Fundamentals of corporate finance (European edition) by David Hillier
Quartile 4 IBA
Chapter 1 - 14
Chapter 1 Introduction to corporate finance
1.1 Corporate finance and the financial manager
Corporate finance must be considered with three basic types of question:
1. What long-term investments to make
2. Where will we get the money for those investments from
3. How will we manage everyday financial activities
1. What long-term investment to make:
To process of planning and managing long-term investments is called capital budgeting
Capital budgeting = the process of planning and managing a firm’s long-term investments.
Managers try to indentify investment opportunities that are worth more than they cost to acquire.
Capital budgeting involves evaluating the size, timing and risk of future cash flows.
2. Where will we get the money for those investments from?
Capital structure = the mixture of long-term debt and equity maintained by a firm
Long-term debt = borrowing by the firm (> 1 year) to finance its long-term investments
Equity= the amount of money raised by the firm that comes from the owners investment
A manager has two concerns in this area:
1. What mixture of debt and equity is the best
2. What are the least expensive sources of funds for the firm?
3. How will we manage everyday financial activities?
Working capital = a firm’s short-term assets and liabilities
Managing the firm’s working capital is a day-to-day activity which ensures that the firm has sufficient
resources to continue its operations and avoid costly interruptions.
1.2 The goal of financial management
Possible goals for for-profit organisations:
 Survive
 Avoid financial stress or bankruptcy
 Beat the competition
 Maximize sales or market share
 Minimize costs
 Maximize profits
 Maintain steady earnings growth
Goals are or related to profitability or related to controlling risk.
The goal of financial management is to maximize the current value per share of the existing equity.
1.3 Financial markets and the corporation
Financial markets facilitate the flow of money from those that have surplus cash to those that need
financing.
See figure 1.2 for the cash flows between the firm, financial markets and the economy
Primary market: the corporation is the seller and the transaction raises money for the corporation.
Can be:
 Public offerings ( selling securities to the general public)
 Private placements( negotiated sale for specific buyers)
Secondary market: One owner sells its securities to another. It transfers ownership.
Two kinds of secondary markets:
1. Auction markets:
 Physical location
 Matches buyers and sellers
2. Dealer markets
 Over- the-counter (OTC) markets  can happen anywhere
 Buying and selling is done by the dealer
The equity shares of most large European firms trade in organized auction markets. These kinds of
shares are said to be listed on that exchange.
Chapter 2 Corporate Governance
2.1 Forms of Business organization
Three legal forms of business organization:
1. Sole proprietorship
Sole proprietorship = a business owned by a single individual
 Keeps all profit
 Unlimited liability ( also proprietor’s personal assets can be taken for payment)
 Limited to owners lifespan
 Amount of equity is limited to the amount of the proprietor’s personal wealth
 Micro companies
2. Partnership
Partnership = a business formed by two or more individuals or entities
 Partnership agreement ( description of the way partnership gains are divided)
 General partners run the business
 Limited partners don’t actively participate in the business
Most important for the kind of businesses:
 Unlimited liability for business debts on the part of the owner
 Limited life of the business
 Difficulty of transferring ownership
Central problem: the ability to grow can be limited by an inability to raise cash for investment.
3. Corporation
Corporation = A business created as a distinct legal entity composed of one or more individuals or
entities
 Separate legal entity
 To start a memorandum of association and articles of incorporation must be made.
o Memorandum of association: describes how the corporation regulates its existence.
 Ownership can easily be transferred (shares)



Limited liability for business debt
Unlimited life of the business
Disadvantage : must pay tax
2.2 The agency problem and control of the corporation
Type 1 agency problem = the possibility if conflict of interest between the shareholders and
management of a firm.
Agency costs: the cost of the conflict of interest between shareholders and management. These costs
can be direct or indirect:
 Indirect costs is a lost opportunity
 Direct costs are a corporate expenditure that benefits management but costs the
shareholders.
 Direct costs is also an expense that comes from the need to monitor management actions
These problems can be solved by managerial compensation.
Control of the firm ultimately rests with shareholders. They elect the board of directors, who in turn
hire and fire managers.
Single tier board: shareholders elect the directors
Two tier board: supervisory board elects the directors
Cumulative voting = a procedure in which a shareholder may cast all votes for one member of the
board of directors.
This permits minority participation.
Number of shares * number of directors to be elected.
1/ (n+1) =per cent of shares needed to win the election. N= number of directions up for election
Straight voting = a procedure in which a shareholder may cast all votes for each member of the board
of directors
Own more than 50% to win the seat.
Freeze out minority shareholders
Devices to minimize the impact of cumulative voting:
 Staggering: only a fraction of the directorships are up for election at a particular time
 Two effects:
o Harder for minority to elect director.
o Take-over attempts are less likely to be successful.
Proxy = A grant of authority by a shareholder allowing another individual to vote his or her share
Classes of shares: Different kinds of equities have different voting rights.
Other right in addition to vote for directors:
 Right to share proportionally in dividends paid.
 Right to share proportionally in assets remaining after liabilities have been paid in case of
liquidation.
 Right to vote on shareholder matters of great importance.
Pre-emptive right: the right to share proportionally in new equity sold.
Dividends = payments by a corporation to shareholders, made in either cash or shares
 Are not liabilities
 Are no business expenses

Are taxable
Type 2 agency problem = the possibility of conflict of interest between controlling and minority
shareholders.
Sometimes management goals are pursued at the expense of some or all shareholders, at least
temporarily
Stakeholder = someone, other than a shareholder or creditor, who potentially has a claim on the cash
flows of the firm
2.3 International corporate governance
Legal environment has a big impact on the firms’ decisions.
Three law systems:
1. Common law: the law evolves as a result of the judgment decisions
2. Civil law: judges interpret the law
3. Religious law: specific religious principles form the basis of legal decisions
Also the adherence to the rule of law and efficiency of law enforcement have a major impact on
corporate decision-making and regulatory compliance.
Financial environment also influences firms’ decisions
In a bank based financial system, banks play a major role in facilitating the flow of money.
In market based systems, financial markets take on the role of the main financial intermediary.
Chapter 3 Financial analysis and planning
3.1 The annual report
Annual report consists of:
 Balance sheet
 Income statement
 Cash flow statement
Balance sheet: financial statement showing a firm’s accounting value on a particular date.
 Assets = Liabilities + Shareholders’ equity
Net working capital = current assets less current liabilities
(3.1)
Income statement = financial statement summarizing a firm’s performance over a period of time
 Revenues – Expenses = Income
(3.2)
Non – cash items = expenses charged against revenues that do not directly affect cash flow, e.g.
depreciation.
Corporate tax rate = the rate of tax that corporations have to pay.
Average tax rate = tax bill dividend by taxable income.
Marginal tax rate = the tax paid if one euro more is earned.
Cash flow statement = financial statement summarizing all the cash flows of a firm over a period of
time
Total cash flow = the total of cash flow from operating, investing and financing activities.
 Cash flow from assets = Cash flow to creditors + cash flow to shareholders
(3.3)
Cash flow from
Cash flow from
Cash flow from
 Total cash flow = operating activities + investing activities + financing activities
(3.4)
Operating cash flow = cash flows generated from a firm’s normal business activities
Cash flow from investing activities = cash generated from a firm’s long-term investments
Cash flow from financing activities= cash generated as a result of its debt and equity choices.
3.2 Ratio Analysis
Financial ratios: relationships determined from a firm’s financial information, used for comparison.
Short term solvency measures

𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(3.5)

𝑞𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
(3.6)

𝑐𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜 =

𝑛𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑜 𝑎𝑠𝑠𝑒𝑡𝑠 =

𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡−𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑐𝑎𝑠ℎ
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑛𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠
Long term solvency measures
𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡−𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦

𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =

Debt - equity ratio = 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦

𝑒𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

𝑙𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =

𝑡𝑖𝑚𝑒𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 =

𝑐𝑎𝑠ℎ 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
(3.7)
(3.8)
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
(3.9)
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡
𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡+𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡+𝑛𝑜𝑛−𝑐𝑎𝑠ℎ 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛𝑠
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
(3.10)
(3.11)
Asset Management measures (turnover measures)
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑑𝑎𝑦𝑠 ′ 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =

𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =


𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
365 𝑑𝑎𝑦𝑠
′
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑠𝑎𝑙𝑒𝑠
𝑡𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
365 𝑑𝑎𝑦𝑠
𝑑𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠𝑖𝑛 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 =
𝑁𝑊𝐶 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑆𝑎𝑙𝑒𝑠
𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
(3.12)
(3.13)
(3.14)
(3.15)
(3.16)
𝑁𝑊𝐶
𝑆𝑎𝑙𝑒𝑠

PPE turnover=𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦,𝑝𝑙𝑎𝑛𝑡 𝑎𝑛𝑑 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡

𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑠𝑎𝑙𝑒𝑠
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
(3.17)
(3.18)
Profitability measures
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =

Return on assets(ROA) = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Return on equity(ROE) =
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

ROE =
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑠𝑎𝑙𝑒𝑠
𝑠𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑠𝑎𝑙𝑒𝑠
𝑎𝑠𝑠𝑒𝑡𝑠
(3.19)
(3.20)
(3.21)
∗ 𝑎𝑠𝑠𝑒𝑡𝑠 ∗ 𝑒𝑞𝑢𝑖𝑡𝑦
Market value measures
𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

P/E ratio = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃𝐸𝐺 𝑟𝑎𝑡𝑖𝑜 =

Price-sales ratio=
(3.22)
𝑝𝑟𝑖𝑐𝑒−𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒(%)
𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
(3.23)

Market-to-book value=

Tobin’s Q=
𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚′ 𝑠 𝑎𝑠𝑠𝑒𝑡𝑠
𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑟𝑚′ 𝑠 𝑎𝑠𝑠𝑒𝑡𝑠
(3.24)
(3.25)
3.3 The Du Pont identity
Du pont identity = popular expression breaking ROE into three parts: efficiency, asset use efficiency,
financial leverage.
 ROE= profit margin ×
total asset turnover ×
equity multiplier
(3.26)
Operating efficiency asset use efficiency
financial leverage
3.4 Using financial statement information
Financial statements are used by internal and external users.
To compare how you are doing in the market (benchmark):
 A time trend analysis
 A Peer group analysis
3.5 Financial planning
Planning:
 Examining interactions
 Exploring options
 Avoiding surprises
 Ensuring feasibility and internal consistency
Managers should think about goals and establishing priorities
3.6 Financial Planning models
Percentage of sales approach = a financial planning method in which account are varied depending
on a firm’s predicted sales.
 Dividend payout rate = the amount of cash paid out to shareholders divided by net income
𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑠
Dividend payout ratio= 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
(3.27)

Retention ratio/Plough back ratio = the addition to retained earnings divided by net income
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑒𝑎𝑡𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
 Capital intensity ratio = a firm’s total assets divided by its sales, or the amount of assets
needed to generate £1 in sales
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Capital intensity ratio: 𝑠𝑎𝑙𝑒𝑠
3.7 External financing and growth
EFN = external financing needed
Internal growth rate = the maximum growth rate a firm can achieve without external finance of any
kind
𝑅𝑂𝐴∗𝑏
 𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 1−𝑅𝑂𝐴∗𝑏
where b = retention ratio
(3.28)
Sustainable growth rate = the maximum growth rate a firm can achieve without external equity
financing, while maintain a constant debt equity ratio
𝑅𝑂𝐸∗𝑏
 𝑠𝑢𝑠𝑡𝑎𝑖𝑛𝑎𝑏𝑙𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 1−𝑅𝑂𝐸∗𝑏
(3.29)
Sustainable growth depends on:
 Profit margin: an increase in profit margin will increase the firm’s ability to generate funds
internally and thereby increase its sustainable growth
 Dividend policy : a decrease in the percentage of profit attributable to shareholders paid out
as dividend will increase the retentions ratio
 Financial policy : an increase in the debt-equity ratio increases the firm’s financial leverage.
 Total asset turnover: An increase in the firm’s total asset turnover increases the sales
generated for each pound in assets. This decreases the firm’s need for new assets as sales
grow and thereby increase the sustainable growth rate.
(Is the same as decreasing capital intensity)
3.8 Some caveats regarding financial planning models
Financial planning models rely on accounting relationships and not financial relationships. The three
basic elements of firm value tend to get left out ( cash flow size, risk, timing)
Planning is an iterative process. The plans have to be modified over and over again.
Chapter 4 Introduction to valuation: the time value of money
4.1 Future value and compounding
Future value (FV) = the amount an investment is worth after one or more periods
Compounding = the process of accumulating interest on an investment over time to earn more
interest
Interest on interest = interest is earned on the reinvestment of previous interest payments
Compounded interest = interest earned on both the initial principal and the interest reinvested from
prior periods
Simple interest= interest earned only on the original principal amount invested.

Future value = €1 * (1+r)t
(4.1)
4.2 Present value and discounting
Present value (PV) = the current value of future cash flows discounted at the appropriate discount
rate
Discount = calculate the present value of some future value

1
€1
Present value = €1 *[ (1+𝑟)𝑡] = (1+𝑟)𝑡
(4.2)
Discount rate = the rate used to calculate the present value of future cash flows
Discounted cash flow(DCF) valuation = calculating the present value of a future cash flow to
determine its value to day
4.3 More about present and future values
 PV= FVt * (1+r)-t
(4.3)
The rule of 72 : For reasonable rates of return, the time it takes to double your money is given
approximately by 72/r% (r between 5 & 20 %)
Chapter 5 Discounted cash flow valuation
5.1 Future and present values of multiple cash flows
Calculate future values for multiple cash flow:
1. Compound the accumulated balance forward one year at a time
2. Calculate the future value of each cash flow first and then add them up
Calculate present value with multiple cash flows:
1. Discount back one period at a time
2. Calculate the present values individually and add them up
We almost always assume that the cash flow occurs at the end of each period.
5.2 Valuing level cash flows: annuities and perpetuities
Annuity = a level stream of cash flows for a fixed per of time.
The present value of an annuity of €C per period for t periods when the rate of return or interest rate
is r is given by:

1
1
Annuity present value = 𝐶 × ({𝑟 − 𝑟(1+𝑟)𝑡 }
(5.1)
The future value of an annuity of €C per period for t periods when the rate of return or interest rate
is r is given by:

(1+𝑟)𝑡
𝑟
Annuity FV factor= 𝐶 × {
1
− 𝑟}
(5.2)
Annuity due = an annuity for which the cash flows occur at the beginning of the period
Perpetuity = a annuity in which the cash flows continue for ever
Consol = a type of perpetuity
The present value of a perpetuity of €C per period when the rate of return or interest rate is r is given
by:
 PV for a perpetuity = 𝐶/𝑟
(5.3)
The present value of a growing annuity of €C per period with a growth rate of g for t periods when
the rate of return or interest rate is r is given by:

Growing annuity present value = 𝐶 × {
1+𝑔 𝑡
)
1+𝑟
1−(
𝑟−𝑔
}
(5.4)
The present value of a perpetuity of €C per period with a growth rate of g when the rate of return or
interest rate is r is given by:

Growing perpetuity present value = 𝐶/(𝑟 − 𝑔)
(5.5)
5.3 Comparing rates: The effect of compounding
Nominal interest rate = the interest rate expressed in terms of the interest payment made ach period
Effective annual percentage rate (EAR) = the interest rate expressed as if it was compounded once per
year.
 EAR = [1 + (Quoted rate/m)]m  1 , where m is the number of times the interest is
(5.6)
compounded during a year.
Annual percentage rate (APR) = the harmonized interest rate that expresses the total cost of
borrowing or investing as a percentage interest rate
𝐶𝑖
 PV = C0 +∑𝑇𝑖=1
𝑖

(1+𝐴𝑃𝑅)
𝐸𝐴𝑅 = 𝑒 𝑞 − 1 q is the quoted rate
(5.7)
(5.8)
5.4 Loan types and loan amortization
Pure discount loans:
 Get money today
 Repay a single lump sum ate sometime in the future that includes the interest
Interest only loans:
 Pay interest each period
 Repay the entire principal at some point in the future
A mortised loans:
 Repay parts t the loan amount over time
o Pay interest + fixed amount
Chapter 6 Bond valuation
6.1 Bonds and bond valuation
Bond = corporation/ government borrows money from the public on long-term basis
 Interest only loan
 None of the principal will be repaid until the end
Coupon = regular interest payments, stated on the bond
Face/ per value = the principal amount of a bond that will be repaid at the end of the loan
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
Coupon rate = 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 *100%
Maturity = the specified dat on which the principal amount of a bond is paid.
Yield to maturity (YTM)= the rate required in the market on a bond
The value of bonds fluctuate because of changes in interest rates.
 Interest ↑ pv↓ bond value ↓ : Discount bond self for less than the value
 Interest↓ pv↑ bond value↑ : Premium bonds sells for more than its face value.
1−
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 ∗ [
1
(1+ 𝑟𝑡 )
𝑟
+
𝐹
(1+𝑟)𝑡
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝑝𝑟𝑒𝑠𝑒𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛𝑠 + 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑎𝑐𝑒 𝑎𝑚𝑜𝑢𝑛𝑡
Interest rate risk = risk that arises for bond owners from fluctuating interest
How sensitive is its price to interest rate changes
Depends on:
 Time to maturity : the longer the time, the higher the risk
 Coupon rate: the lower the rate, the greater the risk.
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
Current yield =
𝑝𝑟𝑖𝑐𝑒
Finding a yield on a bond  trial & error
If the rate ↑ bond value↓
(6.1)
6.2 More about bond features
Equity securities
 Dividend paid out
 Not tax deductible
Securities
Debt securities
 Must be repaid
 Not an ownership interest
No voting power
 Payment of interest  cost of doing
business  tax deductible
 Unpaid debt = liability
o If not paid = claim on asset
o Can lead to :
Liquidation
Reorganization
Long-term debt (>1 year)
The indenture = the written agreement between the corporation and the lender detailing the terms of
the debt issue
Includes:
 Basic terms:
o Principal value
o Register form = the registrar of the company records ownership of each bond (payment is
made directly to the owner of record)
o Or bearer form = the bond is issued without record of the owner’s name( payment goes to
who holds the bond)
o Drawbacks:
 Difficult if lost or stolen to recover
 Bondholders are not notified of important events.
 Security
Collateral = securities that are pledges as securities for payment of debt
Mortgage: secured by a mortgage on the real property of the borrower
Unsecured bond = an unsecured debt security usually with a maturity of >10year (no specific pledge
of property)
Note = an unsecured debt security usually with a maturity under 10 years (no specific pledge on
property )
Both have a claim on property not otherwise pledged. So the property that remains after mortage
and collateral trusts are taken into account.
 Seniority = indicates preference in position over other lenders.
 Repayment: when the bond is repaid.
o Sinking fund: account managed by the bund trustee for early bond redemption
 The call provision = an agreement giving the corporation the option to repurchase a bond at a
specific price prior to maturity.
o Call premium =the amount by which the call price exceeds the par value of a bond.
o Deferred call provision = a call provision prohibiting the company from redeeming a
bond prior to a certain date.
o Call protected bond =a bond that during a certain period, cannot be redeemed by the
issuer.
o During that period the call is protected

Protective covenant = agreement that limits certain actions a company might wish to take
during the term of the loan, usually to protect the lender’s interest.
6.3 Bond rating
Junk bonds are bonds with a low degree and have a major default risk
Factors influencing the credit ranking of sovereign bonds:
 Political risk
 Economic strength
 Growth prospects
 Government debt
 Monetary flexibility
 Fiscal flexibility
Factors influencing the credit ranking of corporate bonds:
 Financial risk
 Debt payments
6.4 Some different types of bond
Government bonds:
Treasury notes and bonds
 No default risk
 Exempt of tax
Zero coup bonds:
 Zero coupon bond = a bond that makes no coupon payments and is thus initially priced at a
deep discount.
 Makes no coupon payments
 Priced at a deep discount
Floating rate bonds:
 Coupon payments are adjustable
 Inflation linked bond
Other types:
 Catastrophe bond
 Warrant
 Income bond
 Convertible bond
 Put bond
 CoCo bond
 NoNo bond
6.5 Bond markets
There is no place where buying and selling of bonds take place  OTC
Two reasons why the bond market is bigger than the equity market:
1. Only 1 ordinary equity per company
2. Government borrowing
Clean price = price of bond net of accrued interest.
Dirty price= price of a bond including accrued interest .(Price a buyer actually pays)
6.6 Inflation and interest rates
Real rates: interest rates that have been adjusted for inflation
Nominal rates: interest rates that have not been adjusted for inflation
The nominal rate on an investment is the percentage change in the amount of cash you have
The real rate on an investment is the percentage change in how much you can buy with your cash.
The fisher effect = the relationship between nominal return, real returns and inflation.
 The fisher effect
1 + R = (1 +r) * (1 +h)
(6.2)
R= nominal rate; r= real rate; h= inflation rate
 Nominal rate : R =r + h + r *h
(6.3)
Nominal rate without the consideration that the money earned on investment is also worth less
because of inflation:
 R = r +h
(6.4)
6.7 Determinants of bond yields
Term structure of interest rates = the relationship between nominal interest rates on default-free, pre
discount securities and time to maturity: that, is the pure time value of money.
Bond yields represent the combined effect of:
 Real rate of interest
 Expected future inflation
 Interest rate risk
 Default risk
 Taxability
 Lack of liquidity
Inflation premium = the portion of a nominal interest rate that represent compensation for expected
future inflation.
Interest rate risk premium= the compensation investors demand for bearing interest rate risk.
Treasury yield curve = a plot of the yields on treasury notes and bonds relative to maturity.
Default risk premium = the portion of a nominal interest rate or bond yield that represent
compensation for the possibility of default.
Taxability premium = the portion of the nominal interest rate or bond yield that represents
compensation for unfavorable tax status
Liquidity premium = the portion of a nominal interest rate or bond yield that represents compensation
for lack of liquidity
Chapter 7 Equity valuation
7.1 Share valuation
Reasons why share prices are more difficult to value than bonds:
 The promised cash flows are not known in advance
 Life of the investment is forever ( has no maturity)
 No way to observe the rate of return
𝐷 +𝑃
1
1
 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝑃0 = 1+𝑅
(7.1)
𝑃0 is current equity price, 𝑃1 is price in one period. 𝐷1 is the cash dividend paid at the end of the
period. R is required return on the equity.
No matter what the share price is, the present value is essentially zero if we push the sale of equity
far enough away
Also possible:
Zero growth rate:
𝐷
 𝑃0 = 𝑅
(7.2)
Constant growth rate:
𝐷1
 𝑃0 = 𝑅−𝑔
(7.3)
Dividend growth model = a model that determines the current share price as its dividend next period
divided by the discount rate less the dividend growth rate

Pt =
(1+𝑔)∗ 𝐷𝑡
𝑅−𝑔
=
1+ 𝐷𝑡
𝑅−𝑔
(7.4)
Two stage growth :
𝐷
1+𝑔
𝑃

1
𝑡
P0 = 𝑅−𝑔
* [1 − ( 1+𝑅1 )𝑡 ] + (1+𝑅)
𝑡

𝑡+1
P1 = 𝑅−𝑔
=
1
𝐷
2
(7.5)
𝐷0 ∗ ( 1+ 𝑔1 )𝑡 ∗( 1+ 𝑔2 )𝑡
𝑅− 𝑔2
(7.6)
Components of required return
𝐷
 R= 1
(7.7)
𝑃0 +𝑔
Dividend yield= an equity’s expected cash dividend divided by its current price
Capital gains yield = the dividend growth rate, or the rate at which the value of an investment grows
7.2 Some features of ordinary and preference shares
Ordinary equity= equity without priority for dividend or in bankruptcy
Preference shares = equity with dividend priority over ordinary shares, normally with a fixed dividend
rate, sometimes without voting rights.
7.3 The stock market
Primary market: new securities are sold to investors
Secondary market: securities are traded among investors
Dealer = buys and sells securities from inventory
Broker = arranges security transactions among investors
Chapter 8 Net present value and other investment criteria
8.1 Net present value.
Investment makes sense if it is more worth in the market place than it costs to acquire
Capital budgeting is about trying to determine whether a proposed investment is worth more than it
costs
Net present value(NPV) = difference between an investment’s market value and its costs
Discounted cash flow valuation (DCF) = the process of valuing an investment by discounting its future
cash flows
An investment should be accepted if the npv is positive and rejected if the npv is negative
8.2 The payback rule
Payback period = the amount of time required for an investment to generate cash flows sufficient to
recover its initial costs
Based on the payback rule, an investment is acceptable if its calculated payback period is less than
some pre-specified number of year,
Advantages
Disadvantages
Easy to understand
Adjusts for uncertainty of later cash flows
Biased towards liquidity
Ignores time value of money
Requires an arbitrary cut-off point
Ignores cash flows beyond the cut-off period
Biased against long-term projects
8.3 The discounted payback
Discounted payback period = the length of time required for an investments discounted cash flows to
equal its initial costs
Based on the discounter payback rule , an investment is acceptable if the discounted payback is less
than pre-specified number of years
Advantages
Disadvantages
Easy to understand
Includes time value of money
Biased towards liquidity
Doesn’t accept negative estimated NPV
investments
May reject positive NPV investments
Requires an arbitrary cut-off point
Ignores cash flows beyond the cut-off period
Biased against long-term projects
8.4 The average accounting return.
Average accounting return =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Based on the average accounting rule, accept an investment if its average accounting return exceeds
a target average accounting return
Advantages
Disadvantages
Easy to calculate
Needed information will usually be available
Time value of money is ignored
Uses an arbitratry benchmark cut-off rate
Based on accounting values not on cash flows
and market values
8.5 The internal rate of return
The internal rate of return (IRR)= the discount rate that makes the NPV of an investment zero
Based on the IRR rule, an investment is acceptable if the IRR exceed the required return, it should
be rejected otherwise.
The IRR on an investment is the required rturn that results in a zero NPV when it is used a the
discount rate
Net present value profile = a graphical representation of the relationship between an investment’s
NPV’s and various discount rates
Problems with the IRR:
 Non-conventional cash flows give multiple rates of return = the possibility that more than
one discount rate will make the NPV of an investment zero
 Mutually exclusive investment decisions = a situation in which taking one investment prevent
the taking of another
 Cross over rates = the discount rate that makes the NPV of two projects equal NPV (B-A)
Advantages
Disadvantages
Closely related to NPV, often leading to identical
decisions
Easy to understand and communicate
May result in multiple answers
Hard to use when mutually exclusive
investments have to be made
Modified internal rate of return:
 Discounting approach:
Discount all negative cash flows back to the future
 Reinvestment approach: compound all cash flows except the first out to the end of the
projects life
 The combination approach negative cash flows are discounted back to the present and
positive cash flows are compounded to the end of the projects
8.6 The profitability index
Profitability index = the present value of an investments future cash flows dividend by its initial costs.
Advantages
Disadvantages
Easy to understand and communicate
May lead to incorrect decisions in comparison of
mutually exclusive investments
Closely related to NPV
Chapter 9 Making Capital investment decisions
9.1 Project cash flows; a first look
Incremental cash flow = the difference between a firm’s future cash flows with a project and those
without that project.
The incremental cash flows for a project evaluation consist of any and all changes in the firm’s future
cash flows that are a direct consequence of taking the project.
Stand alone principle = the assumption that evaluation of a projects may be based on the project’s
incremental cash flows.
9.2 Incremental Cash flows
Sunk costs = a cost that has already been incurred and cannot be removed.
 Not considered in an investment decision.
Opportunity costs = the most valuable alternative that is given up if a investment is undertake.
 Should be taken into account in an investment decision
Erosion= the cash flow of a new project that comes at the expenses of a firm’s existing projects.
 Not included in investment decision: interest paid or any financial costs
9.3 Pro forma financial statements and project cash flows.
Pro forma financial statement = financial statement projecting future years ‘operations.
Projects cash flow = project operating cash flow – project capital spending
Operating cash flow = net income +depreciation – increase in net working capital
9.4 More about project cash flow
Total cash flow = operating cash flow – change in net working capital – capital spending
Reducing balance method= a depreciation method allowing for the accelerated write off of assets
under various classifications.
Equivalent annual costs – the present value of a project’s costs, calculated on an annual base
9.5 Alternative definitions of operating cash flow
Bottom up approach for calculating operating cash flows:
 OCF = net income + depreciation
(9.1)
Top down approach for calculating OCF:
 OCF= sales – costs – taxes
(9.2)
Depreciation tax shield = the tax saving that results from the depreciation deduction calculated as
depreciation multiplied by the corporate tax rate.
 OCF = (Sales – Costs) * (1-T) + Depreciation * T
(9.3)
9.6 Some special cases of discounted cash flow analysis
Common cases involving discounted cash flow analysis:
 Improving efficiency & cutting costs
 Submitting competitive bids
 Evaluating equipment options with different lives
Equivalent annual cost (EAC) = the present value of a project’s costs calculated on an annual basis.
Calculating by : PV of costs/ annuity factor
Chapter 10 Project analysis and evaluation
10.1 Evaluating NPV estimates
Two circumstances leading to a positive NPV:
 There is a positive NPV
 Investment appears to have a positive NPV because our estimate is inaccurate
Forecasting risk = the possibility that errors in projected cash flows will lead to incorrect decisions.
10.2 Scenario and other what-if analyses
Important to realize what the source of value for the NPV is.
What to do if you start a new project
 Estimate NPV (base case)
 Scenario analysis = the determination of what happens to NPV estimates when we ask whatif questions.
o Best case
o Worst case
 Sensitivity analysis = investigation of what happens to NPV if only one variable is changes 
points out where forecasting errors will do damage but doesn’t tell what to do about
possible errors.
 Simulation analysis = a combination of scenario and sensitivity analysis
o No decision rule tells us what to do
o Possible values aren’t equal to occur, we assume that they are
10.3 Break-even analysis
Break even analysis: how bad do sales have to get before we lose money
Variable costs =costs that change when the quantity of output changes (VC).
Fixed costs = costs that do not change when the quantity changes during a particular time period (FC).
TC= VC+FC
TC= v*Q+FC
Marginal (incremental )costs = the change in costs that occurs when there is a small (1) change in
output.
Accounting breakeven = the sales level that results in zero projects income.
 Break-even level = Q = ( FC+D)/ (P-v)
(10.1)
Q= Total units sold; FC = fixed costs; D=depreciation; P= Selling price per unit; v= Cost pet unit of
output
Why using accounting break-even:
 To see if the market share you need to get break even is achievable
 Easy to calculate and explain
 To see what a project will contribute to the firm’s total accounting earning
 Other opportunities
10.4 Operating cash flow, sales volume and break-even.
 OCF= (P-v) * Q – FC
𝐹𝐶+𝑂𝐶𝐹
 Q = 𝑃−𝑣
Cash break-even = the sales level that results in a zero operating cash flow
Financial break-even= the sales level that results in a zero NPV
(10.2)
(10.3)
See Table 10.1 for summary
10.5 Operating leverage.
Operating leverage = the degree of which a firm or project relies on fixes costs.
High degree of operating leverage = capital intensive.
Degree of operating leverage (DOL) = the percentage change in operating cash flow relative to the
percentage change in equity sold.
𝐹𝐶
 DOL = 1 +
(10.4)
𝑂𝐶𝐹
10.6 Capital rationing
Capital rationing= the situation that exists if a firm has positive NPV projects but cannot find the
necessary financing.
Soft rationing = the situation that occurs when units in a business are allocated a certain amount of
financing for capital budgeting  makes sure that the corporation as a whole isn’t short of capital.
Hard rationing = the situation that occurs when a business cannot raise financing for a project under
any circumstances.
Chapter 11 Some lessons from recent capital market history
11.1 Returns
Return on investment: gain/loss from investments.
Income component: cash you receive directly while you own the investment.
Capital gain/loss of investment:
 Total cash return = dividend income + capital gain(or loss)
 Total cash if equity is sold = initial investment + total return
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑠 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑+𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑣𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
Percentage return =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
1 + Percentage return =
(11.1)
(11.2)
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑠 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑+ 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
Or dividend yield ( Dt+1/pt) + capital gains yield ( (Pt+1 - Pt)/Pt).
11.3 Average returns: The first lesson
Average return =
𝑠𝑢𝑚 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑦𝑒𝑎𝑟𝑠
Risk premium = the excess return required from an investment in a risky asset over that required from
a risk-free investment.
Excess return = difference between risk-free returns and very risky returns.
Risky assets , on average, earn a risk premium. There is a reward for bearing risk.
11.4 The variability of returns: the second lesson
Variance = the average squared difference between the actual return and the average return.
Standard deviation= the positive square root of the variance.
Historical variance & standard deviation
√𝑎𝑐𝑡𝑢𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛
Variance = the sum of the squared deviations by the number of returns -1
Var (R) = σ2
Standard deviation = √ var(R)  SD(R) = σ
Sum of deviations = 0
See p.323
1
[(𝑅1 − 𝑅̅ )2 + (𝑅2 − 𝑅̅ )2 + ⋯ + (𝑅𝑇 − 𝑅̅ )2 ]
 Historical variance = 𝑉𝐴𝑅(𝑅) =
(11.3)
𝑇−1
Normal distribution= a symmetric bell-shaped frequency distribution that is completely defined by its
mean and standard deviation.
The greater the potential reward, the greater the risk.
11.5 More about average returns.
Geometric average return = the average compound return earned per year over a multi-year period.
Arithmetic average return = the return earned in an average year over a multi-year period.
Use the arithmetic average if you know the true value
 [(1 + 𝑅1 ) × (1 + 𝑅2 ) × … × (1 + 𝑅𝑇 )]1/𝑇 − 1
Which to use?
 Up to a decade: arithmetic
 Few decades: split the difference between arithmetic and geometric
 Many decades: geometric

𝑇−1
𝑁−𝑇
R(T)= 𝑁−1* Geometric average + 𝑁−1 * Arithmetic average
(11.4)
(11.5)
11.6 Capital market efficiency
Efficient capital market = market in which security prices reflect available information
Efficient markets hypothesis= the hypothesis that actual capital markets are efficient
See figure 11.8
Forms of market efficiency:
 Strong-form efficient= all information of every kind is reflected in share prices
 Semi- strong form efficiency = all public information is reflected in the share price
 Weak-form efficiency = at a minimum the current share price reflects the equity’s own past
prices
Chapter 12 Return, risk and the security market line.
12.1 Expected returns and variances.
Expected return = the return on a risky asset expected in the future.
 Risk premium = Expected return – risk free rate
(12.1)
12.2 Portfolios
Portfolio = a group of assets such as equities and bonds held by an investor.
Portfolio weight = the percentage of a portfolio’s tot value that is in a particular asset.
 Expected return on portfolio = 𝑥1 * E(𝑅1 )* 𝑥2*E(𝑅2 )* ….
(12.2)
12.3 Announcement, surprises and expected returns.
 Total return = expected return + Unexpected return
 Announcement = expected part + surprise
(12.3)
(12.4)
12.4 Risk: Systematic and unsystematic.
Unanticipated part of the return in the true risk.
Two types of risk:
Systematic risk affects almost all assets in the economy
Unsystematic risk affects at most a small number of assets
 R= E(R) + Systematic portion + unsystematic portion
(12.5)
12.5 Diversification and portfolio risk .
Principle of diversification = spreading an investment across a number of assets will eliminate some,
but not all, risk.
Unsystematic risk is eliminated by diversification so a portfolio with many assets has almost no
unsystematic risk.
 Total risk = systematic risk + unsystematic risk
(12.6)
12.6 Systematic risk and Beta.
Systematic risk principle= the expected return on a risky assets depends only on that assets systematic
risk.
The expected return on a asset depends only on that asset’s systematic risk.
Beta coefficient ß = the amount of systematic risk present in a particular risky asset relative to that in
an average risky asset.
Calculating portfolio beta:
 What part of the portfolio is share A and what part is share B
 What is the beta of that share.
 Beta = part of the portfolio A * Beta of share A + part of the portfolio B * Beta of share B
12.7 The security market line.
Reward to risk ratio =
E(𝑅𝑛 )− 𝑅𝑓
ß𝑖
Basic argument = compare the reward to risk ratios
The reward to risk ratio must be the same for all the assets in the market
Security market line = a positively sloped straight line splaying the relationship between expected
return and beta.
SLM slope = E(𝑅𝑛 ) − 𝑅𝑓 The market risk premium = the slope of the sml. The difference between
the expected return on a market portfolio and the risk free rate.
Capital asset pricing model(CAPM) = The equation of the SML showing the relationship between
expected return and beta.
 E(𝑅𝑖 )= 𝑅𝑓 + [ E(𝑅𝑚) - 𝑅𝑓 ] * ß𝑖
(12.7)
Shows:
 The pure time value of money
 The reward for bearing systematic risk
 The amount of systematic risk
See p. 368
Chapter 13 Cost of capital
13.1 The cost of capital: some preliminaries.
Cost of capital = the minimum required return on a new investment.
The cost of capital depends primarily on the use of the funds, not the source.
A firm’s overall cost of capital will reflect the required return on the firm’s assets as a whole 
reflects both cost of debt capital and equity capital .
13.2 The cost of equity.
Cost of equity = the return that equity investors require on their investment in the firm.
The dividend growth model approach:
 𝑅𝐸 = 𝐷1/𝑝0 +g D1=Do *(1+g)
g can be estimated by:
1. using historical growth rates
2. using analysts forecasts of future growth rates
(13.1)
Advantages
Disadvantages
Easy
Applies only if dividend is paid
Assumes that dividend grows at a constant rate
Doesn’t consider risk
The SML approach:
 𝑅𝐸 = 𝑅𝑓 + ß𝑒 ∗ (𝑅𝑚 − 𝑅𝑓 )
Advantages
Adjusts for risk
Applicable to companies that don’t pay steady
dividend
(13.2)
Disadvantages
Estimates risk premium and beta coefficient
Relies on the past
13.3 The cost of debt and preference shares.
The costs of debt the return that lenders require on the firm’s debt.
Can be:
 Interest rate
 Rating of bonds
 Coupon rate if irrelevant
The cost of preference shares:
 𝑅𝑝 = D/𝑝0
(13.3)
13.4 The weighted average costs of capital.
 V(value)= E(equity+D(debt)
(13.4)
 100% = E/V + D/V
(13.5)
Weighted average cost of capital WACC= the weighted average of the cost of equity and the after-tax
cost of debt.
 WACC = ( E/V) * 𝑅𝐸 + (D/V) *𝑅𝐷 * (1- 𝑇𝐶 )
(13.6)
 WACC = ( E/V) * 𝑅𝐸 +(P/V) * 𝑅𝑃 (D/V) *𝑅𝐷 * (1- 𝑇𝐶 )
(13.7)
Projects that have the same risk are said to be in the same risk class
See page 394!
WACC can only be used is possible investment with risks are more or less the same from those of the
overall firm
13.5 Divisional and project costs of capital.
Pure play approach = the use of a WACC that is unique to a particular project, based on companies in
similar lines of business.
13.6 Flotation costs and the weighted average cost of capital.
Flotation = the issue new bonds and shares.
Divisional cost of capital – cost of capital are separated division otherwise divisions with less risk will
have no potential.
 fa= (E/V) * fe+ (D/V) * fd
(13.8)
Chapter 14 Raising capital
14.1 The financing life cycle of a firm.
Venture capital (VC) = financing for new, often high risk ventures
Capital supplied by:
 Private equity firms
 Venture capital
o Families traditionally provided start-up capital to promising businesses
o Private partnerships and corporation
o Venture capital subsidiaries form large corporations
o Individual investors
Stages of financing:
 seed money
 start-up
 Later stage capital
 Growth capital
 Replacement capital
 Buyout financing
14.2 Selling securities to the Public: The basic procedure.
Selling securities to the public:
 Path finder prospectus
 Pre-underwriting conferences
 Full prospectus
 Public offering and sale
 Market stabilization
14.3 Alternative issue methods.
General cash offer= an issue of securities offered for sale to the general public on a cash basis.
Right issue: a public issue of securities in which securities are first offered to existing shareholders.
Initial public offering (IPO)= a company’s fires equity issue made available to public.
Seasoned equity offering(SEO) = new equity issue of securities by a company that has previously
issued securities to the public.
14.4 Underwriters
Underwriters = investment firms that act as intermediaries between a company selling securities and
the investing public.
Tasks:
 Pricing.
 Selling.
 Formulating method to issue securities.
Syndicate = a group of underwriters formed to share the risk and to help sell an issue.
Gross spread= compensation to the underwriter, determined by the difference between the
underwriter’s buying price and offering price.
Types of underwriting:
 Firm commitment underwriting : underwriter buys entire issue, assuming full financial
responsibility for any unsold shares.
 Best effort underwriting : sells as much of the issue as possible, but can return any unsold
shares to the issuer without financial responsibility.
 Dutch auction underwriting: the offer price is set based on competitive bidding by investors.
Green shoe provision = a contract provisions giving the underwriter the option to purchase additional
shares from the issues at the offering price.
Lock-up agreement = the part of the underwriting contract that specifies how long insiders must wait
before an IPO before they can sell equity.
14.5 IPOs and underpricing
In Europe IPO’s are mostly offered below their true market price. Higher for firms with few o no sales
in previous years.
IPO buyers might actually lose money.
14.6 New equity sales and the value of the firm.
Share prices of firms that announce that new equity issues are coming go down because of:
 Managerial information
 Debt usage
 Issue costs
14.7 The costs of issuing securities.
Flotation costs:
 Gross spread: direct fees paid to the underwriting syndicate (difference between receiving
price and offer price).
 Other direct expenses: legal fees, tax.
 Indirect expenses: salary managers working on issuing the shares
 Abnormal returns : price of existing shares drop
 Underpricing: selling the equity below the true value
 Green shoe option
14.8 Rights
Right issue = the firm must offer any new issue of equity to existing shareholders first.
Subscription price- the price that existing shareholders are allowed to pay for a share of equity.
Standby underwriting = underwriter agrees to purchase the unsubscribed portion of the issue.
Standby fee= an amount paid to an underwriter participating in a standby underwriting agreement.
14.9 Dilution
Dilution = loss in existing shareholders ‘value in terms of ownership market value, book value or EPS.
Oversubscription privilege= privilege that allows shareholders to purchase unsubscribed shares in a
rights offering at the subscriptions pric.e
Dilution of proportionate ownership
If new shares are being issued and you don’t buy them  right issues to solve this problem
14.10 Issuing long-term debt
Term loans= direct business loans of typically one to five years.
Private placements= loans provided by a limited number of investors.
Difference with public issue of debt:
 No cost of stock exchange registration
 Has more restrictive covenants
 Easier to renegotiate
 Costs of distributing bonds are lower in the private marker
14.11 Shelf registration
Shelf registration = registration permitted by many stock exchanges that allows a company to register
all issues it expects to sell within a certain period at one time, with subsequent sales at any time
within that period.
Dribbling= a company registers the issue and hires an underwrites as its selling agent.
Arguments against:
Cost of new issues goes up  not able to provide information
Market overhang  possibility of issuing new shares has a negative impact on current prices.