Slide
Texbook
Manual
1 – Intro to Corporate
Finance
C1 (18)
C1
(1)
2 – Financial
Statements & CF
C2 (35)
C2
(1)
Note
• Corporate finance / Financial management decision types
o
Capital budgeting: long-term investment that earn returns higher than risk adjusted hurdle rate
o
Capital structure: long-term financing + debt/equity mix
o
Working capital management:
o
The focus on which decision change across life cycle: investment decision in early stage, capital structure
decision or dividend decision in mature stage (debt capacity increase)
• Financial management goal
o
For-profit business: maximize value of the firm value ⇒ stock price (easily observable, constantly updated)
o
Not-for-profit business: revenue minimization (provide servcies/goods at the lowest cost to society)
• Corporate form
o
Pros: easy to raise money, transfer ownership interst ⇒ enhanced by existence of financial markets
o
Cons: double taxation
• Agency Theory: seperation of ownership and control ⇒ managers might not act in the best interest of owners
o
Annual meeting: 1 small stakeholder not go, 2 incumbent management staff use the avantage of non-voted
proxies, 3 large stakeholders are passive (ex: mutual, pension funds), 4 scripted & controlled
o
Board of director: 1 picked by CEO, 2 not have big equity takes, 3 CEO of other firms, 4 lack expertise to
ask tough questions
o
and Corporate Ownership: less severed with higher % of large financial instituions (1 better able to
implement monitoring mechanism; 2 higher degree of agreement with managers)
• Assets = Liabilities + Equity
• Net working capital = Current assets – Current liabilities
• EPS earnings per share = Net income / Total shares outstanding
• DPS dividends per share = Dividends / Total shares outstanding
• Tax rate
o
Average tax rate = Tax bill / Taxable income (calculated then after marginal tax rate)
o
Marginal tax rate = the tax you would pay on the next dollar earned ⇒ apply to part of income in ranges, not
all
• Balance sheet format
o
Current Assets + Net Fixed Assets = Total Assets
o
Current Liabilities + Long-term Debt + Equity = Total Liabilities
• Income statement format
o
Sales/Total operating revenue
o
Cost of goods sold
o
Selling, general and administrative expenses
o
Depreciation
o
Operating income
o
Other income
o
EBIT Earning before interst and taxes
o
Interest expense
o
EBT Earning before taxes
o
Tax (Current / Defer)
o
Net income (addition to RE Retained earnings / dividend)
• Cash flow: Cash flow of the firm = Cash flow to creditors + Cash flow to shareholders
o
Cash flow of the firm = OCF – NCS – NWC
1
OCF Operating cash flow = EBIT + depreciation – current taxes (Cash in, earnings excl. interst, depr.,
tax)
 NCS Net capital spending = purchase of fixed assets – sale of fixed assets
= ending net fixed assets – beginning net fixed assets + depr. (Cash
out)
 NWC Changes in net working capital = ending NWC – beginning NWC (Cash out)
o
Cash flow to investor in the firm
 Debt (Cash flow to creditors) = interst paid + retirement of debt – proceed from new debt
= interst paid – net new borrowing = interest paid – (ending long-term debt – beginning long-term debt)
 Equity (Cash flow to shareholders) = dividend paid + stock repurchase – proceed from new stock issue
= dividend paid – net equity raised = dividend paid – (stock sold – stock repurchase)
o Increase in share capital, share premium/capital surpulus ⇒ stock sold
o Increase in treasury stock ⇒ stock repurchase
• Standardize financial statements for comparison purposes
o
Common-Size Balance Sheets: Compute all accounts as a percent of total assets
o
Common-Size Income Statements: Compute all line items as a percent of sales
• Ratio analysis
o
Short-term solvency / Liquidity (ability to pay bills in the short-run)
 Current Ratio = current assets / current liabilities
 Quick Ratio = (current assets – inventory) / current liabilities
 Cash Ratio = cash / current liabilities
o
Long-term solvency / Leverage, Coverage (ability to meet long-term obligations)
 Leverage
o Total debt ratio = (total assets – total equity) / total assets
o Debt/equity ratio = (total assets – total equity) / total equity
o Equity multiplier = total assets / total equity
= (total debt + total equity) / total equity = 1 + debt/equity ratio
 Coverage: Measure the level of indebtedness and the ability to service debt
o Times interest earned ratio = EBIT / interest
o Cash coverage ratio = (EBIT + depreciation + amortization) / interest = EBITDA / interest
o
Asset management / Turnover (Efficiency of asset use) ⇒ Cái gì turnover thì nó nằm ở mẫu
 Inventory turnover = cost of goods sold / inventory
o Days’ sales in inventory = 365 days / inventory turnover
 Receivables turnover = sales / accounts receivable
o Days’ sales in receivables/avg. collection period/days’ sales outstanding
= 365 days / receivables turnover
 Total Asset Turnover
o Total Asset Turnover (TAT) = sales / total assets
o Fixed Asset Turnover (FAT) = sales / fixed assets
o Net Working Capital Turnover = sales / net working capital
o
Profitability (Efficiency of operations and how this translates to the “bottom line”)
 Profit margin = net income / sales
 EBITDA Margin = EBITDA / sales
 Return on Assets (ROA) = net income / total assets
 Return on Equity (ROE) = net income / total equity
o DuPont: ROE = PM * TAT * EM = ROA * EM

3 – FS Analysis &
Financial Models
C3 (74)
C3
(1)
2
Market value (How the market values the firm relative to the book values)
 Earnings Per Share (EPS) = net income / shares outstanding
o Measures how much money a company makes for each share of its stock
 Price-earnings ratio = price per share / earnings per share
o Measures how much investors are willing to pay per dollar of current earnings
 Market-to-book ratio = market value per share / book value per share
o Helps investors assess whether a stock is overvalued or undervalued
 Dividend payout ratio = Dividend / Net icome
 Market capitalization = Price per share x Shares Outstanding
o Useful for potential buyer
 Enterprise Value (EV) = Market capitalization + Market value of interest-bearing debt – Cash
o If not avai. Info, Market value of interst-bearing debt = Book value of Notes paybles, Long-term debt
o Estimate how much it would take to buy all the outstanding stocks and pay off the debt
 EV multiple = EV / EBITDA (multiple thì cái gì lớn hơn, nó ở tử số)
o Estimate the value of the firm’s total business rather than focusing on its equity value only
o Similar to P/E ratio, firms with high growth opportunities have higher EV multiple
• External Financing Needed (EFN)
o
= forecasted increase in assets - forecasted increase in liabilities, equity
o
= (Assets/Sales) × Change in sales – (Spontaneous liabilities/Sales) × Change in sales
– Profit margin × Project sales for next year × (1 – Dividend payout ratio)
o
Growth rate (p = plowback (retention ratio) = addition to retained earnings/net income)
 Internal growth rate = (ROA*b) / [1 – ROA*b]
o the maximum growth rate that can be achieved with no external financing kind
 Sustainable growth rate = (ROE*b) / [1 – ROE*b]
o the maximum growth rate that can be achieved with no external financing kind
while maintaining a constant D/E
• 𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)𝑡 ⇒ r : annual interst rate APR
𝐴𝑃𝑅 𝑚𝑡
• Compounding: 𝐹𝑉 = 𝐶0 (1 +
) , 𝐹𝑉 = 𝐶0 (1 + 𝐸𝐴𝑅)𝑡 ⇒ Continuous compounding: 𝐹𝑉 = 𝐶0 𝑒 𝐴𝑃𝑅 𝑥 𝑡 (e ~
𝑚
2.718)
𝐴𝑃𝑅 𝑚
• Effective annual rate 𝐸𝐴𝑅 = (1 +
) −1
⇒ Continuous compounding: 𝐸𝐴𝑅 = 𝑒 𝐴𝑃𝑅 − 1
𝑚
• Cash flow
o
First payment occurs at year 1
𝐶
 Perpetuity (a constant stream of cash flows that lasts forever): 𝑃𝑉 =
o
𝑟
4 – Discounted CF
C4 (121)
C4
(1)

Growing Perpetuity (a growing stream of cash flows that lasts forever): 𝑃𝑉 =

Annuity (a constant stream of cash flows with a fixed maturity): 𝑃𝑉 =
𝐶
𝑟

o
𝐶
𝑟
𝐶
𝑟−𝑔
1 𝑡
(1 − (
1+𝑟
) ) ; 𝐹𝑉 =
((1 + 𝑟)𝑡 − 1)
Growing Annuity (a growing stream of cash flows with a fixed maturity): 𝑃𝑉 =
First payment occurs immediately (year 0)
 𝐹𝑉 𝑑𝑢𝑒 = 𝐹𝑉 (1 + 𝑟)
 𝑃𝑉 𝑑𝑢𝑒 = 𝑃𝑉 (1 + 𝑟)
3
𝐶
𝑟−𝑔
(1 − (
1+𝑔 𝑡
1+𝑟
))
5 – Net Present Value
& Other Investment
Rules
C5 (158)
C6
(2)
• Loan
o
Pure discount: receive money today + repay a single lump sum in the future ⇒ treasury bills
o
Interst-only: interst payment each period + full principal at maturity date
o
Amortised: interst payment each period + principal payment each period
• Net present value NPV (most popular and effective technique)
o
Formula: NPV = - Cost + Present value of future
o
Rule: for single project – accept if possitive NPV, for multi-independent projects – take all those positive
NPVs, for mutually exclusive projects – accept highest possitive NPV
o
Pros:
o
Cons:
• Payback period
o
Formula: Number of years to recover initial costs
o
Rule: accept if less than a predefined number
o
Pros: easy to understand, biased toward liquidity
o
Cons: ignore time value of money, ignore cash flow beyond cutoff date
• Discounted payback period
o
Formula: discount CF first ⇒ then number of years to recover initial costs (if CF & CF > 0, discouted
payback period is larger than payback period)
o
Rule: accept if less than a predefined number
o
Pros:
o
Cons: ignore cash flow beyond cutoff date
• Internal rate of return IRR
o
Formula: discount rate that NPV = 0 (assume all future CF are reinvested at IRR)
o
Rule: accept if IRR > required return (investing CF), IRR < required return (borrowing CF)
o
Pros: easy to understand and communicate
o
Cons: ignore scale, not distinguish borrowing (CF0 >0, CFn <0) vs investing CF (CF0 <0, CFn >0), multiple
IRR if con-conventional CF (change sign more than once)
• Modified internal rate of return
o
Discounting approach: discount negative CF to present at required return ⇒ add them to initial cost
o
Reinvestment approach: compound all CF (except the first) to the end of project
o
Combination approach: discount negative CF to present, compound positive CF to the end of project
o
Mutually exclusive projects:
 Calculate NPV of two projects
 Calculate incremental NPV from incremental CF (large-budget or large-initial investment – small-budget
CF)
o Accept larger project if incremental NPV > 0
 Calculate incremental IRR from incremental CF (large-budget or large-initial investment – small-budget
CF)
o Accept larger project if incremental IRR > discount rate or required return
• Profitability Index PI
o
Formula = PV of all CF subsequent to initial investment / Initial investments
o
Rule: accept if > 1
o
Pros: easy to understand
4
o
6 – Making Capital
Investment Decisions
7 – Intro to risk &
return
C6 (192)
C7 (226)
C7
(2)
C9
(3)
Cons: problems with mutually exclusive investments
• Relevant cash flows: CF that occur (or do not occur) because a project is undertaken.
Cash flows that will occur whether or not we accept a project are not relevant
• Incremental cash flows: any & all changes in firm’s future CF that are a direct consequence of taking the
project
• Use after-tax cash flows, not pretax (the tax bill is a cash outlay, even though it is based on accounting
numbers)
• Sunk cost: a CF already paid or accrued, not be included in the incremental CF.
• Opportunity costs: any CF lost or forgone by taking one course of action rather than another, applies to any
asset or resource that has value if sold, or leased, rather than used ⇒ ex: CF0 = -250, CFn = +250
• Side effects
o
Erosion (Cannibalism) – new project revenues gained at the expense of existing
o
Synergies – new projects add revenues to existing
• Depreciation ⇒ Not a CF, only used to calculate tax shield in OCF, Net capital spending
o
MACRS 3-year: Year 1 - 33.33%, Year 2 - 44.45%, Year 3 - 14.81%, Year 4 - 7.41%
o
MACRS 5-year: Year 1 - 20.0%, Year 2 - 32.00%, Year 3 - 19.20%, Year 4 - 11.52%, Year 5 - 11.52%, Year 6
- 5.76%
o
MACRS 7-year: Year 1 - 14.29%, Year 2 - 24.49%, Year 3 - 17.49%, Year 4 - 12.49%, Year 5 - 8.93%, Year
6 - 8.92%, Year 7 - 8.93%, Year 8 - 4.46%
o
Declining balance: for each year - Higher of (Carrying amount x %, Carrying amount / Remaining year)
o
Sum-of-the-Years' Digits (SYD) Depreciation: each year = Cost * (Remaining year / Sum-of-the-Years’ Digit)
• Cash flow of the firm = OCF – NCS – NWC
o
OCF Operating cash flow = EBIT + depreciation – current taxes (Cash in, earnings excl. interst, depr., tax)
= Net income + Depreciation = Sales – Cash costs – Taxes = (Sales – Cash costs) x (1-Tax rate) + Depr. x
Tax rate
= Pre-tax cost saving x Tax rate + Depreciation increase x Tax rate
o
NCS Net capital spending = purchase of fixed assets – sale of fixed assets
= ending net fixed assets – beginning net fixed assets + depr. (Cash out)
 after-tax salvage value = sale price – gain x tax rate = sale price – (sale – carrying amount) x tax rate
 after-tax salvage value = sale price + loss x tax rate = sale price + (carrying amount – sale) x tax rate
o
NWC Changes in net working capital = ending NWC – beginning NWC (Cash out)
 all working capital is assumed to be recovered at the end ⇒ sum of all year = 0
 ex: project requires an initial investment in net working capital 250 ⇒ ex: CF0 = -250, CFn = +250
• Inflation and Capital budgeting
o
Use normal discount rate for normal cash flow, real discount rate for real cash flow
(1 + 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑟𝑎𝑡𝑒) = (1 + 𝑁𝑜𝑟𝑚𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑟𝑎𝑡𝑒) (1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)
o
1+𝑁𝑜𝑟𝑚𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑟𝑎𝑡𝑒
o
𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑟𝑎𝑡𝑒 =
o
𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑁𝑜𝑟𝑚𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
1+𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
−1
• Return
o
Dollar return = Dividend income + Capital gain (or loss) (ignoring taxes)
5
o
o
o
Percentage return = Dollar retun / Beginning market value
= (Dividend + Change in market value) / Beginning market value = Dividend yield + Capital gain yield
 Divident yield = Dt+1 / Pt
 Capital gain yield = (Pt+1 – Pt) / Pt
Holding period return: return an investor get when holding an investment over a period of T years, when the
return during year i is given as Ri ⇒ HPR = (1 + R1)(1 + R2)…(1 + RT )−1
𝑅 +𝑅 +⋯+𝑅𝑇
Average return (historical data) 𝑀𝑒𝑎𝑛 = 𝑅̅ = 1 2
𝑇

o
o
Arithmetic average return: return earned in an average period over a particular period,
overly optimistic for long horizons
 Geometric average return: average compound return per year over a particular period
overly pessimistic for short horizons
𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 = [(1 + 𝑅1 )(1 + 𝑅2 ) … (1 + 𝑅𝑇 )]1/𝑇 − 1
Variance (historical data): average squared deviation between actual returns and their mean
(𝑅1 − 𝑅̅ )2 + (𝑅2 − 𝑅̅)2 + ⋯ + (𝑅𝑇 − 𝑅̅)2
𝑉𝑎𝑟 = 𝜎 2 =
𝑇−1
Standard deviation (historical data): measure of the spread of a sample, square root of variance 𝑆𝐷 = 𝜎 =
2
√𝑉𝑎𝑟
• Return on individual stocks
o
Expected Return: return that individual expects a stock to earn over the next period, historial avg or analyst
 Ri the return in state i, pi the probability of state I ⇒ expected return: 𝑅̅ = 𝑝1 𝑅1 + 𝑝2 𝑅2 + ⋯ + 𝑝𝑇 𝑅𝑇
o
Variance: assess volatility security’s return, = squared deviations security’s return form its expected return
 𝑉𝑎𝑟 = 𝑝1 (𝑅1 − 𝑅̅ )2 + 𝑝2 (𝑅2 − 𝑅̅)2 + ⋯ + 𝑝𝑇 (𝑅𝑇 − 𝑅̅)2
2
o
Standard deviation is the square root of the variance 𝑆𝐷 = 𝜎 = √𝑉𝑎𝑟
o
Covariance: 𝐶𝑜𝑣(𝑎, 𝑏) = 𝜎𝑎,𝑏 = ∑(𝑎 − 𝐸(𝑎))(𝑏 − 𝐸(𝑏)) a statistic measure of interrelationship between two
securities
o
∑ 𝑎𝑏 −𝑛𝑎̅𝑏̅
𝑛
or 𝜌𝜎𝑎 𝜎𝑏
Correlation: 𝐶𝑜𝑟𝑟(𝑎, 𝑏) = 𝜌 =
𝐶𝑜𝑣(𝑎,𝑏)
𝜎𝑎 𝜎𝑏
If correlation is positive, variables are positively correlated and vice
versa
o
Variance, Standard deviation measure variability of individual stock
Covariance, Correlation measure relationship btw return on 1 stock on return on another ⇒ to understand
the beta coefficient
• Return on portfolio
o
Expected Return on a Portfolio: weight average of expected returns on the individual securities (percentage,
total weight = 1) 𝐸(𝑅) = 𝑅̅ = 𝑤1 𝑅1 + 𝑤2 𝑅2 + ⋯ + 𝑤𝑁 𝑅𝑁
o
Variance 𝑉𝑎𝑟 = 𝜎 2 = 𝑤𝑎2 𝜎𝑎2 + 2𝑤𝑎 𝑤𝑏 𝜎𝑎,𝑏 + 𝑤𝑏2 𝜎𝑏2 = 𝑤𝑎2 𝜎𝑎2 + 2𝑤𝑎 𝑤𝑏 𝜌𝜎𝑎 𝜎𝑏 + 𝑤𝑏2 𝜎𝑏2
2
Standard deviation is the square root of the variance 𝑆𝐷 = 𝜎 = √𝑉𝑎𝑟
o
Beta: weighted average of each beta 𝛽 = 𝑤1 𝛽1 + 𝑤2 𝛽2 + ⋯ + 𝑤𝑁 𝛽𝑁
• CAPM
o
𝐸(𝑅) = 𝑅𝑓 + 𝛽 [𝐸(𝑅𝑚 − 𝑅𝑓 )]
o
Expected return on a security = Risk-free rate + Beta of the security x Risk-premium
o
6
o
Risk-premium = Difference between expected return on market and risk-free rate
Risk-free rate ⇒ T-bill rate
o
Beta (i – individual assets, m – market) 𝛽𝑖 =
o
o
o
𝐶𝑜𝑣(𝑅𝑖 ,𝑅𝑚 )
𝜎 2 (𝑅𝑚 )
= 𝜌𝑖,𝑚
𝜎(𝑅𝑖 )
𝜎(𝑅𝑚 )
 Beta of market portfolio = 1
 Beta of risk-free rate asset = 0 as no risk
 Market has a correlation = 1 with itself
 Risk-free rate asset has a correlation = 0 with market portfolio
 Risk-free rate asset has standard deviation = 0
Security Market Line (SML)
 𝑅𝑓 Slope ⇒ upward-sloping
 [𝐸(𝑅𝑚 − 𝑅𝑓 )] Intercept
 Exercise: 𝐸(𝑅) = 𝑅𝑓 + 𝛽 [𝐸(𝑅𝑚 − 𝑅𝑓 )] ⇒ Giải phương trình 1 ẩn, 2 ẩn
Capital Market Line (CML)
 A well-diversed portfolio has no unsystematic risk, the portfolio lie on CML
 𝑆𝑙𝑜𝑝𝑒𝐶𝑀𝐿 = (𝐸(𝑅𝑀 ) − 𝑅𝑓 )/𝜎𝑀
 Expected return on (well-diversified) portfolio 𝐸(𝑅𝑃 ) = 𝑅𝑓 + 𝑆𝑙𝑜𝑝𝑒𝐶𝑀𝐿 (𝜎𝑃 )
𝑆
𝑃
𝐵
• Weighted average cost of capital 𝑊𝐴𝐶𝐶 =
𝑅 +
𝑅 +
𝑅 (1 − 𝑇𝐶 )
𝑆+𝑃+𝐵 𝑆
𝑆+𝑃+𝐵 𝑃
𝑆+𝐵 𝐵
• Cost of Equity 𝑅𝑆
o
CAPM: more popular, explicitly adjust for risk
8 – Risk, Cost of
Capital and Valuation
C11 (362)
C13 (420)
C10-12
(3)
o
DDM Dividend discount model: for only company pay dividend 𝑅𝑆 =
C16 (512)
C17 (546)
C15 –
17
(4)
𝑃0
+𝑔
• Cost of prefered stock (fixed dividends, no voting rights, convertibility) 𝑅𝑃 =
𝐷 (𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑖𝑑 𝑜𝑟 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑)
𝑃𝑉 (𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒)
Dividends – not fully deductible as interest expense (1) for individual investors – ordinary for income taxes,
(2) for corporate investors – 70% amount received can be exempted from income taxes
• Cost of debt 𝑅𝐵
• 𝑉 = 𝐵 + 𝑆 in which, B = market value of debt, S = market value of debt
• M&M Modigliani-Miller model (L = levered = use debt, U = unlevered = totally equity, no debt):
assume 1) no transaction costs, 2) indi and corp can borrow at the same rate
note: current value = current CF + present of future CF (ex: after tax earnings), market value = market value of
debt and equity ⇒ value can be current value can be market value, read carefully the requirement in questions
o
Proposition 1 (No taxes): firm value not change with leverage
⇒ through homemade leverage, indi can duplicate or undo the effects corp leverage
 𝑉𝐿 = 𝑉𝑈
o
Proposition 1 (Taxes): firm value increase with leverage
⇒ because corp can deduct interst payments but not dividend payments, corp lower tax payments
 𝑉𝐿 = 𝑉𝑈 + 𝑇𝐶 𝐵 (increase = present value of interest tax shield = PV (Interst payment x Tax rate))
o
Proposition 2 (No taxes): leverage increase risk & return to stockholders
⇒ cost of equity rise as risk to equity rise with leverage
o
9 – Capital Structure:
Basic Concepts
𝐷1

𝐵
𝑅𝑆 = 𝑅0 + (𝑅0 − 𝑅𝐵 )
𝑆
7
o
Proposition 2 (Taxes): some of increase in risk & return by leverage is offset by tax shield
⇒ cost of equity rise as risk to equity rise with leverage

o
o
10 – Dividends and
Other payouts
C19
(604)
C18
(4)
𝐵
𝑅𝑆 = 𝑅0 + (𝑅0 − 𝑅𝐵 )(1 − 𝑇𝐶 )
𝑆
o 𝑅𝑆 return on levered equity (cost of equity new)
o 𝑅0 return on unlevered equity (cost of capital old)
o 𝑅𝐵 interest rate (under MM, debt is assumed risk-free 𝑅𝐵 = 𝑅𝑓 = treasury bill rate if not mentioned
specifically)
o 𝑇𝐶 tax rate
o 𝐵 value of debt (ex: amount borrow, not interst amount), 𝑆 value of levered equity
Beta

No taxes 𝛽𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝛽𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 (1 +

Taxes 𝛽𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝛽𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 (1 +
𝐷𝑒𝑏𝑡
)
𝐸𝑞𝑢𝑖𝑡𝑦
(1−𝑇𝐶 )𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
)
Expected return on firm’s equity ROE = After tax annual earnings / Market value of firm’s equity (Q23-24
C16)
• Cash dividend
o
Type
 Regular cash dividend: normal dividends, usually paid on a quarterly basis
 Extra cash dividend: paid over and above the regular dividend, may or may not be repeated
o
Date
 Declaration date: BoD declared ⇒ becomes a liability of the firm
 Ex-Dividend Date: anyone holding stock immediately before this date is entitled to a dividend
⇒ (no tax) stock price drop = dividend amount
 ⇒ (tax) stock price drop = after-tax dividend amount (Price x (1-Tax rate))
 Date of record: list of stockholders who will receive dividends.
 Date of payment: checks are mailed
o
Dividend policty irrelevance: dividend policy have no impact firm value as investors can use homemade
dividends (reinvest dividend to buy or sell off stock to achieve net cash payout ~ homeade leverage
concept)
• Special dividend: one-time dividend paid over and above the regular dividend, will not be repeated
• Stock dividend: pay owners with additional shares of stock
⇒ 1) No cash actually leaves, 2) firm increases outstanding shares number
• Dividends in kind: pay owners using products or services of the firm
• Stock repurchase: alternative form of cash payout
⇒ not change Price per share (<> dividend), change outstanding shares number ⇒ change EPS ⇒ change PE
ratio
8
⇒ in a perfect capital market, shareholders indifferent btw 2
⇒ in a personal taxes world, shareholder prefer stock repurchase more
o
Benefit
 Flexibility for shareholders: Companies often view dividends as a commitment to stockholders,
while repurchases don’t represent such a commitment
 Keeps stock price higher: Good for insiders who hold stock options
 Offset to dilution: The exercises of stock options also increases the no. of shareholding, causing dilution
of stocks; Firms frequently buy back shares of stock to offset this dilution
 As an investment of the firm (undervaluation): Stock buyback occurs when managers believe that the
stock price is depressed, and stock market reaction to the announcement is usually favorable
 Tax benefits: Repurchases provide a tax advantage over dividends
• Stock market repsonse
o
Negative with decrease in dividends and vice versa ⇒ Suggest that there is information in dividend
payments
o
Hence, there is high (low) dividend firms to meet different dividend preferences
• Residual dividend policy
o
Firm should focus on investment needs and maintan desire debt-equity ratio first ⇒ residual is to pay div.
o
Drawback: variability in div. payment
9