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The primary goal of any profit run business is to maximise the value of the existing shares, or maximise the market value of the existing owners equity (or the firms current market share price). Stakeholders in firm (and relation to managers): Theory Reality Shareholders Fire & hire managers in board + annual meeting Little control over managers Society Financial markets No social costs since costs can be traced to firm Significant social costs, some cannot be traced Markets are efficient & assess effect on value Reveal info honestly and on time Markets can make mistakes and overreact due to speculators Can get ripped off when loans default

Debtholders Lend money + protect self interests

AGENCY PROBLEMS Shareholders vs. Managers

Direct agency costs arise when managers act in their own self-interest rather than in shareholders eg. managers use shareholder's profits to increase their fringe benefits: office environment, car managers need to be monitored creates monitoring costs Indirect agency costs value maximising investment opportunities are rejected Mechanisms to solve agency conflicts Board of directors SH meetings Managerial compensation Corporate governance Internal Employing executive and non-executive members of the board Can exert considerable influence on the company, eg. Proxy fight Compensation that gives managers incentive to act in best interests of the shareholders (eg. Using stock options giving managers + employees stocks of the company) Issues: board composition, directors' ditues, executive remuneration, financial reporting, information disclosure, shareholder participation, audit and risk mgmt. Recognises that the firm has obligations to other stakeholders: debtholders + employees, customers, suppliers, regulators + society at large External Managers who are successful in pursuing SH value are in greater D and command higher salaries Debt acts as a monitoring mechanism Mergers and acquisitions SH can threaten to sell their shares in a hostile takeover: managers usually fired after acquisiting

Managerial labour market Debt contracts and legal mechanisms Market for corporate control

Shareholders vs. Debtholders

Debtholders have a claim on part of the earnings of the firm or some of the assets if the firm goes bankrupt, but have no control over the firm. Debtholders charge interest based on their perception of the risk of a firms current and future projects and capital structure An agency problem arises if a firm elects a very risky project: SH benefit if successful, but no benefit to DH To protect themselves, debtholders may demand that restrictive covenants be written into the loan contract to restrict the firms behaviour: specified levels of working capital, charger higher IR, refuse to lend, etc Conflicts of interest can also arise with: employees, customers, suppliers, govt, b/c they all have financial interest in the firm

A financial market brings together buyers and sellers of debt and equity. The Primary Market facilitates the sale of original securities. Issuers or sellers are corporations and governments. Types of offerings include public and private. The Secondary Market is the market in which issued securities are traded between parties. Shares that are traded in an organised exchange are said to be listed on that exchange. To be listed on the ASX, a company is required to have a market value for its publicly held shares of at least $10 million and a total of at least 500 shareholders, each holding a parcel of shares with a minimum value of $2000.


Time Value of Money A dollar received today is worth more than a dollar received in the future. If the dollar is invested today, it may generate a return to create another dollar in the future

An annuity is a level/regular stream of cash flows for a fixed/ltd time, eg. Student loan repayment, mortgage Cash flow occurrence Example Ordinary END of each period Interest Annuities No payment on 0, Payment on 1, 2, 3 Annuities Due BEGINNING of each time period Rent for a lease Payment on 0, 1, 2, no payment on 3 Deferred Annuity Begins at time t+k Futures K = no of periods before the first cash flow HECS No payment on 1, 2, payment on 3

A perpetuity is an annuity in which the CFs are expected to continue forever, i.e. infinite stream of constant CFs Dividends from corporations Growing Perpetuities: A growing perpetuity is an annuity in which the cash flows are expected to grow at a constant rate forever, eg. increasing dividends from a growing corporation Uneven Cash Flow Stream: A series of CF in which the amount varies from one period to the next i.e. non-constant


Future Value (FV) refers to the amount of money an investment will grow to over some period of time at some given interest rate the amount an investment is worth after one or more periods = (1 + ) The amount an investment is worth after one or more periods To find FV you need: o C = cash amount, R = interest rate, t = time period


Present Value (PV) is the value on a given date of a future payment or series of future payments, discounted to reflect the TV of M. = (1 + ) The current value of future cash flows discounted at the appropriate discount rate o We have the future value, need to work out how much to invest now (PV) in order to get to that value in a certain time period To find PV you need: FV, r = discount rate/interest rate, t= time period When experiencing difficulties for questions regarding FV and PV, drawing a time line will help. Different Compounding Periods The difference in compounding means that comparisons b/w investments are difficult unless a common base is used.

There are several different types of interest rates: Nominal interest rates, denoted inom, or Annual Percentage Rate (or APR), Stated rate, Quoted rate Effective interest rates, denoted EFF or, Equivalent annual rate (EAR) Periodic interest rates, iPER Nominal Interest Rates 1. The nominal (or quoted) IR is the rate that is quoted by financial institutions and written into contracts. 2. For this IR to be meaningful, it is also necessary to know how many compounding periods there are in a year. 3. Once the nominal interest rate is known, it can be used to find other interest rates. Effective Annual Interest Rates 1. The Effective Annual Interest Rate is the rate of interest actually being earned by the investor. 2. This is the IR that would generate the same future value if annual compounding had been used. 3. It is used to compare returns on investments with different payments per year. It is also used in calculations when annuity payments do not match compounding periods. 4. Its relationship to the nominal IR is shown here, where EFF = effective annual IR, m is the # of times interest is compounded per year Periodic Interest Rates The Periodic Interest Rate is the rate charged by a lender in each period. This can be given in terms of any period (year, semi-annual period, quarters, per month, per day etc) This is the rate that usually appears on time lines and is the one used in calculations. If m = 1, inom = iper = EFF

A firm can be valued in two ways: PV of cash flows generated by the firms real (productive) assets, OR Sum of the PV of cash flows generated by the firms individual securities (debt & equity) = + where, V = PV of cash flows generated, D = PV of cash flows generated by debt securities, E = PV of cash flows generated by equity securities Valuing a firms real asset cash flows The net cash flows from real assets after reinvestment costs are known as free cash flows If a firm is assumed to have an infinite life, the value of the firm is given by: (where C refers to the free cash flows of the firm) = (1 + )

When a corp or govt wants to borrow money from 1500 the public on a LT basis, they do so by issuing or selling debt securities that are typically referred to 1400 1300 as bonds (or debentures/unsecured notes). The 1200 borrower will pay the interest every period, but 1100 none of the principal will be repaid until the end 1000 of the loan. Par/Face value the principal amount to be 900 repaid 800 Coupon stated interest payment made on a 700 bond, usually = YTM at issue 600 Coupon rate the annual coupon divided by the 0% 2% 4% 6% 8% 10% 12% face value 1. Fixed coupon coupon rate remains fixed over life of bond 2. Zero coupon no coupon paid but sold at deep discount to face value 3. Floating rate coupon rate is adjusted periodically to account for changes in the market interest rate


Coupon payment par value x coupon rate Interest paid on a per annum basis Maturity date date the par value is to be repaid Discount bond occurs when V<F Yield to Maturity (YTM) The market required RoR for bonds with similar risk and maturity The DR used to value a bond Return if bond held to maturity Quoted as an APR Yield and bond value have an inverse relationship graphical relationship b/w $P and YTM: CR = 8%, PV = 1000, M=10 o When IR rises, the PV of the bonds remaining cash flows declines and the bond is worth less o When IR falls, the bond is worth more o If YTM = Coupon rate (CR) par value = bond value Par bond o If YTM > CR par value > bond value Discount bond o If YTM <CR par value < bond value Premium bond Rate of return required in the market if the bond is held to maturity (also called the promised yield) Bonds market rate of interest Value over time At maturity, the value of any bond must equal its par value If YTM remains constant throughout the life of a bond: o The value of a premium bond would decrease over time until it reached par value o The value of a discount bond would increase over time until it reached par value o The value of the par bond stays at par value Zero-Coupon and Floating Rate Bonds A zero coupon bond makes no coupon payments so its value is based only on the PV of its par value there is substantial price risk. The coupon rate on a floating rate bond changes with a benchmark index value. There is less price risk b/c the coupon remains quite close to the yield to maturity. Interest rate risk 1. Uncertainty regarding the rate at which cash flows can be reinvested 2. If r falls, future CFs will have to be reinvested at lower rates, hence reducing Y 3. The risk is higher for bonds with a shorter maturity and callable bonds Price effect The change in the value of a bond due to a change in YTM (IR) The concern that a rising r will cause the value of a bond to fall The risk is higher for bonds with a longer maturity or a lower coupon rate Term structure of interest rates The relationship between the time to maturity and the nominal IR on default free, pure discount debt securities is called the term structure of IR. No coupons and no default risk pure time value of money A yield curve is a graph that displays the relationship between the ST and LT IR for the same risk class, ie. Reflects the term structure of IR (can be upward sloping {resembles y=sqrt(x)}, downward sloping or flat) The shape of the yield/ term structure is determined by: Real rate of interest Inflation (premium) compensates for decrease in purchasing power Interest rate risk (premium)

Other Issuer fails to pay promised amount of principal or interest on the due date Influenced by issuers financial strength and terms of the bond contract Increases r Relationship between default risk and IR is called the default structure of interest rates o Liquidity premium comp for lack of liquidity o Taxability is coupon interest payment subject to tax?

Equity instrument giving the holder ownership rights in a firm Ordinary Shares Voting rights Residual claim to any assets of earning left in the business Last claim on dividends Variable dividends Dividends can be non-cumulative Preference Shares No voting rights Preferential rights to dividends. Dividend is usually a stated % of the FV of the share. First claim on dividends Receive a fixed dividend every period Dividends can be cumulative if firm cant pay during specific period, it will be paid another period, but for ordinary shareholders, this is not the case

Standard Features Market price $P at which the share is trading on the SX Intrinsic value Perceived actual value based on firm fundamentals Required rate Minimum return on a share for an investor to buy the share, taking into account alternative of return investments and the risk of the share itself Dividends Payments made to shareholders either in cash or shares. The decision to pay dividends and the amount to be paid is determined by mgmt. based on the past years bus perf. it represents the Y component of the return on shares Dividend growth rate expected rate of growth in dividends in the future Dividend growth model A model that determines the current price of a share as its dividend next period divided by the discounted rate less the dividend growth rate. The price of a share today is the present value of all of its future dividends.

Cost of capital = discount rate = required rate of return CAPITAL BUDGETING DECISION CAPITAL BUDGETING AND INVESTMENT DECISIONS
Capital budgeting is the process of analysing LT investment projects that will generate cash flows Determines the nature of a firms operations and products in the medium to long term o Fixed asset investments are generally long lived and not easily reversed once they are made Decides whether a particular project is acceptable, or the best to choose between a no. of proposals Capital Budgeting Process Generating investment proposals

Screening, analysing and selecting from variety of proposals Implementing and monitoring selected proposals
One project




Multiple projects


Screening Independent Projects 1. Projects that no impact on each others cash flows 2. Each project is analysed independently and has no impact on others 3. Firm could accept one or more projects or it could reject them all

Mutually Exclusive

Screening Mutually Exclusive Projects Accepting one project requires rejecting all other options (cannot be simultaneously pursued) Analysed separately but need to be ranked relative to each other in order to determine which to undertake Screening Contingent Projects Acceptance or rejection of a project is dependent on the decision to accept or reject a related project Requires the cash flow interactions of the projects to be incorporated Complementary o Projects A and B: cash flows AB > cash flow of A+B o Eg. Opening a movie cinema and candy bar Substitute o Eg. Froyo and ice cream Evaluation: Quantitative Analysis 1. Forecast cash flows Initial cost Expected future cash flows inc. any final salvage value 2. Determine risk of cash flows Discount rate based on the projects level of risk Alternative cash flow forecasts are generated 3. Apply evaluation method Often more than one technique is used


Incremental cash flows - The incremental cash flows for project evaluation consist of any and all changes in the firms future cash flows that are a direct consequence of taking the project. The standalone principle: The assumption that evaluation of a project may be based on the projects incremental cash flows by viewing the project as a mini-firm The NPV of the mini-firm is equal to the change in firm value due to undertaking the project. = + Sunk cost a cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment decision, since the interest lies in expected cash flows. Opportunity cost the most valuable alternative that is given up if a particular investment is undertaken, since eliminating a future cash flow is equivalent to losing money on the investment. Will creating a new product cause it to lose sales from another product its own line? However, they may also lose sales from a competitor by not filling the void in the market Net working capital refers to costs that are incurred in running a business (float, inventory). Investment in a project net working capital closely resembles a loan, the firm supplies working capital at the beginning and recovers it towards the end Financing costs- the particular mix of debt and equity a firm chooses to finance a project is analysed separately from the investment decision, since we are interested in the value of the project itself

for example interest paid is a component of cash flow to creditors, not cash flow from assets (interest is NOT included in analysis)

FINDING INCREMENTAL PROJECT CASH FLOWS 1) Table of book value of assets

To calculate depreciation, we need: initial acquisition cost, asset life, method What is not considered: capital gains tax, expected salvage value, land cannot be depreciated Depreciation can be calculated as straight line depreciation (prime cost) or diminishing value depreciation. We only need to know straight line depreciation for tests and exams. Straight line cost is divided by how many years the good is used and each year, it depreciates on a constant level. It is expected to be $0 value at the end of the assets life.

2) Table of operating cash flows

Pro forma financial statement financial statements predicting future years operations, convenient and easily understood means of summarising much of the relevant info for a project: estimations of unit sales, selling price per unit, variable cost per unit, total fixed costs = +

+ Sales - Variable Costs - Fixed costs - Depreciation = Earnings Before Income Tax (EBIT) - Taxes = Net Income + + =
EBIT Depreciation Taxes

Operating Cash Flow

Tax shield approach - tax saving that results from tax allowable dep deduction, calculated as depreciation multiplied by the corporate tax rate

3) Table of net working capital requirements

Net working capital - increase in net working capital is a cash outflow 0 1 N OCF X X X NWC -Y +Y Capital spending Z Total Project CF -Y+(-Z) X X X+Y Types of net working capital: Accts Rec Sales that have been recognised in Pro Forma operating cash flows but have not yet been received Inventory Items needed for the continued operation of the business. A/C Payable Expenses that have been recognised in Pro Forma operating cash flows, but have not yet been paid

Increase meaning operating cash flows are too high

After tax salvage the cash received for selling an asset adjusted for taxes over- or under-paid b/c the selling price differs from the book value. Evaluating NPV Estimates there exists forecasting risk/estimation risk o projects may appear to have a positive NPV b/c estimate is inaccurate need to keep in mind the degree of competition in the market basic principle: positive NPV investments will be rare in a highly competitive environment Scenario analysis just change your assumptions and see the resulting change in NPV. You will want to consider best and worst case scenarios. Start with a base case estimate on NPV based on projected cash flows (upper and lower bounds) tells us minimum + maximum NPV of the project - to achieve worst case, assign the least favourable value to each item (low output price, high input costs) worst/best bound by likelihood of it becoming true Sensitivity analysis choose a variable and change it by a few percent up and down (ie. 1%, 5%), keeping all other variables at their base case value. Repeat for other variables in your model. See which variables affect NPV the most. freeze all variables except on and see how sensitive estimate of NPV is to changes in that one variable - if NPV est is v. sensitive to relatively small changes in the projected value of some component, then the forecasting risk is high useful in pointing out the variables that deserve the most attention if NPV is esp. sensitive to a variable that is difficult to forecast (eg. unit sales), then the degree of forecasting risk is high

Managerial Options
NPV Estimates assume mgmt. cannot change a project after it begins. Options allow for these changes. Contingency planning taking into account the managerial options implicit in a project Option to expand (existing product lines, products, new markets) Option to abandon (eliminate or suspend project) Option to wait (delay a project to see if market conditions improve) Strategic options Options do not need to be used, so they can only add to the NPV of a project


Real assets are used to produce G&S. Financial assets are claims on real assets or the Y generated by them. Dividends represent income gain, whilst the increase in the share price represents capital gain. The Holding period return (HPR) is the % increase or decrease in the value of the asset over the holding period. Equivalently, where HPR = Capital gains + Dividend Yield +1 +1 = +


GAR represents the smoothest way to get from the start to the finishing point. Formally, it is the constant per-period return that makes a hypothetical investment have the same total return as the actual investment. It is meaningless without specifying the period length. Normalises what is paid per period of time

Looks at what was gained or lost every period each period has the same start to end value doesnt take into account volatility Selling a stock makes no difference to the GM, since the returns are equal, as stocks are highly liquid and can be sold at any time. The GM also represents the value of the asset increasing


AAR GAR Not equivalent per-period return b/c it neglects compounding Useful for forecasting the return next period Return in an average year over a particular period Average compound return per year over a particular period


Treat return on a risky asset as a Random Variable Concentrate on two properties of a RV o Expected return E(R) A summary statistic for the value of a random variable o Standard Deviation (Volatility) (R) How variable the return is around its average A measure for the risk of the return

Return variance
The variance is a measure of the return dispersion, how much returns vary around the average.

Standard deviation
The SD is the square root of the variance, which is sometimes called volatility. It is in the same units as the average. For returns, the unit of SD is %. This measures volatility rather than profitability

The SD makes statements on how often we'll see returns in certain areas. It helps to show the relationship between risk and return. Higher risks will yield higher returns, if successful. A general axiom: investors must be rewarded for bearing (systematic) risk, otherwise no one would own risky assets. As systematic risk increases, expected returns increase. Historically, equity yields higher returns than bonds or cash. This is due to the higher risk involved with equity. Subsequently, equity markets (All Ordinaries) have been more volatile than the return on bonds, which have been more volatile than cash returns. Risk premium the reward for bearing risk

Measured as the excess return on a risky asset over the risk-free rate, which is the rate of return on a riskless investment (eg. Treasury bills) Essentially compensations for varying risk Cash refers to cash saved in banks therefore there is no risk premium Investment All Ordinaries Index 10-year Govt Bonds Cash Average return 13.3% 9.7% 8.0% Risk premium 5.3% 1.7% 0.0%


Direct search market buyers and sellers seek each other directly lots of work on both sides Dealer (market maker) market dealers specialise in a certain asset, purchase these assets for their account and later sell them for a profit dealer has some kind of inventory, broker will help with transaction in most markets, people are both all trying to compete for best price dealer holds inv & quotes bid and ask $P - provides a service of liquidity in exchange for the bid-ask spread Auction market all traders converge at one place to buy or sell an asset Liquidity ability to sell an asset immediately at a fair price. Asset markets should be designed to provide liquidity. The efficient markets hypothesis: stock prices are in equilibrium, stocks are fairly priced, informational efficiency if true you should not be able to earn abnormal or excess returns (or beat the market) o efficient markets do not imply that investors cannot earn a positive return on the stock market o on avg, you will earn a return appropriate for the risk undertaken o there is no bias in prices that can be exploited to earn excess returns

Prices & Information Returns

Strong-form Reflects all public and private No such thing s insider information No one, even insiders, can earn abnormal returns everything thats known is reflected in the price

Semistrong-form ALL public information is reflected in the share price No abnormal returns from fundamental analysis

Weak-form At a minimum, the CP of a share reflects its own past prices No abnormal returns from technical analysis Its a way of looking at past prices and predicting what will happen in the future Markets are generally weak form efficient


Markets are NOT SFE and insiders can earn abnormal returns Prices reflect an informational consensus on the firms or the economys future expected cash flows. The only thing that will change the prices is a surprise that changes the consensus. Markets stay efficient as investors compete and trade on interpreting surprises.


A portfolio is a collection of assets (stocks, cash) defined by: The amount invested in each asset The combined expected return The combined risk


Systematic risk affects every firm in the economy macroeconomic environment, technological changes, political situations microeconomic policy in the 1990s structural change non diversifiable risk, market risk - cannot be diversified away even in a large portfolio Idiosyncratic risk affects certain firms/sectors of the economy this type of risk becomes less prevalent as more stock is increased non systematic risk, diversifiable risk, asset specific risk, unique risk The principle of diversification as different types of stocks are added to a portfolio and the average size of each position shrinks, the amount of idiosyncratic risk in the portfolio declines to zero and only systematic risk remains. This occurs as individual stocks become less and less relevant. As diversity increases, risk approaches 0. A stocks contribution to the portfolio expected return is proportional to the stocks level of systematic risk. Beta the level of systematic risk in any asset relative to that of the market market beta is 1 by definition (risk is same as itself, eg. The All Ords beta relative to the All Ords is 1) risk free: no relative to something that has risk = 0, therefore risk free asset beta is 0 negative beta is possible but very hard to find An average risk stock will move in step with the market and have a beta of 1 An asset that is more volatile than the market will have a beta greater than 1.0 An asset that is less volatile than the market will have a beta less than 1.0


Expected return of a security is linear in its beta. investors are compensated for holding systematic risk in form of higher returns the size of the compensation depends on the equilibrium risk premium E[Rm]-Rf the equilibrium risk premium is increasing in o the variance of the market portfolio (volatile times) o the degree of risk aversion of average investor

Security market line (SML)

for Beta>1: they are goods that are easily forgone when the market is in a downswing

CAPM: Market equilibrium requires a unique market risk premium which means that all assets and portfolios must have the same reward to risk ratio.

( ) ( ) =
Applications of CAPM: 1. Benchmark for portfolio performance evaluation 2. Identifying undervalued/overvalued assets in investment evaluation 3. Estimating cost of capital or cost of equity capital for budgeting project evaluation

Portfolio weights
The portfolio weight Wj is the value of the investment in asset j as a % of the total portfolio value. an assets risk and return is important in how it affecs the risk and return of the portfolio portfolio standard deviation is NOT a weighted average of the standard deviation of the component securities risk o if it were, there would be no benefit to diversification o if the stocks move together, idiosyncratic risk is not minimised should seek stocks that move independently of each other correlation of 1 they move exactly the same way correlation of 0 they move independently of each other A stocks contribution to portfolio risk: proportional to the stocks beta in a well diversified portfolio a complicated function of stock standard deviation and correlation with the rest of the portfolio in general


Cost of equity the return that equity investors require on their investment in the firm

Dividend Growth Model Approach

Since RE is the return that the shareholders require on the share, it can be interpreted as the firms cost of equity capital Estimating g: Can use historical growth rates or use analysts forecasts of future growth rates Advantage: Simplicity easy to understand and use Disadvantages o Applicable only to companies that pay dividends o Underlying assumption is that dividend grows at a constant rate, which will never exactly occur o Estimated CC is very sensitive to the est. growth rate o Does not explicitly consider risk

The SML Approach

The required or expected return on a risky return depends on: Risk free rate, the market risk premium, beta Using SML, the expected return on the companys equity can be written as: ( ) = + ( ) Advantages: Explicitly adjusts for risk, applicable to all companies Disadvantages: must estimate beta and market risk premium, must rely on the past to predict the future


In addition to ordinary equity, firms use debt and preference shares to finance their investments

The Cost of Debt

The cost of debt is the return that the firms creditors demand on new borrowing.

CoD can be observed directly or indirectly CoD = IR the firm must pay on new borrowing, and we can observe IR in fin markets If the firm already has bonds outstanding, then the yield to maturity on those bonds is the market required rate on the firms debt o The coupon rate on the firms outstanding debt is irrelevant here - It just tells us roughly what the firms cost of debt was back when the bonds were issued, not what the cost of debt is today

The Cost of Preference Shares

Preference shares have a fixed dividend paid every period forever, so a preference share is essentially a perpetuity. Preference shares are rated in much the same way as bonds, so the cost of preference shares can be estimated by observing the required returns on other, similarly rated preference shares = 0


E= market value of firms equity, D= market value of the firms debt = + Percentages of capital structure weights can be interpreted just like portfolio weights. Must use MARKET values of the D & E WACC is the required return on a portfolio composed of all the asset or project of the firm Useful in situations when the project under evaluation is believed to have the same market risk as the firms existing operations, If a project under evaluation has a diff market risk, then the WACC is not the correct DR for the project o Project A has lower business risk than the firms existing operations lower beta Regarded too harshly since the WACC > projects true required RoR Projects similar to A would be incorrectly rejected b/c NPVs would be incorrectly understated o Project B has a higher business risk than the firms existing operation higher beta Regarded too leniently since the WACC < projects true required RoR Projects similar to B would be incorrectly accepted b/c NPVs would be incorrectly overstated

Taxes and the WACC (classical taxation system)

Interest paid by a corporation is tax deductible Payments to shareholders (dividends) are not Need to distinguish pre-tax and after-tax cost of debt To calculate the firms overcall CC (for a classical tax system), we multiply the capital structure weights by the associated costs and add them up to get the WACC. The WACC is the overall return the firm must earn on its existing assets to maintain the value of the shares. Also the reqd return on any investments by the firm that have essentially the same risks as existing operations Can use WACC as discount rate when calculating NPV, but only when the proposed investment is similar to the firms existing activities, eg. Expanding a firm to a new location, expanding production Imputation tax system Under the imputation tax system, some of the tax paid by the company is effectively returned to the shareholders as a tax credit attached to the dividends As capital budgeting from Ch8&9 were on an after tax basis, the simplest way to make the adjustment is to alter the cost of equity to take into account the value of the franking credit to the shareholder If the dividend model was used to obtain the RRR on equity, the dividend used in the calculation is an aftercompany tax amount The dividend in the hands of the shareholder is increased by the value of the tax paid by the company on their profits (pre-tax) o Known as franking credit and represents a prepayment of tax for the shareholder


The SML and the WACC

When we are evaluating investments that are substantially different from those of the overall firm, the use of the WACC will potentially lead to poor decisions. a firm that uses its WACC to evaluate all projects will have a tendency to accept unprofitable investments and become increasingly risky

The Pure Play Approach

since we cannot observe the returns on some investments, there is no direct way of finding beta examine other investments outside the firm in the same risk class and use market RR as the DR A company that focuses only on a single line of business is called a pure play PPA the use of a WACC unique to a particular project, based on companies in similar lines of business Want to look for companies that deal exclusively with this sector, since they would be most affected Firms often adopt an approach that involves making subjective adjustments to the overall WACC Group projects into high, moderate and low risk Some risk adjustment, even if it is subjective, is probs better than no risk adjustment

Subjective Approach


Generally firms use internally generated cash flows, such as RE, but there are times when a firm must go outside the firm to obtain capital. EARLY STAGE FINANCING AND VENTURE CAPITAL VC financing for new, often high risk, ventures Entrepreneurs need capital to bring product to market Banks dont often lend to this type of market v. likely many of these firms/products do not survive There are individual venture capitalists and VC firms that pool funds from sources and invest them in a portfolio of companies To limit risk, VC generally provide financing in stages at each stage enough money is invested to reach the next milestone or planning stage o First stage, or first round = building a prototype (seed money/ground floor) o Second stage/mezzanine= major investment to begin marketing/manufacturing/distribution If successful, the firm will grow to become publicly traded at which point, VC may choose to cash out The basic procedures for a new issue to the public going public after some years, if the business idea has grown into a corporation, it may need funding beyond what VC can offer raise capital on financial markets will raise capital by undergoing an Initial Public Offering (IPO) 1. Obtain approval from the board of directors Mgmt. obtains expert opinions on a range of matters advice on level of expected support for the issue, financing options, possible pricing + marketing strategies Mgmt. will appoint an underwriter which will formalise the structure of the issue, prepare timetable and a prospectus and determine the pricing - Underwriter undertakes to market and sell the issue 2. Prepare and lodge a prospectus to ASIC (or in the US: SEC) A legal doco that discloses all material information required by the corp law concerning the firm making a public offering Time from when the prospectus is lodged w/ ASIC until the time it is approved is called rego period o Will meet with investors to get indicators of interest o If D is low, underwriters may lower the $P or withdraw the issue With a few exceptions, a prospectus is required for all public issues of securities 3. Once final prospectus is approved by ASIC, selling efforts by underwriter begin The cash offer - terminology Cash offer raise capital in financial markets by issuing stocks and/or bonds

Underwriter a single underwriter or a syndicate buys the sec and sells them to the public UW bears risk in offering and must be compensated if the issue is very large, the norm is to use a syndicate - v. risky endeavour - syndicate is a way to mitigate risk by spreading it able to tap into wider distribution channels, some companies have separate retail sector eg Merryl Lynch Spread - the difference b/w what the UW pays and the offering price of the securities sell at a profit (ie. Spread is positive), since they provide a service to the issuer - expose themselves to risk: underwriters purchase shares at an agreed upon price and resells them to the public the spread is a cost to the issuing company - direct cost o no spread = money goes directly to issuing company Selling period underwriting group agrees not to sell secs for less than the offering $P until the syndicate dissolves occurs if there's a group of underwriters - none of the members of the syndicate are allowed to sell below the price for X amount of time always incentive for syndicate to sell at slightly lower prices - they will be able to get the whole market once the period expires, they are able to do whatever they want w/ prices Overallotment Option/Green Shoe Provision allows the UW group to buy additional shares at the offering price net of fees and commissions, which allows them to meet additional demands or oversubscriptions Types of UW Deals Regular purchase off sec from issuing company by an NB for resale to the public Firm commitment UW buys the entire issue assuming full financial responsibility for any unsold shares (also: standby deal or bought deal) money goes toward issue company - able to raise capital, sells them to public for a profit if there is any risk, underwriters will bear it all, since they buy all the issue what if theyre not able to sell the issue at offer price - sell at loss, hold stock in inventory until the market improves Best efforts UW sells as much of the issue as possible, but can return any unsold shares to the issuer w/o financial responsibility - minority of cases - U/W do not absorb any losses or risks Role of UW usually involved if the public issue of sec is a cash offer UW (or syndicates groups of UW) perform the following services for corporate issuers o Formulating the method used to issue o Marketing and pricing o Selling new sec bear a lot of risk - can be left with unsold securities, etc The offer price and underpricing Determining the correct offering price is the most difficult thing an underwriter must do too high shares might not be sold and the issue has to be withdrawn too low existing shareholders sell their shares for less than they are worth Underpricing occurs when the offer price is set below the true/market value (which can be measured by the first day of trading return). Underpricing is fairly common and imposes costs on the existing shareholders and is an indirect cost of issuing new secs o New shareholders gain at the expense of the existing SH o loss in wealth of the original owners equal to the total U/P cost (Market-issue price)*no shares Much of the underpricing occurs in small, speculative issues Investors must be compensated for investing in highly speculative issues, otherwise they will not buy shares in IPOs UW under$P on purpose to reduce their risk Ceteris parabis, the following are correlated w/ higher IPO prices o Firms that disclose favourable acct info o Use of auditors and UW w/ good rep

o o

Entrepreneurial ownership retention Use of proceeds for risky investment

The costs of securities (flotation costs) Direct Spread: difference b/w offer $P and $P received by the issuer Filing and underwriting fees, legal fees, taxes Indirect Cost of managers time spent on issue expenses Abnormal returns stock prices drop after issue Underpricing shares sold at price below MV Overallotment Common stock UW direct costs as a % of proceeds raised: Size of firm % of proceeds raised Proceeds raised ($M) Small 10-15 1-5 Medium 6-8 10-100 Large 2-4 500+ Market reaction to stock issues (SEO) In the past, prices have dropped 1-3% on the announcement of a stock offering: Asymmetric info issuing equity signals bad info about the company o Market timing managers tend to issue equity when the firm is overvalued o Pecking order theory and firm type good firms are undervalued and bad firms are overvalued if there is asymmetric info Issuing E suggests a comp is bad and cant borrow Due to AI problem, good firms should issue debt Rights offering The firm is able to choose whether to offer the issue to existing shareholders or to the public. However, if a right is contained in the firms articles of incorporation, the new shares must be offered to existing shareholders first (b/c of dilution concern). Rights offering offer additional shares to existing shareholders if you own X shares, you will own X rights (each existing shareholder receives one right per share owned) General Cash Offer Shares sold to all investors (D/E) issue price determines amount raised Higher Rights Issue To existing SE (E, convertible D) Subscription price is not important, b/c can adjust the # of rights required to buy one share Lower (simpler underwriting arrangements)

Investors Relevance of issue prices Flotation costs

Issuing LT debt/private placement of debt Private placements sale of sec to a ltd # of investors w/o a public offering loans, usually LT in nature best suited to small and medium-sized firms There are many differences from public issues: rego costs are lower (no prospectus/ASIC rego) easy to renegotiate in case of default (few lenders) issue costs are lower (few buyer, no UW) from perspective of the issue, its a tradeoff b/w higher IR vs. better negotiation and lower flotation costs


Financial Leverage is the extent to which a company is committed to fixed charges related to interest payments from the companys debt. the more that a company has borrowed, the more they have to pay back and the higher the

leverage. Leverage increases the risk to stockholders Capital structure refers to the mix of debt and equity that makes up a companys total market value. Debt to Equity ratio D/E: the market value of outstanding debt divided by the market value of equity debt to market value ratio D/V: D/V = D/(D+E) MV of debt is difficult to obtain, so use book values The effect of FL depends on EBIT, ROE = return on equity, EPS = earnings per share when EBIT is high FL raises ROE and EPS when EBIT is low FL lowers ROE and EPS higher leverage firm has higher high and lower lows in ROE and EPS than a low leverage firm variability of ROE/EPS increasing w/ financial leverage Higher FL magnifies the effect of changes in EBIT on ROE and EPS. Using more debt makes ROE and EPS more risky higher FL also means higher risks to stock holders. HOMEMADE LEVERAGE Homemade leverage the use of personal borrowing/lending to change the overall amount of FL to which the individual is exposed by borrowing from personal account (debt) to fund shares (equity), the individual is able to create the FL that they want their own ratio of D/E same returns as if the firm had borrowed Assumptions investors can borrow or lend at the same rate as the corporation (perfect capital markets - PCM) they can always use HL to under in their own portfolios any change to a firms capital structure they can attain the same CF that they would have attained w/o or w/ the firms change b/c investors can create HL and can expose themselves to expose themselves to any financial risks they want investors are indifferent to changes in the firms CS and share $P should be the same regardless firms should not be valued any higher or lower based on their own capital structure Modigliani and Millers Proposition I: The value of the firm is independent of its capital structure since investors can create any level of leverage through their own portfolio, investors would not pay a premium for the securities of a firm that follows a particular capital structure perfect capital market o individuals + firms can costless trade securities o no taxes, no bid-ask spreads, no differences in IR on borrowing and lending, efficient information levered = debt, unlevered = no debt Assumptions: no taxes, PCM,The firms CF are independent of how it is financed The effect of debt on risk & return on equity Leverage increases both the risk and expected return on equity. However, it does not affect the risk of the firms CFs. Introducing corporate taxes Since interest expenses are deductible against taxable income, debt increases the CF to the firms stakeholders. how much of profit goes to debtholders vs equityholders a company who borrows more has more CF going to these stakeholders Interest tax shield the tax saving attained by a firm from interest expenses: asset that tax generates for the firm Let X = firms perpetual EBIT. Since there is no interest, what is left for equity holders is: Total after tax CF of U = X(1-Tc) Firm Value = PV of X(1-Tc) Total after tax CF of L = CF to equityholders + CF to debtholders = ( )(1 ) +

Value of firm is greater when debt is higher due to ITS. When tax is factored in, tax shield increases more and more CF kept by firm MM proposition line, no matter how much you borrow, the value of the firm remains unchanged Implications 1. According to M&M I and II w/o tax and bankruptcy, debt financing always increases firm value, so using debt is very attractive company should borrow as much as possible to fully shield profits from being taxed by company in order to maximise the value of the firm 2. The value of the corporate tax shield is represented by the lower after tax cost of debt some people take company private by borrowing and then buying back all the equity (reverse of the company going public) now the more a company borrows, towards a lower cost of capital Rd is further reduced by tax rate decreases CoC for a firm M&M II: WACC as the Return on Assets (RA): The WACC is the same for firms whether they are levered or not Unlevered firm: = = = Levered firm: = ( ) + ( ) = The WACC (as the Return on Assets) is the same for firms whether they are levered or not. RRR on Assets - it is fixed since its related to operations of the company, therefore unaffected by FL Given that CF do not depend on D/E the MV of the firm is independent of D/E only if the cost of capital (WACC) used to discount those cash flows is also independent of D/E o Even though the cost of equity increases, the total cost of capital does not increase The expected return on E increases linearly with the D/E ratio (w riskless debt), Re = bus risk + fin risk Assumptions: no taxes, P(bankruptcy) = 0 = = ( ) + ()

= + ( ) ( )

As D/E increases, RE increases: Ba remains unchanged (since operations are unchanged) o No change in future CF o No change in riskiness of the CF Ra = WACC is unchanged Re, Be both go up as the required ROE increases w/ the increase in risk of CFs to shareholders Rd, Bd stay the same if P (bankruptcy) = 0 (by assumption) A firms cost of equity capital is a positive linear function of its capital structure. Capital structure Tc=0 and Riskless Debt risks of stock can be expressed as a function of risk of the company, and as a function of FL risk stays same since there's not issue of bankruptcy = ( ) 0 + ( ) = + ( ) ( )

The beta of a firm reflects 3 fundamental decisions a firm makes 1. the type of business it is in, and the G&S it provides more elastic, the higher the beta 2. the cost structure of the business as measured by the operating leverage (business risk) more capital intensive more fixed operating costs operating leverage 3. the financial leverage that the firm takes on; higher financial leverage leads to higher equity betas (financial risk)

All else equal, the higher the financial leverage of a stock, due to greater corporate borrowing, the greater the required rate of return due to greater business risk exposure. Introducing corporate taxes into MM II WACC is now lower since RD(1-Tc)<RD slope is not as steep with extra component, - dampens effect, rising, but not as steeply as before implications are similar to the case without taxes, equity returns become riskier the higher the financial leverage w/ taxes, capital structure matters a lot, since the cost of debt is a tax deductible expense for the firm o interest on the firms debt shields operating profits from being taxed the value of the TS increases as D/E ratio increases FV increases and COC decreases w/ leverage = + ( )(1 )

= (1 ) + ( )

debt tax shield is the firms operating cash flows which was prevented from being taxed debt results in larger CF being shared among the debt and equityholders because less of the firms cash flows is collected by the govt in the form of taxes total firm value increase in the amount of debt o in a taxable environment, debt is a source of value creation

Bankruptcy Costs value creation from debt is ltd by the firms ability to generate sufficient taxable Y to take advantage of the tax shields if company has little profits, having a large interest payment will not result in large tax shields increasing a firms debt beyond a certain level would not increase firm value Direct the costs that are directly associated w/bankruptcy, such as legal and administrative expenses Indirect difficulties of running a business that is experiencing financial distress employees might not work as intensively since they know the firm might not be there for the LT employees may leave suppliers might not provide inventory on credit if they are scared the firm is unable to pay back

THE TRADE OFF THEORY OF OPTIMAL CAPITAL STRUCTURE The tradeoff theory is essential M&M propositions w/ taxes and bankruptcy. Will be able to take advantage of tax shield but higher financial costs as D/E increases, P(financial distress) increases one cost of having debt is the expected bankruptcy costs as the D/E ratio increases, the costs of financial distress increase o insert formula from pg 31 o [change in Vu + change in PV (tax shield) + change in PU (BankruptcyCosts)]/(change in D) = 0 the optimal capital structure is a balanced tradeoff b/w the value gained from the tax shields and the firm value loss from financial distress costs Static Trade Off Theory of Capital Structure = + The optimal capital structure is the D/E level at which the incremental increase in the PV of the tax shield from borrowing additional dollar is just offset by the incremental increase in the financial distress costs. financial distress consequences become higher and higher when the company has borrowed enough, the negative effects outweigh the positive ones (MARGINAL COSTVSBENEFIT) point that minimises overcall cost of capital for the firm an PV of

Optimality condition: = The static trade off explanation firms w mostly safe and tangible assets (utilities, real estate) tend of have higher debt ratios since financial distress costs are likely to be low since these assets dont tend to lose value significantly due to their resale values (vs. risky intangible assets high technology, advertising + consulting companies) distress costs are higher for firms with more intangible assets, these assets tend to erode in value rapidy in case of default these firms should borrow considerably less than firms with more tangible assets WEEK 12 DIVIDENDS AND DIVIDEND POLICY Dividend payment made out of a firms earnings to its owners, in the form of either cash or shares. Extra cash dividends non periodic cash payment o at discretion of firms to pay out not expected by SH Special dividends one time cash payment REGULAR CASH DIVIDENDS Cash dividends are periodic cash payments to shareholders in normal course of business Commonly, public companies pay regular cash dividends twice a year o mid-fin year D = interim dividend, whilst the one paid at the end of a year is the final dividend Amount of the cash dividend is expressed in terms of dollars per share (dividends per share) o also: percentage of the market price (dividend yield), % of net Y or EPS (dividend payout)
Declaration date: payment of cash by the firm to shareholders is declared by the Board The D is paid on the payment date to all SH of record as of the record date (usually 2-3 wks prior to the payment date) To be a shareholder on record, and thus recieve the dividend, one must have bought the stock before the ex-dividend date. The exdividend date is 4 business days before the record date. The record date is the date on which holders of record are designated to receive a dividend

The Ex-Dividend Date

if the stock is bought after the ex-dividend date, then they cannot receive the dividend the price falls, since theyre not paying for the dividend that theyre going to receive

M&M DIVIDEND POLICY IRRELEVANCY PROPOSITION Dividend policy refers to the time pattern of dividend payouts. It addresses the question of whether firms should pay cash to its shareholders now, or invest the money and pay it out later. Assumptions no taxes, no transaction or bankruptcy costs Proposition dividend policy is irrelevant in the M&M world firm values remain the same for both types of firms If investors can raise cash themselves by selling shares (homemade dividends), they do not need firms to provide them with cash through dividend payments. FIRM VALUE AND SHAREHOLDERS WEALTH shareholders wealth does not change in response to changes in dividend SH has paid for their own dividend as the drop in share $P exactly offsets the dividend

DIVIDEND CUTS TO FINANCE POSITIVE NPV PROJECTS Investors are always better off with reinvestments, since the value of the share will go up primary objective of the firm. REAL WORLD FACTORS FOR LOW PAYOUT Taxes when the marginal tax rate for individuals exceeds that for firms, investors may prefer that earnings be retained rather than paid out as dividends o if the MTR individuals > MTR firms, then its better for company to reinvest rather than paid out as dividends, since the money will grow faster o money paid out as dividends will grow much slower o dividend payout = low pay rate on profit o capital gains taxes are usually lower than taxes on dividend Y (classical tax system) Flotation costs firms that pay high dividends and simultaneously sell stock to fund growth will incur higher flotation costs than comparable low payout firms o If we include the costs of selling shares (flotation costs), then the value of the shares decreases if we sell new shares o if you have liabilities, you want to defer them as far as possible into the future - due to PV o if you discount PV into the present, it's worth less Dividend restrictions most bond indentures and some federal and state laws limit the dividends a firm can pay

REAL WORLD FACTORS FOR HIGH PAYOUT Desire for current Desire for current Y the firm paying a larger dividend will sell at a higher price, but not all investors desire higher current Y and they may self-select into different clienteles o Eg. Retirees + others living on their capital Uncertainty resolution - Distant dividends are more uncertain than near dividends, so firms with near dividends should sell at a higher price the uncertainty over future Y is not changed by a firms dividend policy Taxes and legal benefits from high dividends dividend Y to firms are tax-exempt, as well as to pension and trust funds which are usually not allowed to spend their principle Australians may prefer high pay out dividend imputation tax system

Difficulty changing dividend policy Dividend clienteles some groups (wealthy individuals in high marginal tax brackets) have an incentive to pursue low-payout shares, whilst other groups (corporations) have an incentive to pursue high payout shares companies with high payouts will attract one group, whilst low-payout companies will attract another these different groups are called clienteles

Signalling: an increase in dividends has a strong positive impact on a firms share price, while a decrease in dividends has a negative impact on its share price interpretation that investors place on dividend changes is that mgmt. will only increase its dividend payout when they are confident that they will be able to maintain the higher dividend in the future ESTABLISHING A DIVIDEND POLICY Residual dividend approach policy where a firm pays dividends each period only after meeting its investment needs while maintaining a desired D/E ration (selling stock to pay a dividend is expensive). However, dividends can be very unstable. Dividend stability payout ratio is established based on LT averages of projected earnings, an optimal range for capital structure and capital budgeting requirements. A stable dividend policy is in the interest of the shareholders as it reduces uncertainty. But the residual approach grants the manger flexibility. In practice, many firms appear to follow a compromise dividend policy. It is based on: avoid cutting back on positive NPV projects to pay a dividend, avoid dividend cuts, avoid the need to sell equity, maintain a target D/E ratio, maintain a target dividend (relative to earnings) payout ratio Stock dividends and stock splits Stock dividend distribution of additional shares to a firms shareholders, diluting the value of each share outstanding cash is kept in the firm for investment shareholders receive additional shares a 10% stock dividend would issue one share per ten shares outstanding Stock split issuance of additional share to a firms shareholders, without changing owners equity no cash exchanged only a change in the number of shares issued and a change in the value of a share occurs Stock dividend is a mini stock split no cash is involved and the book value of equity does not change w/ more shares outstanding, MV per share drops, but the total MV of the firms stays the same Share repurchase a firm buys back stock from its shareholders a share repurchase has the same effect as a cash dividend: the cash account in the firm is reduced and the SH as a group have more cash the BV of the equity is reduced in both cases

CONCLUSIONS ceteris parabis, high dividends are better than low dividends b/c it means firm is more profitable DP is related to timing pattern of dividends, not size of dividends DP is irrelevant in a perfect capital market w/o imperfections and taxes Managers should not forgo positive NPV projects to pay dividends Investors differ in their investment objectives creating a clientele for high or low dividend payout Share repurchases are similar to cash dividends Stock dividends are not similar to cash dividends they are more like stock splits