNDER THREE SPECIAL CASES
• Case I – Assumptions
• No corporate or personal taxes
• No bankruptcy costs
• Case II – Assumptions
• Corporate taxes, but no personal taxes
• No bankruptcy costs
• Case III – Assumptions
• Corporate taxes, but no personal taxes
• Bankruptcy costs
282
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CASE I – PROPOSITIONS I AND II
• Proposition I
• The value of the firm is NOT affected
by changes in the capital structure
• The cash flows of the firm do not
change; therefore, value doesn’t
change
• Proposition II
• The WACC of the firm is NOT
affected by capital structure
283
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CASE I - EQUATIONS
• Without tax: WACC = RA = (E/V)RE + (D/V)RD
->RE = RA + (RA – RD)(D/E)
-> M&M Proposition II, which tells us that the cost of equity depends on three things:
The required rate of return on the firm’s assets, RA; the firm’s cost of debt, RD; and the
firm’s debt-equity ratio, D/E.
RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets
• (RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return
required by stockholders to compensate for the risk of leverage
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FIGURE 16.3
285
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CASE I - EXAMPLE
• Data
• Required return on assets = 16%; cost of debt = 10%; percent of debt = 45%
• What is the cost of equity?
• RE = 16 + (16 - 10)(.45/.55) = 20.91%
• Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?
• 25 = 16 + (16 - 10)(D/E)
• D/E = (25 - 16) / (16 - 10) = 1.5
• Based on this information, what is the percent of equity in the firm?
• E/V = 1 / 2.5 = 40%
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THE CAPM, THE SML AND PROPOSITION II
• How does financial leverage affect systematic risk?
• CAPM: RA = Rf + A(RM – Rf)
• Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets
• Proposition II
• Replace RA with the CAPM and assume that the debt is riskless (RD = Rf)
• RE = Rf + A(1+D/E)(RM – Rf)
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BUSINESS RISK AND FINANCIAL RISK
• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)
• E = A(1 + D/E)
• Therefore, the systematic risk of the stock depends on:
• Systematic risk of the assets, A, (Business risk)
• Level of leverage, D/E, (Financial risk)
288
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CASE II – M&M PROPOSITIONS I AND II WITH CORPORATE TAXES-CASH FLOW
• Interest is tax deductible
• Therefore, when a firm adds debt, it reduces taxes, all else equal
• The reduction in taxes increases the cash flow of the firm
• How should an increase in cash flows affect the value of the firm?
289
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CASE II - EXAMPLE
Unlevered Firm
Levered Firm
5,000
5,000
0
500
Taxable Income
5,000
4,500
Taxes (34%)
1,700
1,530
Net Income
3,300
2,970
CFFA
3,300
3,470
EBIT
Interest
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INTEREST TAX SHIELD
• Annual interest tax shield
• Tax rate times interest payment
• 6,250 in 8% debt = 500 in interest expense
• Annual tax shield = .34(500) = 170
• Present value of annual interest tax shield
• Assume perpetual debt for simplicity
• PV = 170 / .08 = 2,125
• PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125
291
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CASE II- WITH CORPORATE TAXES– M&M PROPOSITION I
• The value of the firm increases by the present value of the annual interest
tax shield
• Value of a levered firm = value of an unlevered firm + PV of interest tax shield
• Value of equity = Value of the firm – Value of debt
• Assuming perpetual cash flows
• VU = EBIT(1-T) / RU
• VL = VU + DTC
292
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EXAMPLE: CASE II – PROPOSITION I
• Data
• EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%;
Unlevered cost of capital = 12%
• VU = 25(1-.35) / .12 = $135.42 million
• VL = 135.42 + 75(.35) = $161.67 million
• E = 161.67 – 75 = $86.67 million
293
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FIGURE 16.4
294
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CASE II – PROPOSITION II
• The WACC decreases as D/E increases because of the government
subsidy on interest payments
• RA = (E/V)RE + (D/V)(RD)(1-TC)
• RE = RU + (RU – RD)(D/E)(1-TC)
• Example
• RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
• RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%
295
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EXAMPLE: CASE II –
PROPOSITION II
• Suppose that the firm changes its capital structure so that the debt-toequity ratio becomes 1.
• What will happen to the cost of equity under the new capital structure?
• RE = 12 + (12 - 9)(1)(1-.35) = 13.95%
• What will happen to the weighted average cost of capital?
• RA = .5(13.95) + .5(9)(1-.35) = 9.9%
296
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FIGURE 16.5
297
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M&M SUMMARY
298
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M&M SUMMARY
299
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COMPREHENSIVE EXAMPLE
• You are given the following information for the Format Co.: EBIT = $126.58; TC = .21; D = $500; RU
= .20 The cost of debt capital is 10 percent. What is the value of Format’s equity? What is the cost of
equity capital for Format? What is the WACC?
Based on M&M Proposition II with taxes, the cost
of equity is:
Value of the firm if it has no debt:
From M&M Proposition I with taxes, we know that the value of the
firm with debt
Finally, the WACC is
Because the firm is worth $605 total and the debt is worth $500, the
equity is worth $105:
300
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CASE III
• Now we add bankruptcy costs
• As the D/E ratio increases, the probability of bankruptcy increases
• This increased probability will increase the expected bankruptcy costs
• At some point, the additional value of the interest tax shield will be offset by the
increase in expected bankruptcy cost
• At this point, the value of the firm will start to decrease, and the WACC will start to
increase as more debt is added
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BANKRUPTCY COSTS
• Direct costs
• Legal and administrative costs
• Ultimately cause bondholders to incur additional losses
• Disincentive to debt financing
• Financial distress
• Significant problems in meeting debt obligations
• Firms that experience financial distress do not necessarily file for bankruptcy
302
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MORE BANKRUPTCY COSTS
• Indirect bankruptcy costs
•
•
•
•
Larger than direct costs, but more difficult to measure and estimate
Stockholders want to avoid a formal bankruptcy filing
Bondholders want to keep existing assets intact so they can at least receive that money
Assets lose value as management spends time worrying about avoiding bankruptcy instead of
running the business
• The firm may also lose sales, experience interrupted operations and lose valuable employees
303
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OPTIMAL CAPITAL STRUCTURE
• THE STATIC THEORY OF CAPITAL STRUCTURE: The theory that a firm borrows up to
the point where the tax benefit from an extra dollar in debt is exactly equal to the
cost that comes from the increased probability of financial distress.
304
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FIGURE 16.6: THE STATIC THEORY OF CAPITAL STRUCTURE: THE OPTIMAL
CAPITAL STRUCTURE AND THE VALUE OF THE FIRM
305
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FIGURE 16.7: THE STATIC THEORY OF CAPITAL STRUCTURE: THE OPTIMAL CAPITAL
STRUCTURE AND THE COST OF CAPITAL
306
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CONCLUSIONS
• Case I – no taxes or bankruptcy costs
• No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
• Optimal capital structure is almost 100% debt
• Each additional dollar of debt increases the cash flow of the firm
• Case III – corporate taxes and bankruptcy costs
• Optimal capital structure is part debt and part equity
• Occurs where the benefit from an additional dollar of debt is just offset by the
increase in expected bankruptcy costs
307
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• Figure 17.8:
The Capital Structure Question
308
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MANAGERIAL RECOMMENDATIONS
• The tax benefit is only important if the firm has a large tax liability
• Risk of financial distress
• The greater the risk of financial distress, the less debt will be optimal for the firm
• The cost of financial distress varies across firms and industries, and as a manager
you need to understand the cost for your industry
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FIGURE 16.9: THE EXTENDED PIE MODE
310
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THE VALUE OF THE FIRM
• Value of the firm = marketed claims + nonmarketed claims
• Marketed claims are the claims of stockholders and bondholders
• Nonmarketed claims are the claims of the government and other potential stakeholders
• The overall value of the firm is unaffected by changes in capital structure
• The division of value between marketed claims and nonmarketed claims may be
impacted by capital structure decisions
311
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THE PECKING-ORDER THEORY
• Theory stating that firms prefer to issue debt rather than equity if
internal financing is insufficient.
•
Rule 1
•
•
Use internal financing first
Rule 2
•
Issue debt next, new equity last
• The pecking-order theory is at odds with the tradeoff theory:
•
•
•
312
There is no target D/E ratio
Profitable firms use less debt
Companies like financial slack
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OBSERVED CAPITAL STRUCTURE
• Capital structure does differ by industry
• Differences according to Cost of Capital 2008 Yearbook by Ibbotson
Associates, Inc.
• Lowest levels of debt
• Computers with 5.61% debt
• Drugs with 7.25% debt
• Highest levels of debt
• Cable television with 162.03% debt
• Airlines with 129.40% debt
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WORK THE WEB EXAMPLE
• You can find information about a company’s capital structure relative to its industry,
sector and the S&P 500 at Reuters
• Click on the web surfer to go to the site
• Choose a company and get a quote
• Choose Ratio Comparisons
314
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QUICK QUIZ
• Explain the effect of leverage on EPS and ROE
• What is the break-even EBIT, and how do we compute it?
• How do we determine the optimal capital structure?
• What is the optimal capital structure in the three cases that were discussed in this
chapter?
• What is the difference between liquidation and reorganization?
315
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ETHICS ISSUES
• Suppose managers of a firm know that the company is approaching financial distress.
• Should the managers borrow from creditors and issue a large one-time dividend to shareholders?
• How might creditors control this potential transfer of wealth?
316
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COMPREHENSIVE PROBLEM
• Assuming perpetual cash flows in Case II - Proposition I, what is the value of the
equity for a firm with EBIT = $50 million, Tax rate = 40%, Debt = $100 million, cost
of debt = 9%, and unlevered cost of capital = 12%?
317
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END OF CHAPTER
318
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CHAPTER 5
DIVIDENDS AND
DIVIDEND POLICY
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KEY CONCEPTS AND SKILLS
• Understand dividend types and how they are paid
• Understand the issues surrounding dividend policy decisions
• Understand the difference between cash and stock dividends
• Understand why share repurchases are an alternative to dividends
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CHAPTER OUTLINE
•
•
•
•
•
•
•
Cash Dividends and Dividend Payment
Does Dividend Policy Matter?
Real-World Factors Favoring a Low Dividend Payout
Real-World Factors Favoring a High Dividend Payout
A Resolution of Real-World Factors
Stock Repurchase: An Alternative to Cash Dividends
What We Know and Do Not Know about Dividends
and Payout Policies
• Stock Dividends and Stock Splits
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CASH DIVIDENDS
• Regular cash dividend – cash payments made directly to stockholders,
usually each quarter
• Extra cash dividend – indication that the “extra” amount may not be
repeated in the future
• Special cash dividend – similar to extra dividend, but definitely will not be
repeated
• Liquidating dividend – some or all of the business has been sold
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DIVIDEND PAYMENT
• Declaration Date – Board declares the dividend, and it becomes a
liability of the firm
• Ex-dividend Date
• Occurs two business days before date of record
• If you buy stock on or after this date, you will not receive the dividend
• Stock price generally drops by about the amount of the dividend
• Date of Record – Holders of record are determined, and they will
receive the dividend payment
• Date of Payment – checks are mailed
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FIGURE 17.2
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17-324
DIVIDEND PAYMENT-EXAMPLE
• The board of directors of Divided Airlines has declared a dividend of $2.50 per share
payable on Tuesday, May 30, to shareholders of record as of Tuesday, May 9. Cal Icon
buys 100 shares of Divided on Tuesday, May 2, for $150 per share. What is the ex
date? Describe the events that will occur with regard to the cash dividend and the stock
price.
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DOES DIVIDEND POLICY MATTER?
• Dividends matter – the value of the stock is based on the present value of
expected future dividends
• Dividend policy may not matter
• Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the
firm
• In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in
the future
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ILLUSTRATION OF IRRELEVANCE
• Consider a firm that can either pay out dividends of $10,000 per
year for each of the next two years or can pay $9,000 this year,
reinvest the other $1,000 into the firm and then pay $11,120 next
year. Investors require a 12% return.
• Market Value with constant dividend = $16,900.51
• Market Value with reinvestment = $16,900.51
• If the company will earn the required return, then it doesn’t matter
when it pays the dividends
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LOW PAYOUT PLEASE
• Why might a low payout be desirable?
• Individuals in upper income tax brackets might prefer lower dividend
payouts, given the immediate tax liability, in favor of higher capital gains
with the deferred tax liability
• Flotation costs – low payouts can decrease the amount of capital that needs
to be raised, thereby lowering flotation costs
• Dividend restrictions – debt contracts might limit the percentage of income
that can be paid out as dividends
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HIGH PAYOUT PLEASE
• Why might a high payout be desirable?
• Desire for current income
• Individuals that need current income, i.e., retirees
• Groups that are prohibited from spending principal (trusts and endowments)
• Uncertainty resolution – no guarantee that the higher future dividends will
materialize
• Taxes
• Dividend exclusion for corporations
• Tax-exempt investors don’t have to worry about differential treatment
between dividends and capital gains
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DIVIDENDS AND SIGNALS
• Asymmetric information – managers have more information
about the health of the company than investors
• Changes in dividends convey information
• Dividend increases
• Management believes it can be sustained
• Expectation of higher future dividends, increasing present value
• Signal of a healthy, growing firm
• Dividend decreases
• Management believes it can no longer sustain the current level of dividends
• Expectation of lower dividends indefinitely; decreasing present value
• Signal of a firm that is having financial difficulties
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CLIENTELE EFFECT
• Some investors prefer low dividend payouts and will buy stock in those
companies that offer low dividend payouts
• Some investors prefer high dividend payouts and will buy stock in those
companies that offer high dividend payouts
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IMPLICATIONS OF THE
CLIENTELE EFFECT
• What do you think will happen if a firm changes its policy from a
high payout to a low payout?
• What do you think will happen if a firm changes its policy from a
low payout to a high payout?
• If this is the case, does dividend policy matter?
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STOCK REPURCHASE
• Company buys back its own shares of stock
• Tender offer – company states a purchase price and a desired number
of shares
• Open market – buys stock in the open market
• Similar to a cash dividend in that it returns cash from the firm to
the stockholders
• This is another argument for dividend policy irrelevance in the
absence of taxes or other imperfections
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REAL-WORLD CONSIDERATIONS
• Stock repurchase allows investors to decide if they want the
current cash flow and associated tax consequences
• Given our tax structure, repurchases may be more desirable due
to the options provided stockholders
• The IRS recognizes this and will not allow a stock repurchase for
the sole purpose of allowing investors to avoid taxes
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INFORMATION CONTENT OF STOCK REPURCHASES
• Stock repurchases send a positive signal that management
believes the current price is low
• Tender offers send a more positive signal than open market
repurchases because the company is stating a specific price
• The stock price often increases when repurchases are announced
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EXAMPLE: REPURCHASE ANNOUNCEMENT
“America West Airlines announced that its Board of Directors has
authorized the purchase of up to 2.5 million shares of its Class B
common stock on the open market as circumstances warrant over the
next two years …
“Following the approval of the stock repurchase program by the
company’s Board of Directors earlier today. W. A. Franke, chairman and
chief officer said ‘The stock repurchase program reflects our belief that
America West stock may be an attractive investment opportunity for the
Company, and it underscores our commitment to enhancing long-term
shareholder value.’
“The shares will be repurchased with cash on hand, but only if and to
the extent the Company holds unrestricted cash in excess of $200 million
to ensure that an adequate level of cash and cash equivalents is
maintained.”
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WHAT WE KNOW AND DO NOT KNOW
•
Corporations “smooth” dividends
•
Dividends provide information to the market
•
Firms should follow a sensible dividend policy:
• Don’t forgo positive NPV projects just to pay a dividend
• Avoid issuing stock to pay dividends
• Consider share repurchase when there are few better uses for the
cash
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PUTTING IT ALL TOGETHER
•
Aggregate payouts are massive and have increased over time
•
Dividends are concentrated among a small number of large, mature firms
•
Managers are reluctant to cut dividends
•
Managers smooth dividends
•
Stock prices react to unanticipated changes in dividends
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MANAGEMENTS’ VIEW OF
DIVIDEND POLICY
• Agree or Strongly Agree
• 93.8% Try to avoid reducing dividends per share
• 89.6% Try to maintain a smooth dividend from year to year
• 41.7% Pay dividends to attract investors subject to “prudent man”
restrictions
• Important or Very Important
• 84.1% Maintaining consistency with historic dividend policy
• 71.9% Stability of future earnings
• 9.3% Flotation costs to issue new equity
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STOCK DIVIDENDS
• Pay additional shares of stock instead of cash
• Increases the number of outstanding shares
• Small stock dividend
• Less than 20 to 25%
• If you own 100 shares and the company declared a
10% stock dividend, you would receive an additional
10 shares
• Large stock dividend – more than 20 to 25%
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STOCK SPLITS
• Stock splits – essentially the same as a stock dividend
except expressed as a ratio
• For example, a 2 for 1 stock split is the same as a 100% stock
dividend
• Stock price is reduced when the stock splits
• Common explanation for split is to return price to a “more
desirable trading range”
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QUICK QUIZ
• What are the different types of dividends, and how is a
dividend paid?
• What is the clientele effect, and how does it affect dividend
policy relevance?
• What is the information content of dividend changes?
• What are stock dividends, and how do they differ from cash
dividends?
• How are share repurchases an alternative to dividends, and
why might investors prefer them?
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COMPREHENSIVE PROBLEM
• A company’s stock is priced at $50 per share, and it plans
to pay a $2 cash dividend.
• Assuming perfect capital markets, what will the per share price be
after the dividend payment?
• If the average tax rate on dividends is 25%, what will the new
share price be?
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End of Chapter
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MERGERS AND ACQUISITIONS
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KEY CONCEPTS AND SKILLS
• Be able to define the various terms associated with M&A activity
• Understand the various reasons for mergers and whether or not those reasons are in the
best interest of shareholders
• Understand the various methods for paying for an acquisition
• Understand the various defensive tactics that are available
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CHAPTER OUTLINE
1 The Legal Forms of Acquisitions
2 Taxes and Acquisitions
3 Accounting for Acquisitions
4 Gains from Acquisition
5 Some Financial Side Effects of Acquisitions
6 The Cost of an Acquisition
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Ho Chi Minh University of Banking
1 THE LEGAL FORMS OF ACQUISITIONS
• There are three basic legal procedures that one firm can use to
acquire another firm:
• Merger or Consolidation
• Acquisition of Stock
• Acquisition of Assets
Faculty of Finance
Ho Chi Minh University of Banking
MERGER VERSUS CONSOLIDATION
• Merger
•
•
•
•
One firm is acquired by another
Acquiring firm retains name and acquired firm ceases to exist
Advantage – legally simple
Disadvantage – must be approved by stockholders of both firms
• Consolidation
• Entirely new firm is created from combination of existing firms
Faculty of Finance
Ho Chi Minh University of Banking
ACQUISITIONS
• A firm can be acquired by another firm or individual(s) purchasing voting shares of the
firm’s stock
• Tender offer – public offer to buy shares
• Stock acquisition
• No stockholder vote required
• Can deal directly with stockholders, even if management is unfriendly
• May be delayed if some target shareholders hold out for more money – complete absorption
requires a merger
• Classifications
• Horizontal – both firms are in the same industry
• Vertical – firms are in different stages of the production process
• Conglomerate – firms are unrelated
Faculty of Finance
Ho Chi Minh University of Banking
2 TAXES AND ACQUISITIONS
• If it is a taxable acquisition, selling shareholders need to figure their cost basis and pay
taxes on any capital gains.
• If it is not a taxable event, shareholders are deemed to have exchanged their old shares
for new ones of equivalent value.
Faculty of Finance
Ho Chi Minh University of Banking
3 ACCOUNTING FOR ACQUISITIONS
• The Purchase Method
• The source of much “goodwill”
• Pooling of Interests
• Pooling of interest is generally used when the acquiring firm issues voting stock in
exchange for at least 90 percent of the outstanding voting stock of the acquired firm.
• Purchase accounting is generally used under other financing
arrangements.
Faculty of Finance
Ho Chi Minh University of Banking
4 GAINS FROM ACQUISITION
• Most acquisitions fail to create value for the acquirer.
• The main reason why they do not lies in failures to integrate two
companies after a merger.
• Intellectual capital often walks out the door when acquisitions aren't handled
carefully.
• Traditionally, acquisitions deliver value when they allow for scale economies or
market power, better products and services in the market, or learning from the
new firms.
Faculty of Finance
Ho Chi Minh University of Banking
SYNERGY
• Suppose firm A is contemplating acquiring firm B.
• The synergy from the acquisition is
Synergy = VAB – (VA + VB)
• The synergy of an acquisition can be determined from the
standard discounted cash flow model:
S
T
Synergy =
t=1
Faculty of Finance
DCFt
(1 + r)t
Ho Chi Minh University of Banking
SOURCES OF SYNERGY
• Revenue Enhancement
• Cost Reduction
• Replacement of ineffective managers
• Economies of scale or scope
• Tax Gains
• Net operating losses
• Unused debt capacity
• Incremental new investment required in working capital and
fixed assets
Faculty of Finance
Ho Chi Minh University of Banking
CALCULATING VALUE
• Avoiding Mistakes
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•
•
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Do not ignore market values
Estimate only Incremental cash flows
Use the correct discount rate
Don’t forget transactions costs
Faculty of Finance
Ho Chi Minh University of Banking
5 SOME FINANCIAL SIDE EFFECTS
• Earnings Growth
• If there are no synergies or other benefits to the merger, then the growth in EPS
is just an artifact of a larger firm and is not true growth (i.e., an accounting
illusion).
• Diversification
• Shareholders who wish to diversify can accomplish this at much lower cost with
one phone call to their broker than can management with a takeover.
Faculty of Finance
Ho Chi Minh University of Banking
6 THE COST OF AN ACQUISITION
• Typically, a firm would use NPV analysis when making acquisitions.
• The analysis is straightforward with a cash offer, but gets complicated when the
consideration is stock.
Faculty of Finance
Ho Chi Minh University of Banking
CASH ACQUISITION
• The NPV of a cash acquisition is:
• NPV = (VB + ΔV) – cash cost = VB* – cash cost
• Value of the combined firm is:
• VAB = VA + (VB* – cash cost)
• Often, the entire NPV goes to the target firm.
• Remember that a zero-NPV investment may also be desirable.
Faculty of Finance
Ho Chi Minh University of Banking
STOCK ACQUISITION
• Value of combined firm
• VAB = VA + VB + DV
• Cost of acquisition
• Depends on the number of shares given to the target stockholders
• Depends on the price of the combined firm’s stock after the merger
• Considerations when choosing between cash and stock
• Sharing gains – target stockholders don’t participate in stock price appreciation with
a cash acquisition
• Taxes – cash acquisitions are generally taxable
• Control – cash acquisitions do not dilute control
Faculty of Finance
Ho Chi Minh University of Banking
9 DIVESTITURES AND RESTRUCTURINGS
• Divestiture – company sells a piece of itself to another company
• Equity carve-out – company creates a new company out of a subsidiary
and then sells a minority interest to the public through an IPO
• Spin-off – company creates a new company out of a subsidiary and
distributes the shares of the new company to the parent company’s
stockholders
• Split-up – company is split into two or more companies and shares of all
companies are distributed to the original firm’s shareholders
Faculty of Finance
Ho Chi Minh University of Banking