Corporate Finance - Slides

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Corporate Finance
1-0
CHAPTER 1
Introduction to
Corporate Finance
Corporate Finance
1-1
Chapter Outline
1.1 What is Corporate Finance?
1.2 Corporate Securities as Contingent Claims on
Total Firm Value
1.3 The Corporate Firm
1.4 Goals of the Corporate Firm
1.5 Financial Markets
1.6 Outline of the Text
Corporate Finance
1-2
What is Corporate Finance?
Corporate Finance addresses the following three
questions:
1. What long-term investments should the firm engage
in?
2. How can the firm raise the money for the required
investments?
3. How much short-term cash flow does a company
need to pay its bills?
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The Balance-Sheet Model
of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders
Equity
Current
Liabilities
Long-Term
Debt
Total Firm Value to Investors:
Corporate Finance
1-4
of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
Equity
Current
Liabilities
Long-Term
Debt
What long-
term
investments
should the
firm engage
in?
The Capital Budgeting Decision
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of the Firm
How can the firm
raise the money
for the required
investments?
The Capital Structure Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
Equity
Current
Liabilities
Long-Term
Debt
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of the Firm
How much short-
term cash flow
does a company
need to pay its
bills?
The Net Working Capital Investment Decision
Net
Working
Capital
Shareholders
Equity
Current
Liabilities
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Long-Term
Debt
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Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is
to increase the size of the
pie.
The Capital Structure
decision can be viewed as
how best to slice up a the
pie.
If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
50%
Debt
50%
Equity
25%
Debt
75%
Equity
70%
Debt
30%
Equity
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Hypothetical Organization Chart
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
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The Financial Manager
To create value, the financial manager should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
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Cash flow
from firm (C)
The Firm and the Financial Markets
T
a
x
e
s

(
D
)
Firm
Government
Firm issues securities (A)
Retained
cash flows (F)
Invests
in assets
(B)
Dividends and
debt payments (E)
Current assets
Fixed assets
Financial
markets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm
must be a cash
generating activity.
The cash flows from
the firm must exceed
the cash flows from the
financial markets.
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1.2 Corporate Securities as Contingent
Claims on Total Firm Value
The basic feature of a debt is that it is a promise by the
borrowing firm to repay a fixed dollar amount of by a
certain date.
The shareholders claim on firm value is the residual
amount that remains after the debtholders are paid.
If the value of the firm is less than the amount
promised to the debtholders, the shareholders get
nothing.
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Debt and Equity as Contingent Claims
$F
$F
Payoff to
debt holders
Value of the firm (X)
Debt holders are promised $F.
If the value of the firm is less than $F, they get the
whatever the firm if worth.
If the value of the firm is
more than $F, debt holders
get a maximum of $F.
$F
Payoff to
shareholders
less than $F, share holders
get nothing.
more than $F, share holders
get everything above $F.
Algebraically, the bondholders claim is:
Min[$F,$X]
Algebraically, the shareholders claim is:
Max[0,$X $F]
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$F
$F
Combined Payoffs to debt holders
and shareholders
Debt holders are promised $F.
Payoff to debt holders
Payoff to shareholders
If the value of the firm is less than
$F, the shareholders claim is:
Max[0,$X $F] = $0 and the debt
holders claim is Min[$F,$X] = $X.
The sum of these is = $X
If the value of the firm is more than
$F, the shareholders claim is:
Max[0,$X $F] = $X $F and the
debt holders claim is:
Min[$F,$X] = $F.
The sum of these is = $X
Combined Payoffs to Debt and Equity
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1.3 The Corporate Firm
The corporate form of business is the standard
method for solving the problems encountered in
raising large amounts of cash.
However, businesses can take other forms.
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Forms of Business Organization
The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership
The Corporation
Advantages and Disadvantages
Liquidity and Marketability of Ownership
Control
Liability
Continuity of Existence
Tax Considerations
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A Comparison of Partnership
and Corporations
Corporation Partnership
Liquidity Shares can easily be
exchanged.
Subject to substantial
restrictions.
Voting Rights Usually each share gets
one vote
General Partner is in
charge; limited partners
may have some voting
rights.
Taxation Double Partners pay taxes on
distributions.
Reinvestment and
dividend payout
Broad latitude All net cash flow is
distributed to partners.
Liability Limited liability General partners may
have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life
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1.4 Goals of the Corporate Firm
The traditional answer is that the managers of the
corporation are obliged to make efforts to
maximize shareholder wealth.
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Corporate Finance
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The Set-of-Contracts Perspective
The firm can be viewed as a set of contracts.
One of these contracts is between shareholders and
managers.
The managers will usually act in the shareholders
interests.
The shareholders can devise contracts that align the incentives
of the managers with the goals of the shareholders.
The shareholders can monitor the managers behavior.
This contracting and monitoring is costly.
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Managerial Goals
Managerial goals may be different from
shareholder goals
Expensive perquisites
Survival
Independence
Increased growth and size are not necessarily the
same thing as increased shareholder wealth.
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Separation of Ownership and Control
Board of Directors
Management
Assets
Debt
Equity
S
h
a
r
e
h
o
l
d
e
r
s
D
e
b
t
h
o
l
d
e
r
s
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Do Shareholders Control
Managerial Behavior?
Shareholders vote for the board of directors,
who in turn hire the management team.
Contracts can be carefully constructed to be
incentive compatible.
There is a market for managerial talentthis
may provide market discipline to the
managersthey can be replaced.
If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
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1.5 Financial Markets
Primary Market
When a corporation issues securities, cash flows from
investors to the firm.
Usually an underwriter is involved
Secondary Markets
Involve the sale of used securities from one
investor to another.
Securities may be exchange traded or trade over-the-
counter in a dealer market.
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Financial Markets
Firms
Investors
Secondary
Market
money
securities
Sue Bob
Stocks and
Bonds
Money
Primary Market
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Exchange Trading of Listed Stocks
Auction markets are different from dealer
markets in two ways:
Trading in a given auction exchange takes place at a
single site on the floor of the exchange.
Transaction prices of shares are communicated
almost immediately to the public.
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Corporate Finance
Part 1
Firm Financial Statements
and Cash Flow
Financial Statements and Firm
Valuation
Chapter 2
Corporate Finance
2-1
Chapter Outline Part 1
2.1.1 The Balance Sheet
2.1.2 The Income Statement
2.1.3 Net Working Capital
2.1.4 Financial Cash Flow
2.1.5 The Statement of Cash Flows
2.1.6 Summary and Conclusions
Corporate Finance
Sources of Information
Annual reports
Wall Street Journal
Internet
NYSE (www.nyse.com)
Nasdaq (www.nasdaq.com)
Text (www.mhhe.com)
SEC
EDGAR
10K & 10Q reports
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2.1.1 The Balance Sheet
An accountants snapshot of the firms
accounting value as of a particular date.
The Balance Sheet Identity is:
Assets Liabilities + Stockholders Equity
When analyzing a balance sheet, the
financial manager should be aware of three
concerns: accounting liquidity, debt versus
equity, and value versus cost.
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The Balance Sheet of the U.S. Composite Corporation
(in $ millions)
20X2 and 20X1
Balance Sheet
U.S. COMPOSITE CORPORATION
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets:
Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274
Long-term debt 471 458
Less accumulated depreciation -550 -460
Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221
Stockholder's equity:
Total fixed assets $1,118 $1,035
Preferred stock $39 $39
Common stock ($1 per value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
The assets are listed in order
by the length of time it
normally would take a firm
with ongoing operations to
convert them into cash.
Clearly, cash is much more
liquid than property, plant and
equipment.
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Balance Sheet Analysis
When analyzing a balance sheet, the financial
manager should be aware of three concerns:
1. Accounting liquidity
2. Debt versus equity
3. Value versus cost
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Accounting Liquidity
Refers to the ease and quickness with which
assets can be converted to cash.
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firms assets, the less likely
the firm is to experience problems meeting
short-term obligations.
Liquid assets frequently have lower rates of
return than fixed assets.
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Debt versus Equity
Generally, when a firm borrows it gives the
bondholders first claim on the firms cash flow.
Thus shareholders equity is the residual
difference between assets and liabilities.
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Value versus Cost
Under GAAP audited financial statements of
firms in the U.S. carry assets at cost.
Market value is a completely different concept.
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2.1.2 The Income Statement
The income statement measures performance
over a specific period of time.
The accounting definition of income is
Revenue Expenses Income
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U.S.C.C. Income Statement
(in $ millions)
20X2
Income Statement
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings: $43
Dividends: $43
The operations
section of the
income
statement reports
the firms
revenues and
expenses from
principal
operations
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
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(in $ millions)
20X2
Income Statement
Total operating revenues $2,262
Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense - 49
Pretax income $170
Taxes - 84
Current: $71
Deferred: $13
Net income $86
Dividends: $43
The non-
operating
section of
the income
statement
includes all
financing
costs, such
as interest
expense.
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(in $ millions)
20X2
Income Statement
Cost of goods sold
Depreciation
Operating income
Other income
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Dividends: $43
Usually a
separate
section
reports as a
separate
item the
amount of
taxes
levied on
income.
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
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(in $ millions)
20x2
Income Statement
Cost of goods sold
Depreciation
Operating income
Other income
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Dividends: $43
Net income is the
bottom line.
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
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Income Statement Analysis
There are three things to keep in mind when
analyzing an income statement:
1. GAAP
2. Non Cash Items
3. Time and Costs
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Generally Accepted Accounting
Principles
1. GAAP
The matching principal of GAAP dictates that
revenues be matched with expenses. Thus,
income is reported when it is earned, even
though no cash flow may have occurred
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2. Non Cash Items
Depreciation is the most apparent. No firm ever
writes a check for depreciation.
Another noncash item is deferred taxes, which does
not represent a cash flow.
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3. Time and Costs
In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labor and raw materials.
In the long run, all inputs of production (and hence costs)
are variable.
Financial accountants do not distinguish between variable
costs and fixed costs. Instead, accounting costs usually
fit into a classification that distinguishes product costs
from period costs.
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2.1.3 Net Working Capital
Net Working Capital Current Assets Current Liabilities
NWC is usually growing with the firm.
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The Balance Sheet of the U.S.C.C.
(in $ millions)
20X2 and 20X1
Balance Sheet
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Common stock ($1 par value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
Here we see NWC grow to
$275 million in 20X2 from
$252 million in 20X1.
This increase of $23 million is
an investment of the firm.
$23 million
$275m = $761m- $486m
$252m = $707- $455
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2.1.4 Financial Cash Flow
In finance, the most important item that can be
extracted from financial statements is the actual
cash flow of the firm.
Since there is no magic in finance, it must be the
case that the cash from received from the firms
assets must equal the cash flows to the firms
creditors and stockholders.
CF(A) CF(B) + CF(S)
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Financial Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending (173)
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital (23)
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
Operating Cash Flow:
EBIT $219
Depreciation $90
Current Taxes ($71)
OCF $238
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(in $ millions)
20X2
Financial Cash Flow
Capital spending
Additions to net working capital
Total
Debt
Equity
Total
Capital Spending
Purchase of fixed assets
$198
Sales of fixed assets (25)
Capital Spending $173
(173)
(23)
$42
$36
6
$42
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23
(in $ millions)
20X2
Financial Cash Flow
Capital spending
Total
Debt
Equity
Total
NWC grew
from $275
million in
20X2 from
$252 million
in 20X1.
This increase
of $23 million
is the addition
to NWC.
(173)
(23)
$42
$36
6
$42
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24
(in $ millions)
20X2
Financial Cash Flow
Capital spending
Total
Debt
Equity
Total
(173)
(23)
$42
$36
6
$42
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2-
25
(in $ millions)
20X2
Financial Cash Flow
Capital spending
Total
Debt
Equity
Total
Cash Flow to
Creditors
Interest $49
Retirement
of debt 73
Debt service 122
Proceeds from new
debt sales (86)
Total 36
(173)
(23)
$42
$36
6
$42
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2-
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(in $ millions)
20X2
Financial Cash Flow
Capital spending
Total
Debt
Equity
Total
Cash Flow to
Stockholders
Dividends $43
Repurchase of
stock 6
Cash to Stockholders 49
Proceeds from new
stock issue (43)
Total $6
(173)
(23)
$42
$36
6
$42
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(in $ millions)
20X2
Financial Cash Flow
Capital spending
Total
Debt
Equity
Total
) ( ) (
) (
S CF B CF
A CF
+
The cash from

received from the
firms assets must
equal the cash flows
to the firms
creditors and
stockholders:
(173)
(23)
$42
$36
6
$42
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2.1.5 The Statement of Cash Flows
There is an official accounting statement called the
statement of cash flows.
This helps explain the change in accounting cash, which
for U.S. Composite is $33 million in 20X2.
The three components of the statement of cash flows are
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
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U.S.C.C. Cash Flow
from Operating Activities
(in $ millions)
20X2
Cash Flow from Operating Activities
To calculate cash
flow from
operations, start
with net income,
add back
noncash items
like depreciation
and adjust for
changes in
current assets
and liabilities
(other than
cash).
Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations
$86
90
13
(24)
11
16
18
(3)
$199
(8)
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30 U.S.C.C. Cash Flow
from Investing Activities
(in $ millions)
20X2
Cash Flow from Investing Activities
Cash flow from
investing activities
involves changes
in capital assets:
acquisition of fixed
assets and sales of
fixed assets
(i.e. net capital
expenditures).
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
$(198)
25
$(173)
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U.S.C.C. Cash Flow
from Financing Activities
(in $ millions)
20X2
Cash Flow from Financing Activities
Cash flows to
and from
creditors and
owners include
changes in
equity and debt.
Retirement of debt (includes notes)
Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing
$(73)
86
(43)
43
$7
(6)
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2-
32 U.S.C.C. Statement of Cash Flows
The statement of
cash flows is the
addition of cash
flows from
operations,
cash flows
from investing
activities, and
cash flows from
financing
activities.
Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations
$86
90
13
(24)
11
16
18
(3)
$199
(8)
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
$(198)
25
$(173)
Investing Activities
Financing Activities
Retirement of debt (includes notes)
Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing
$(73)
86
(43)
43
$7
(6)
Change in Cash (on the balance sheet) $33
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Statement of Cash Flows versus Cash Flow
from the Firm
Since interest paid is deducted as an expense
when net income is calculated (and not deducted
under financing activities) there is a difference
between cash flow from operations and total cash
flow to the firmthe difference is interest
expense.
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2.1.6 Summary and Conclusions
Financial statements provide important
information regarding the value of the firm.
You should keep in mind:
Measures of profitability do not take risk or timing of
cash flows into account.
Financial ratios are linked to one another.
1
Corporate Finance
2-0
Part 2
Financial Statement Analysis
and Firm Valuation
Financial Statements and Firm
Valuation
Chapter 2
Corporate Finance
16-1
FSA: Ratio Analysis
Liquidity
Long-term Solvency
Asset Management
Profitability
Market Value
Dupont Analysis
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16-2
Liquidity Ratios
Current ratio (Rc)
Case of ABT (2006)
Rc = 1.94
s Liabilitie Current
Assets Current
= Rc
2
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16-3
Liquidity Ratios
Quick ratio (Rq)
Case of ABT (2006)
Rq = 1.47
Inventory - Assets Current
= Rq
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16-4
Liquidity Ratios
Cash ratio (Rq)
Case of ABT (2006)
CR = 0.11
Securities Marketable Cash +
= CR
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16-5
Long-term Solvency Ratios
Total Debt Ratio
Case of ABT (2006)
TDR = 0.39
Assets Total
Debt Total
= TDR
Mean
VN
: 0.54
3
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16-6
Long-term Debt Ratio
Case of ABT (2006)
LDR = 0.008
Assets Total
Debt term - Long
= LDR
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16-7
Long-term Debt/Equity Ratio
Case of ABT (2006)
LD/E R = 0.013
Equity
Debt term - Long
/ = R E LD
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16-8
Asset Management Ratios
Total Asset Turnover
Case of ABT (2006)
TAT = 2.81
Assets Total
Sales
= TAT
Mean
VN
: 1.77
4
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16-9
Fixed Asset Turnover
Case of ABT (2006)
FAT = 14.37
Assets Fixed Net
Sales
= FAT
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16-10
Average Collection Period
Case of ABT (2006)
ACP = 40 (days)
day per Sales Average
Receivable Accounts
= ACP
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16-11
Inventory Turnover
Case of ABT (2006)
IT = 12.86
Inventory
Sold Goods of Cost
= IT
5
Corporate Finance
16-12
Profitability Ratios
Profit Margin
Case of ABT (2006)
PM = 0.09
Sales
Interest Income Net +
= PM
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16-13
Return on Assets (ROA)
Case of ABT (2006)
PM = 0.25
Assets Total
Interest Income Net +
= ROA
Corporate Finance
16-14
Return on Equity (ROE)
Case of ABT (2006)
PM = 0.35
Equity
Income Net
= ROE
6
Corporate Finance
16-15
Market Value Ratios
Price-Earnings Ratio (P/E)
Case of ABT (2006)
P/E = 18
share per Earnings
share per Price
/ = E P
Corporate Finance
16-16
Market Value Ratios
Market-to-Book Ratio (P/B)
Case of ABT (2006)
P/B = 6.4
share per Book value
share per Price
/ = B P
Corporate Finance
16-17
Ratio Analysis Case of ABT
2004 2005 2006 AGF SJ1 TS4 Mean
Current Ratio 1,16 1,07 1,94 1,65 3,15 2,07 2,20
Quick Ratio 0,49 0,71 1,47 1,07 0,95 1,58 1,27
Cash Ratio 0,06 0,10 0,11 0,08 0,11 0,03 0,08
Total Debt Ratio 0,70 0,70 0,39 0,36 0,28 0,43 0,36
Long-term Debt Ratio 0,05 0,06 0,01 0,00 0,00 0,09 0,03
Long-term Debt/Equity Ratio 0,16 0,18 0,01 0,00 0,00 0,16 0,04
Benchmark 2006
7
Corporate Finance
16-18
Ratio Analysis Case of ABT
2004 2005 2006 AGF SJ1 TS4 Mean
Total Asset Turnover 2,38 3,03 2,81 2,54 3,61 1,62 2,65
Fixed Asset Turnover 9,97 13,84 14,37 6,37 27,49 5,92 13,54
Average Collection Period 42,78 47,10 40,10 41,63 18,49 111,37 52,90
Inventory Turnover 5,03 11,49 12,86 10,84 5,44 8,46 9,40
Profit Margin 0,03 0,04 0,09 0,04 0,04 0,04 0,05
Return on Assets (ROA) 0,08 0,12 0,25 0,11 0,14 0,06 0,14
Return on Equity (ROE) 0,20 0,28 0,35 0,16 0,20 0,11 0,20
Benchmark 2006
Corporate Finance
16-19
Du Pont Analysis
Leverage Leverage
Asset Asset
Turnover Turnover
Profit Profit
Margin Margin
Equity Equity
Net Income Net Income
ROE = ROE =
Net Income + Interest Net Income + Interest
xx
Equity Equity
Sales Sales Total Assets Total Assets
Sales Sales
xx
Total Assets Total Assets
xx ROE = ROE =
xx
Equity Equity
Total Assets Total Assets
Sales Sales Total Assets Total Assets
xx
Sales Sales
xx ROE ROE==
Corporate Finance
16-20
Du Pont Analysis Case of ABT
Year 2004 2005 2006 Benchmark 2006
Return on Equity (ROE) 0,20 0,28 0,35
1/ Total Assets / Equity (Leverage) 3,34 3,30 1,63 1,58
2/ Sales / Total Assets (Asset Turnover ) 2,38 3,03 2,81 2,65
3/ (Net Income + Interest)/ Sales (Profit Margin ) 0,03 0,04 0,09 0,05
4/ Net Income / (Net Income + Interest) 0,74 0,69 0,87 0,94
5/ (1)*(4) 2,46 2,29 1,42 1,49
P/E 16,41 17,34
8
Corporate Finance
16-21
Basic earnings per share
Weighted average number of ordinary shares
outstanding (WANOSO)
Share repurchase or treasury shares selling
Private placement
Bonus issue, stock dividend, share split or reverse
share split
Rights issue
Weighted average number of ordinary shares outstanding Weighted average number of ordinary shares outstanding
Profit or loss attributable to ordinary equity holders Profit or loss attributable to ordinary equity holders
Basic EPS = Basic EPS =
Corporate Finance
16-22
Share repurchase, treasury shares selling or
private placement
Share repurchase or treasury shares selling: the event
date is the day when it finishes
Private placement: the event date is the day when issued
shares are officially traded
Number of days in the period Number of days in the period
Number of days from Number of days from
the event date to the the event date to the
end of the period end of the period
Number of Number of
OSO after the OSO after the
event date event date
++
Number of days from Number of days from
the beginning of the the beginning of the
period period to the event date to the event date
Number of OSO Number of OSO

at the beginning at the beginning
of the period of the period
==
WANOSO for WANOSO for
the period the period
Corporate Finance
16-23
Example
Date Event Number of
shares
WANOSO
01/01 Beginning of period 1000 1000 x 3/12 = 250.00
31/03 Private placement 600 1600 x 5/12 = 666.67
Total 1450 1400
30/08 Share repurchase (150) 1450 x 4/12 = 483.33
9
Corporate Finance
16-24
Bonus issue or stock dividend
The number of ordinary shares outstanding before
the event is adjusted for the proportionate change
in the number of ordinary shares outstanding as if
the event had occurred at the beginning of the
earliest period presented (Retrospective
Adjustment)
The event date is the day where issued shares are
officially traded
Corporate Finance
16-25
Basic EPS Case of Hoa An JSC.
Weight
(C)
01-01 Beginning of the period 3,428,124 1.1 256 965,359,718
54
(14/9 - 6/11)
06-10
Ex-bonus date. 1 for 10 bonus
issue => The number of ordinary
shares outstanding before this date
is adjusted. Adjustment factor =
11/10 = 1.1
07-11
Day on which 350,000 bonus
shares were traded
3,850,000 55 211,750,000
31-12 End of the period 3,850,000
Total 365 1,385,009,718
Weighted average number of
ordinary shares outstanding
3,794,547
Profit or loss attributable to ordinary shares for 2005: 36,515,586,209 VND
Weighted average number of ordinary shares outstanding: 3,794,547
EPS = 36,515,586,209 / 3,794,547 = 9,623 VND
Number of
shares (A)
Adjustment
factor (B)
14-09
Finishing date of selling of 71,876
treasury shares
3,500,000 1.1
D = A x B x C
207,900,000
Date Event
Corporate Finance
16-26
Adjusted earnings per share
Share split, reverse share split, bonus issue or
stock dividend:
At the ex-date, basic EPS is adjusted for the
proportionate change in the number of ordinary shares
outstanding
Rights issue:
Diluted EPS = Basic EPS Adjustment factor
Fair value per share immediately before ex Fair value per share immediately before ex--date date
Theroretical ex Theroretical ex--rights fair value per share rights fair value per share
Adjustment factor = Adjustment factor =
10
Corporate Finance
16-27
Adjusted EPS Example (Rights
Issue)
Issuing firm: An Giang Import Export Fishery Joint Stock Company
Stock symbol: AGF
Type of stock: Common stock
Par value: VND 10,000
Issuing purpose: mobilize capital for investment plans
Frozen Warehouse with the capacity 3000 tons and Frozen Fishery Factory
No.1
Supplement the working capital for business purposes
Additional volume: 1,278,000 shares
Issuing method: 05 old shares can buy one additional share
Issue price: VND 10.000/share
Ex-right date: August 2
nd
2006
Record date: August 4
th
2006
Corporate Finance
16-28
Issue)
Rights compensate existing shareholders for
dilution
Maintain ownership proportion if exercised
Maintain value if sold
V + R = P V + R = P
New shareholders
PP
II
+ N + NR = V R = V

N + 1 N + 1
PP
I I
+ N + NPP
V = V =
Adjustment Factor Adjustment Factor
(N + 1) (N + 1)P P
PP
I I
+ N + NP P
==
Corporate Finance
16-29
Issue)
Stock symbol AGF
Ex-rights date August 2
nd
2006
Old shares / New shares (N) 5
Issue price (PI ) 10,000
Stock price immediately before ex-date (P) 66,500
Basic EPS 6,360
Adjustment factor 0.8584
Diluted EPS 5,459
11
Corporate Finance
16-30
Analysis of Price-Earning Ratio (P/E)
No growth assumption
Stock A Stock A Stock B Stock B
EPS EPS 5 $ 5 $ 5 $ 5 $
Payout ratio Payout ratio 100 % 100 % 100 % 100 %
rr 12.5 % 12.5 % 12.5 % 12.5 %
Number of outstanding shares Number of outstanding shares 3 M 3 M 3 M 3 M
($) 40
125 . 0
5
1
= = = =
r
D
P P
B A
Corporate Finance
16-31
Analysis of Price-Earning Ratio (P/E)
Growth assumption
Firm A engages in projects generating ROE of 15% Firm A engages in projects generating ROE of 15%
Plowback ratio: 60%; Payout ratio: 40% (D Plowback ratio: 60%; Payout ratio: 40% (D
00
= 2 $ per share) = 2 $ per share)
Added earnings: 1.35 M (growth rate: 9%) Added earnings: 1.35 M (growth rate: 9%)
Present value of growth opportunities = 62.29 Present value of growth opportunities = 62.29 40 = 22.29 ($) 40 = 22.29 ($)
( )
($) 29 . 62
09 . 0 125 . 0
09 . 1 2 1
0
=
+
=
g r
g D
P
A
|
\
|
+ = + =
r E
PVGO
r E
P
PVGO
r
E
P
/
1
1

0
0
Corporate Finance
16-32
Analysis of Market-to-Book Ratio
(P/B)
( )
( )
( )
( )
g r
d g ROE
B
P
g r
d g B ROE
g r
d g B
B
E
g r
d g E
g r
d E
g r
D
P
+
=
+
=
+
=
+
=
=
1
1
1

1

0
0
0
0
0
0
0 1 1
0
12
Corporate Finance
16-33
Introduction to Valuation: a simple
example
You plan to buy an asset at 316 M VND. This
is a riskless investment as if you buy this asset,
somebody is willing to take it at 400 M VND
after 3 years. Your close friend advices you not
to buy it, recommending more risky investments
with higher return (15 % per year, including a
risk premium of 5 %)
Will you buy this asset?
Corporate Finance
16-34
Equity Valuation Dividend Discount
Model (DDM)
General Model
No growth assumption
Stable growth assumption
1 + r 1 + r
DD
11
== PP
00
(1 + r) (1 + r)
22
DD
22
++
(1 + r) (1 + r)
33
DD
33
++
(1 + r) (1 + r)
44
DD
44
++
(1 + r) (1 + r)
55
DD
55
++

++
rr
DD
== PP
00
r r -- gg
DD
11
== PP
00
Corporate Finance
16-35
DDM A simple example
Stock A: D = 10 $
Stock B:
Forecasted D
1
: 5 $
Forecasted stable growth rate: 3 %
Stock C:
Forecasted D
1
: 5 $
Forecasted growth rate for 5 following years: 20 %
Stable dividends after this fast growth period
Required return for all 3 stocks: 12 %
13
Corporate Finance
16-36
Equity Valuation - Residual Income
Model
DDM
Clean surplus relation
Abnormal earnings
Residual Income Model
( )
( )
=
+
+
=
1 1
t
t t
t
r
d E
P
t t t t
d x b b + =
1
1 + + +
=
t t
a
t
b r x x
( )
( )
=
+
+
+ =
1 1
r
x E
b P
a
t t
t t
Corporate Finance
16-37
Economic Value Added (EVA)
Economic Value Added
Abnormal earnings: Shareholder Value Added
( ) Capital Invested = WACC ROA EVA
1 + + +
=
t t
a
t
b r x x
( )
1 + +
=
t
a
t
b r ROE x
Corporate Finance
16-38
Relative Valuation
=

t j
t j
j t i t i
VD
P
M VD P
i
,
,
, ,
PP
i,t i,t
: Relative value of the stock : Relative value of the stock ii at time at time tt
VD VD
i,t i,t
: Value driver of the stock : Value driver of the stock ii at time at time tt
PP
j,t j,t
: Price of stock j comparable to : Price of stock j comparable to ii at time at time tt
VD VD
j,t j,t
: Value driver of stock : Value driver of stock jj comparable to i at time comparable to i at time t t
MM: Mean or median estimated from the set : Mean or median estimated from the set of stocks comparable of stocks comparable
to to ii
PP
i,t i,t
: Relative value of the stock : Relative value of the stock ii at time at time tt
VD VD
i,t i,t
: Value driver of the stock : Value driver of the stock ii at time at time tt
PP
j,t j,t
: Price of stock j comparable to : Price of stock j comparable to ii at time at time tt
VD VD
j,t j,t
: Value driver of stock : Value driver of stock jj comparable to i at time comparable to i at time t t
MM: Mean or median estimated from the set : Mean or median estimated from the set of stocks comparable of stocks comparable
to to ii
14
Corporate Finance
16-39
Starting with an exercise
Corporate Finance
16-40
Residual Income Model Case of
Chiron Corporation (USA)
Forecast horizon: n
Case of Chiron: n = 3
( )
( )
=
+
+
+ =
1 1
r
x E
b P
a
t t
t t
( )
( )
( )
( )
1
1
1 1 1
=
+
+
+
+
+ =
n
a
n t t
n
i
i
a
i t t
t t
r r
x E
r
x E
b P
( ) ( )
( )
( )
( )
2
3
2
2 1
1 1 1
r r
x E
r
x E
r
x E
b P
a
t t
a
t t
a
t t
t t
+
+
+
+
+
+ =
+ + +
Corporate Finance
16-41
Dividend Discount Model Case of
Bibica (Vietnam)
( )
( )
(
(
(
(
(
+
+
+
\
|
+
+
n
n
n
r r
g
g r
r
g
D P
1
1 1
1
1
1
1 0
15
Corporate Finance
16-42
Bibica (Vietnam)
2003 2004 2005 2006 Average
Return on Equity (ROE) 0,1350 0,1139 0,1342 0,1140 0,1243
Earnings per share (EPS) 1893 1642 2194 2713
Dividend per share (DPS) 1200 1200 1200 1200
Plowback ratio (b) 0,3661 0,2692 0,4531 0,5577 0,4115
Long-term growth rate (g) 0,0511
Forecast DPS
1 1261,37
Corporate Finance
16-43
Bibica (Vietnam)
Price = 54 (Comparable price = 541.12 = 61)
n r Po n r Po n r Po
10 0,08 22396,30 20 0,08 27452,54 50 0,08 36493,96
0,09 19630,05 0,09 23535,56 0,09 29455,92
0,1 17434,27 0,1 20494,67 0,1 24454,14
0,11 15652,07 0,11 18079,11 0,11 20776,25
0,12 14178,96 0,12 16123,42 0,12 17990,69
0,13 12942,70 0,13 14514,32 0,13 15825,90
0,14 11891,79 0,14 13171,92 0,14 14105,26
0,15 10988,50 0,15 12038,39 0,15 12710,46
0,16 10204,61 0,16 11070,99 0,16 11560,16
0,17 9518,57 0,17 10237,53 0,17 10597,10
0,18 8913,66 0,18 9513,34 0,18 9780,05
Corporate Finance
16-44
Bibica (Vietnam)
70 0,08 39510,26 100 0,08 41844,07 VC 0,08 43705,55
0,09 31005,97 0,09 31969,88 0,09 32458,79
0,1 25266,90 0,1 25675,24 0,1 25815,65
0,11 21209,97 0,11 21386,88 0,11 21429,75
0,12 18225,78 0,12 18304,00 0,12 18317,70
0,13 15955,14 0,13 15990,36 0,13 15994,90
0,14 14177,22 0,14 14193,35 0,14 14194,90
0,15 12751,00 0,15 12758,51 0,15 12759,05
0,16 11583,26 0,16 11586,80 0,16 11587,00
0,17 10610,39 0,17 10612,09 0,17 10612,16
0,18 9787,77 0,18 9788,59 0,18 9788,62
16
Corporate Finance
16-45
SACOM (Vietnam)
2002 2003 2004 2005 2006 Average
Return on Equity (ROE) 0,2923 0,2750 0,2842 0,1867 0,2930 0,2662
Earnings per share (EPS) 4835 3562 4061 5593 5531
Dividend per share (DPS) 1600 1600 1600 1600 1600
Plowback ratio (b) 0,6691 0,5508 0,6060 0,7139 0,7107 0,6501
Long-term growth rate (g) 0,1731
Forecast DPS1 1876,94
Corporate Finance
16-46
SACOM (Vietnam)
19 0,08 189706,21 20 0,08 207794,92 25 0,08 324491,85
0,09 152838,87 0,09 166211,00 0,09 250006,46
0,1 125215,80 0,1 135241,60 0,1 196292,97
0,11 104065,75 0,11 111671,13 0,11 156694,35
0,12 87577,68 0,12 93404,49 0,12 126952,5
0,13 74525,71 0,13 79028,28 0,13 104251,01
0,14 64055,87 0,14 67561,35 0,14 86675,17
0,15 55558,72 0,15 58306,13 0,15 72892,99
0,16 48590,37 0,16 50756,55 0,16 61959,50
0,17 42821,82 0,17 44538,97 0,17 53192,85
0,18 38005,41 0,18 39373,33 0,18 46093,62
0,19 33952,22 0,19 35046,89 0,19 40291,18
Corporate Finance
16-47
Relative Valuation based on P/E Case of
the Transport Sector (Vietnam)
GMD 169 3990 42,36 92,7
HAX 51 2540 20,08 59,0
HTV 40,7 3090 13,17 71,8
MHC 39,1 1640 23,84 38,1
SHC 33,5 1740 19,25 40,4
TMS 68 3900 17,44 90,6
VFC 41,8 1580 26,46 36,7
VIP 95,5 1980 48,23 46,0
Sector Mean 23,23
Stock Price EPS P/E
Relative
Value
8/18/2013
1
Corporate Finance
6-0
Capital Budgeting
Chapter 3
Corporate Finance
6-1
Why Use Net Present Value?
Accepting positive NPV projects benefits shareholders.
Example
Riskless project:
Initial cost: 100; unique cash flow in one year: 107; discount rate: 6 %
NPV = 0.94
If the project is forgone: bank deposit 100 106 in one year the
project benefits shareholders (absolute opportunity cost: 6)
Firm value without project: V + 100; with project: V + 107/1.06
Risky project:
About as risky as the stock market: expected return (=required return) =
10 % NPV < 0
Opportunity cost = expected return on stock market = 10 %
Corporate Finance
6-2
The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CFs - Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
8/18/2013
2
Corporate Finance
6-3
Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate.
Corporate Finance
6-4
The Payback Period Rule
How long does it take the project to pay back
its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management
Ranking Criteria:
set by management
Corporate Finance
6-5
The Payback Period Rule (continued)
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may
not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
8/18/2013
3
Corporate Finance
Year A B C
0 -100 -100 -100
1 20 50 50
2 30 30 30
3 50 20 20
4 60 60 60,000
Payback period (years) 3 3 3
6-6
Corporate Finance
Managerial perspective
Used by large, sophisticated companies when making
relatively small decisions
Desirable features for managerial control: shorter time to
evaluate the managers decision-making ability
Also used by firms with good investment opportunities but no
or little cash available
Practitioners: academic criticisms of payback overstate real-
world problems (e.g., project C)
Bigger projects: NPV becomes the order of the day
6-7
Corporate Finance
6-8
The Discounted Payback Period Rule
How long does it take the project to pay back
its initial investment taking the time value of
money into account?
By the time you have discounted the cash flows,
you might as well calculate the NPV.
8/18/2013
4
Corporate Finance
6-9
The Average Accounting Return Rule
Investment of Value Book Average
Income Net Average
AAR =
Corporate Finance
The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set
by management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
6-10
Corporate Finance
6-11
The Internal Rate of Return (IRR) Rule
IRR: the discount that sets NPV to zero
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
Does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate
8/18/2013
5
Corporate Finance
6-12
The Internal Rate of Return: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
3 2
) 1 (
150 $
) 1 (
100 $
) 1 (
50 $
0
IRR IRR IRR
NPV
+
+
+
+
+
= =
Corporate Finance
6-13
The NPV Payoff Profile for This Example
Discount Rate NPV
0% $100.00
4% $71.04
8% $47.32
12% $27.79
16% $11.65
20% ($1.74)
24% ($12.88)
28% ($22.17)
32% ($29.93)
36% ($36.43)
40% ($41.86)
If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
IRR = 19.44%
($60.00)
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
-1% 9% 19% 29% 39%
Discount rate
N
P
V
Corporate Finance
6-14
Problems with the IRR Approach
Multiple IRRs.
Are We Borrowing or Lending?
The Scale Problem
The Timing Problem
8/18/2013
6
Corporate Finance
Problems with the IRR Approach
6-15
Corporate Finance
6-16
Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200 $800
-$200
- $800
($150.00)
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50% 0% 50% 100% 150% 200%
Discount rate
N
P
V
100% = IRR
2
0% = IRR
1
Which one
should we use?
Corporate Finance
Summarizing rules
6-17
8/18/2013
7
Corporate Finance
6-18
The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000 investment?
Corporate Finance
6-19
The Timing Problem
0 1 2 3
$10,000 $1,000 $1,000
-$10,000
Project A
0 1 2 3
$1,000 $1,000 $12,000
-$10,000
Project B
The preferred project in this case depends on the discount rate, not
the IRR.
Corporate Finance
6-20
The Timing Problem
($4,000.00)
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
$4,000.00
$5,000.00
0% 10% 20% 30% 40%
Discount rate
N
P
V
Project A
Project B
10.55% = crossover rate
16.04% = IRR
A
12.94% = IRR
B
8/18/2013
8
Corporate Finance
6-21
Calculating the Crossover Rate
Compute the IRR for either project A-B or
B-A
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
0% 5% 10% 15% 20%
Discount rate
N
P
VA-B
B-A
10.55% = IRR
Corporate Finance
6-22
Mutually Exclusive vs.
Independent Project
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one project
does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
Corporate Finance
6-23
The Profitability Index (PI) Rule
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
Investment Initial
Flows Cash Future of PV Total
PI =
8/18/2013
9
Corporate Finance
Independent projects
Accept if PI > 1
Reject if PI < 1
6-24
Corporate Finance
Mutually exclusive projects
PI may lead to wrong selection
This flaw can be corrected using incremental analysis
In case of capital rationing: PI may be useful
3 independent projects, limited funds: $20 million
Project 3:
6-25
Corporate Finance
6-26
The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting rate of
return.
The most frequently used technique for large
corporations is IRR or NPV.
8/18/2013
10
Corporate Finance
6-27
Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
Corporate Finance
6-28
Project A Project B
CF
0
-$200.00 -$150.00
PV
0
of CF
1-3
$241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
Corporate Finance
6-29
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
8/18/2013
11
Corporate Finance
6-30
Relationship Between NPV and IRR
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
Corporate Finance
6-31
Project A
Project B
($200)
($100)
$0
$100
$200
$300
$400
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
Discount rates
N
P
V
IRR
1
(A) IRR (B)
NPV Profiles
Cross-over Rate
IRR
2
(A)
Corporate Finance
7-32
Incremental Cash Flows
Cash flows matternot accounting earnings.
Incremental cash flows matter.
Cash flows with project cash flows without project
Sunk costs dont matter.
Sunk costs: cost already occurred, cannot be changed by
the decision to accept or reject the project.
Opportunity costs matter.
e.g., by taking a project, a firm forgoes other
opportunities for using an asset.
8/18/2013
12
Corporate Finance
Incremental Cash Flows (cont.)
Side effects
Erosion: e.g., a new product reduces the cash flows
of existing products
Synergy: e.g., a new product increases the cash flows
of existing products
Allocated costs
An expenditure may benefit a number of projects
Viewed as cash outflow only if it is an incremental
cost of the project
7-33
Corporate Finance
7-34
Cash FlowsNot Accounting Earnings
Consider depreciation expense.
You never write a check made out to
depreciation.
Much of the work in evaluating a project
lies in taking accounting numbers and
generating cash flows.
Corporate Finance
7-35
Sunk costs are not relevant
Just because we have come this far does not mean
that we should continue to throw good money after
bad.
Opportunity costs do matter. Just because a
project has a positive NPV that does not mean
that it should also have automatic acceptance.
Specifically if another project with a higher NPV
would have to be passed up we should not
proceed.
8/18/2013
13
Corporate Finance
7-36
Side effects matter.
Erosion and cannibalism are both bad things.
If our new product causes existing customers
to demand less of current products, we need to
recognize that.
Corporate Finance
7-37
Estimating Cash Flows
Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT Taxes + Depreciation
Net Capital Spending
Dont forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a
return of net working capital.
Corporate Finance
7-38
Interest Expense
Later chapters will deal with the impact that
the amount of debt that a firm has in its
capital structure has on firm value.
For now, its enough to assume that the
firms level of debt (hence interest expense)
is independent of the project at hand.
8/18/2013
1
Corporate Finance
9-0
Part 1
Capital Market Theory:
An Overview
Risk, Return and Firm Cost of
Capital
Chapter 4
Corporate Finance
Returns
Holding-Period Returns
Return Statistics
Average Stock Returns and Risk-Free Returns
Risk Statistics
Summary and Conclusions
Corporate Finance
9-2
Returns
Dollar Returns
the sum of the cash received
and the change in value of the
asset, in dollars.
Time 0 1
Initial
investment
Ending
market value
Dividends
Percentage Returns
the sum of the cash received and the
change in value of the asset divided by
the original investment.
8/18/2013
2
Corporate Finance
Dollar Return = Dividend + Change in Market Value Dollar Return = Dividend + Change in Market Value
Returns
yield gains capital yield dividend
+ =
ue market val beginning
ue market val in change dividend
+
=
ue market val beginning
return dollar
return percentage
=
Corporate Finance
9-4
Returns: Example
Suppose you bought 100 shares of Wal-Mart (WMT)
one year ago today at $25. Over the last year, you
received $20 in dividends (= 20 cents per share 100
shares). At the end of the year, the stock sells for $30.
How did you do?
Quite well. You invested $25 100 = $2,500. At the
end of the year, you have stock worth $3,000 and cash
dividends of $20. Your dollar gain was $520 = $20 +
($3,000 $2,500).
Your percentage gain for the year is 20.8% =
$2,500
$520
Corporate Finance
9-5
Returns: Example
Dollar Return:
$520 gain
Time 0 1
-$2,500
$3,000
$20
Percentage Return:
20.8% =
$2,500
$520
8/18/2013
3
Corporate Finance
9-6
Holding-Period Returns
The holding period return is the return that
an investor would get when holding an
investment over a period of n years, when
the return during year i is given as r
i
:
1 ) 1 ( ) 1 ( ) 1 (
return period holding
2 1
+ + + =
=
n
r r r L
Corporate Finance
9-7
Holding Period Return: Example
Suppose your investment provides the following
returns over a four-year period:
Year Return
1 10%
2 -5%
3 20%
4 15%
% 21 . 44 4421 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
1 ) 1 ( ) 1 ( ) 1 ( ) 1 (
return period holding Your
4 3 2 1
= =
=
+ + + + =
=
r r r r
Corporate Finance
9-8
So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
actually realized an annual return of 9.58%:
An investor who held this investment would have
actually realized an annual return of 9.58%:
Year Return
1 10%
2 -5%
3 20%
4 15% % 58 . 9 095844 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 (
return average Geometric
4
4 3 2 1
4
= =
=
+ + + + = +
=
g
g
r
r r r r r
4
) 095844 . 1 ( 4421 . 1 =
8/18/2013
4
Corporate Finance
9-9
Note that the geometric average is not the same
thing as the arithmetic average:
Year Return
1 10%
2 -5%
3 20%
4 15%
% 10
4
% 15 % 20 % 5 % 10
4
return average Arithmetic
4 3 2 1
=
+ +
=
+ + +
=
r r r r
Corporate Finance
9-10
Holding Period Returns
A famous set of studies dealing with the rates of returns
on common stocks, bonds, and Treasury bills was
conducted by Roger Ibbotson and Rex Sinquefield.
They present year-by-year historical rates of return
starting in 1926 for the following five important types of
financial instruments in the United States:
Large-Company Common Stocks
Small-company Common Stocks
Long-Term Corporate Bonds
Long-Term U.S. Government Bonds
U.S. Treasury Bills
Corporate Finance
9-11
The Future Value of an Investment
of $1 in 1925
0.1
10
1000
1930 1940 1950 1960 1970 1980 1990 2000
Common Stocks
Long T-Bonds
T-Bills
$59.70
$17.48
Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, IbbotsonAssociates, Inc., Chicago(annuallyupdates work by
Roger G. Ibbotsonand Rex A. Sinquefield). All rights reserved.
$1,775.34
8/18/2013
5
Corporate Finance
9-12
Return Statistics
The history of capital market returns can be summarized
by describing the
average return
the standard deviation of those returns
the frequency distribution of the returns.
T
R R
R
T
) (
1
+ +
=
L
1
) ( ) ( ) (
2 2
2
2
1
+ +
= =
T
R R R R R R
VAR SD
T
L
Corporate Finance
9-13
Historical Returns, 1926-2002
Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Inc., Chicago
(annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
90% + 90% 0%
Average Standard
Series Annual Return Deviation Distribution
Large Company Stocks 12.2% 20.5%
Small Company Stocks 16.9 33.2
Long-Term Corporate Bonds 6.2 8.7
Long-Term Government Bonds 5.8 9.4
U.S. Treasury Bills 3.8 3.2
Inflation 3.1 4.4
Corporate Finance
9-14
Average Stock Returns
and Risk-Free Returns
The Risk Premium is the additional return (over and
above the risk-free rate) resulting from bearing risk.
One of the most significant observations of stock market
data is this long-run excess of stock return over the risk-
free return.
The average excess return from large company common stocks
for the period 1926 through 1999 was 8.4% = 12.2% 3.8%
The average excess return from small company common stocks
for the period 1926 through 1999 was 13.2% = 16.9% 3.8%
The average excess return from long-term corporate bonds for
the period 1926 through 1999 was 2.4% = 6.2% 3.8%
8/18/2013
6
Corporate Finance
9-15
Risk Premia
Suppose that The Wall Street Journal announced that
the current rate for on-year Treasury bills is 5%.
What is the expected return on the market of small-
company stocks?
Recall that the average excess return from small
company common stocks for the period 1926 through
1999 was 13.2%
Given a risk-free rate of 5%, we have an expected return
on the market of small-company stocks of 18.2% =
13.2% + 5%
Corporate Finance
9-16
The Risk-Return Tradeoff
2%
4%
6%
8%
10%
12%
14%
16%
18%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation
A
n
n
u
a
l

R
e
t
u
r
n

A
v
e
r
a
g
e
T-Bonds
T-Bills
Large-Company Stocks
Small-Company Stocks
Corporate Finance
9-17
Rates of Return 1926-2002
-60
-40
-20
0
20
40
60
26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000
Common Stocks
Long T-Bonds
T-Bills
8/18/2013
7
Corporate Finance
9-18
Risk Premiums
Rate of return on T-bills is essentially risk-free.
Investing in stocks is risky, but there are
compensations.
The difference between the return on T-bills and
stocks is the risk premium for investing in stocks.
An old saying on Wall Street is You can either
sleep well or eat well.
Corporate Finance
9-19
Stock Market Volatility
0
10
20
30
40
50
60
1
9
2
6
1
9
3
5
1
9
4
0
1
9
4
5
1
9
5
0
1
9
5
5
1
9
6
0
1
9
6
5
1
9
7
0
1
9
7
5
1
9
8
0
1
9
8
5
1
9
9
0
1
9
9
5
1
9
9
8
The volatility of stocks is not constant from year to year.
Corporate Finance
9-20
Risk Statistics
There is no universally agreed-upon definition of
risk.
The measures of risk that we discuss are variance
and standard deviation.
The standard deviation is the standard statistical
measure of the spread of a sample, and it will be the
measure we use most of this time.
Its interpretation is facilitated by a discussion of the
normal distribution.
8/18/2013
8
Corporate Finance
9-21
Normal Distribution
A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability
Return on
large company common
stocks
99.74%
3
49.3%
2
28.8%
1
8.3%
0
12.2%
+ 1
32.7%
+ 2
53.2%
+ 3
73.7%
The probability that a yearly
return will fall within 20.1
percent of the mean of 13.3
percent will be
approximately 2/3.
68.26%
95.44%
Corporate Finance
9-22
Normal Distribution
The 20.1-percent standard deviation we
found for stock returns from 1926 through
1999 can now be interpreted in the
following way: if stock returns are
approximately normally distributed, the
probability that a yearly return will fall
within 20.1 percent of the mean of 13.3
percent will be approximately 2/3.
Corporate Finance
9-23
Normal Distribution
S&P 500 Return Frequencies
0
2
5
11
16
9
12 12
1
2
1 1
0
0
2
4
6
8
10
12
14
16
62% 52% 42% 32% 22% 12% 2% -8% -18% -28% -38% -48% -58%
Annual returns
R
e
t
u
r
n

f
r
e
q
u
e
n
c
y
Normal
approximation
Mean = 12.8%
Std. Dev. = 20.4%
Source: Stocks, Bonds, Bills, and Inflation 2002 Yearbook, IbbotsonAssociates, Inc., Chicago
(annually updates work by Roger G. Ibbotsonand Rex A. Sinquefield). All rights reserved.
8/18/2013
9
Corporate Finance
9-24
This chapter presents returns for four asset
classes:
Large Company Stocks
Small Company Stocks
Long-Term Government Bonds
Treasury Bills
Stocks have outperformed bonds over most of
the twentieth century, although stocks have also
exhibited more risk.
Corporate Finance
9-25
The stocks of small companies have
outperformed the stocks of small
companies over most of the twentieth
century, again with more risk.
The statistical measures in this chapter are
necessary building blocks for the material
of the next three chapters.
8/18/2013
1
Corporate Finance
10-0
Part 2
The Capital Asset Pricing Model
(CAPM)
Risk, Return and Firm Cost of
Capital
Chapter 4
Corporate Finance
10-1
Individual Securities
Expected Return, Variance, and Covariance
The Return and Risk for Portfolios
The Efficient Set for Two Assets
The Efficient Set for Many Securities
Diversification: An Example
Riskless Borrowing and Lending
Market Equilibrium
Relationship between Risk and Expected Return (CAPM)
Corporate Finance
10-2
Individual Securities
The characteristics of individual securities that
are of interest are the:
Expected Return
Variance and Standard Deviation
Covariance and Correlation
8/18/2013
2
Corporate Finance
10-3
Expected Return, Variance,
and Covariance
Consider the following two risky asset world.
There is a 1/3 chance of each state of the
economy and the only assets are a stock fund and
a bond fund.
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Corporate Finance
10-4
and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Corporate Finance
10-5
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
% 11 ) (
%) 28 (
3
1
%) 12 (
3
1
%) 7 (
3
1
) (
=
+ + =
S
S
r E
r E
8/18/2013
3
Corporate Finance
10-6
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
% 7 ) (
%) 3 (
3
1
%) 7 (
3
1
%) 17 (
3
1
) (
=
+ + =
B
B
r E
r E
Corporate Finance
10-7
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
% 24 . 3 %) 7 % 11 (
2
=
Corporate Finance
10-8
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
% 01 . %) 12 % 11 (
2
=
8/18/2013
4
Corporate Finance
10-9
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
% 89 . 2 %) 28 % 11 (
2
=
Corporate Finance
10-10
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
%) 89 . 2 % 01 . 0 % 24 . 3 (
3
1
% 05 . 2
+ + =
Corporate Finance
10-11
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
and Covariance
0205 . 0 % 3 . 14
=
8/18/2013
5
Corporate Finance
10-12
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
The Return and Risk
for Portfolios
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.
Corporate Finance
10-13
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the
returns on the stocks and bonds in the portfolio:
S S B B P
r w r w r + =
%) 17 ( % 50 %) 7 ( % 50 % 5 + =
Corporate Finance
10-14
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
%) 7 ( % 50 %) 12 ( % 50 % 5 . 9 + =
S S B B P
r w r w r + =
8/18/2013
6
Corporate Finance
10-15
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
%) 3 ( % 50 %) 28 ( % 50 % 5 . 12 + =
S S B B P
r w r w r
+ =
Corporate Finance
10-16
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted average
of the expected returns on the securities in the portfolio.
%) 7 ( % 50 %) 11 ( % 50 % 9 + =
) ( ) ( ) (
S S B B P
r E w r E w r E + =
Corporate Finance
10-17
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets portfolio is
BS S S B B
2
S S
2
B B
2
P
) )(w 2(w ) (w ) (w + + =
where
BS
is the correlation coefficient between the returns on the
stock and bond funds.
8/18/2013
7
Corporate Finance
10-18
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.
An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held in isolation.
Corporate Finance
10-19
Portfolo Risk and Return Combinations
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Portfolio Risk (standard deviation)
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50.00% 3.08% 9.00%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
We can consider other
portfolio weights besides
50% in stocks and 50% in
bonds
100%
bonds
100%
stocks
Corporate Finance
10-20
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
We can consider other
portfolio weights besides
50% in stocks and 50% in
bonds
100%
bonds
100%
stocks
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
8/18/2013
8
Corporate Finance
10-21
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
100%
stocks
100%
bonds
Note that some portfolios are
better than others. They have
higher returns for the same level of
risk or less. These compromise the
efficient frontier.
Corporate Finance
10-22
Two-Security Portfolios with Various Correlations
100%
bonds
r
e
t
u
r
n

100%
stocks
= 0.2
= 1.0
= -1.0
Relationship depends on correlation coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = 1.0, complete risk reduction is possible
Relationship depends on correlation coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = 1.0, complete risk reduction is possible
Corporate Finance
10-23
Portfolio Risk as a Function of the Number of Stocks
in the Portfolio
Nondiversifiable risk;
Systematic Risk;
Market Risk
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
n

In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Thus diversification can eliminate some,
but not all of the risk of individual securities.
Portfolio risk
8/18/2013
9
Corporate Finance
10-24
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations
of various portfolios.
r
e
t
u
r
n

P
Individual Assets
Corporate Finance
10-25
Given the opportunity set we can identify the
minimum variance portfolio.
r
e
t
u
r
n

P
minimum
variance
portfolio
Individual Assets
Corporate Finance
10-26
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
r
e
t
u
r
n

P
minimum
variance
portfolio
Individual Assets
8/18/2013
10
Corporate Finance
10-27
Optimal Risky Portfolio with a Risk-Free Asset
In addition to stocks and bonds, consider a world
that also has risk-free securities like T-bills
100%
bonds
100%
stocks
r
f
r
e
t
u
r
n

Corporate Finance
10-28
Now investors can allocate their money across the
T-bills and a balanced mutual fund
100%
bonds
100%
stocks
r
f
r
e
t
u
r
n

Balanced
fund
Corporate Finance
10-29
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with the
steepest slope
r
e
t
u
r
n

P
r
f
8/18/2013
11
Corporate Finance
10-30
Market Equilibrium
With the capital allocation line identified, all investors choose a point along the
linesome combination of the risk-free asset and the market portfolio M. In a
world with homogeneous expectations, M is the same for all investors.
r
e
t
u
r
n

P
r
f
M
Corporate Finance
10-31
The Separation Property
The Separation Property states that the market portfolio, M, is the
same for all investorsthey can separate their risk aversion from
their choice of the market portfolio.
r
e
t
u
r
n

P
r
f
M
Corporate Finance
10-32
Investor risk aversion is revealed in their choice of where to stay
along the capital allocation linenot in their choice of the line.
r
e
t
u
r
n

P
r
f
M
8/18/2013
12
Corporate Finance
10-33
Market Equilibrium
Just where the investor chooses along the Capital Asset Line depends
on his risk tolerance. The big point though is that all investors
have the same CML.
100%
bonds
100%
stocks
r
f
r
e
t
u
r
n

Balanced
fund
Corporate Finance
10-34
Market Equilibrium
All investors have the same CML because they all have the
same optimal risky portfolio given the risk-free rate.
100%
bonds
100%
stocks
r
f
r
e
t
u
r
n

Optimal
Risky
Portfolio
Corporate Finance
10-35
The separation property implies that portfolio choice can be
separated into two tasks: (1) determine the optimal risky portfolio,
and (2) selecting a point on the CML.
100%
bonds
100%
stocks
r
f
r
e
t
u
r
n

Optimal
Risky
Portfolio
8/18/2013
13
Corporate Finance
10-36
Optimal Risky Portfolio with a Risk-Free Asset
By the way, the optimal risky portfolio depends on
the risk-free rate as well as the risky assets.
100%
bonds
100%
stocks
r
e
t
u
r
n

First
Optimal
Risky
Portfolio
Second Optimal
Risky Portfolio
0
f
r
1
f
r
Corporate Finance
10-37
Definition of Risk When Investors Hold
the Market Portfolio
Researchers have shown that the best measure of
the risk of a security in a large portfolio is the
beta ()of the security.
Beta measures the responsiveness of a security to
movements in the market portfolio.
) (
) (
2
,
M
M i
i
R
R R Cov
=
Corporate Finance
10-38
Estimating with regression
S
e
c
u
r
i
t
y

R
e
t
u
r
n
s
S
e
c
u
r
i
t
y

R
e
t
u
r
n
s
Return on Return on
market % market %
RR
ii
= =
ii
+ +
ii
RR
mm
+ + ee
ii
Slope = Slope =
ii
8/18/2013
14
Corporate Finance
10-39
Estimates of for Selected Stocks
Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05
Green Mountain
Power
0.55
Homestake Mining 0.20
Oracle, Inc. 0.49
Corporate Finance
10-40
The Formula for Beta
) (
) (
2
,
M
M i
i
R
R R Cov
=
Clearly, your estimate of beta will depend upon your
choice of a proxy for the market portfolio.
Corporate Finance
10-41
Relationship between Risk
and Expected Return (CAPM)
Expected Return on the Market:
Expected return on an individual security:
Premium Risk Market + =
F
M R R
) (
F
M
i F
i R R R R + =
Market Risk Premium
This applies to individual securities held within well-
diversified portfolios.
8/18/2013
15
Corporate Finance
10-42
Expected Return on an Individual Security
This formula is called the Capital Asset Pricing
Model (CAPM)
) (
F
M
i F
i R R R R
+ =
Assume
i
= 0, then the expected return is R
F
.
Assume
i
= 1, then
M i R R
=
Expected
return on
a security
=
Risk-
free rate
+
Beta of the
security

Market risk
premium
Corporate Finance
10-43
Relationship Between Risk & Expected Return
E
x
p
e
c
t
e
d

r
e
t
u
r
n

) (
F
M
i F
i R R R R
+ =
F
R
1.0
M
R
Corporate Finance
10-44
Relationship Between Risk & Expected Return
E
x
p
e
c
t
e
d

r
e
t
u
r
n

% 3
=
F
R
% 3
1.5
% 5 . 13
5 . 1 =
i % 10
=
M R
% 5 . 13 %) 3 % 10 ( 5 . 1 % 3 = + = i R
8/18/2013
16
Corporate Finance
10-45
This chapter sets forth the principles of modern portfolio theory.
The expected return and variance on a portfolio of two securities
A and B are given by
By varying w
A
, one can trace out the efficient set of portfolios.
We graphed the efficient set for the two-asset case as a curve,
pointing out that the degree of curvature reflects the
diversification effect: the lower the correlation between the two
securities, the greater the diversification.
The same general shape holds in a world of many assets.
AB A A B B
2
B B
2
A A
2
P
) )(w 2(w ) (w ) (w + + =
) ( ) ( ) (
B B A A P
r E w r E w r E + =
Corporate Finance
10-46
The efficient set of risky assets can be combined with riskless
borrowing and lending. In this case, a rational investor will
always choose to hold the portfolio of risky securities represented
by the market portfolio.
r
e
t
u
r
n

P
r
f
M
Then with borrowing
or lending, the
investor selects a point
along the CML.
Corporate Finance
10-47
The contribution of a security to the risk of a well-diversified
portfolio is proportional to the covariance of the security's return
with the markets return. This contribution is called the beta.
The CAPM states that the expected return on a security is
positively related to the securitys beta:
) (
) (
2
,
M
M i
i
R
R R Cov
=
) (
F
M
i F
i R R R R
+ =
8/18/2013
1
Corporate Finance
15-0
Corporate Capital Structure
Chapter 5
Corporate Finance
15-1
Chapter Outline
The Capital-Structure Question and The Pie Theory
Maximizing Firm Value versus Maximizing Stockholder
Interests
Financial Leverage and Firm Value: An Example
Modigliani and Miller: Proposition II (No Taxes)
Taxes
Corporate Finance
15-2
The Capital-Structure Question
and The Pie Theory
The value of a firm is defined to be the sum of
the value of the firms debt and the firms equity.
V = B + S
If the goal of the management
of the firm is to make the firm
as valuable as possible, the the
firm should pick the debt-equity
ratio that makes the pie as big
as possible.
Value of the Firm
S B S B S B S B
8/18/2013
2
Corporate Finance
15-3
The Capital-Structure Question
There are really two important questions:
1. Why should the stockholders care about maximizing
firm value? Perhaps they should be interested in
strategies that maximize shareholder value.
2. What is the ratio of debt-to-equity that maximizes the
shareholders value?
As it turns out, changes in capital structure benefit the
stockholders if and only if the value of the firm
increases.
Corporate Finance
15-4
Financial Leverage, EPS, and ROE
Current
Assets $20,000
Debt $0
Equity $20,000
Debt/Equity ratio 0.00
Interest rate n/a
Shares outstanding 400
Share price $50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
Consider an all-equity firm that is considering going
into debt. (Maybe some of the original shareholders
want to cash out.)
Corporate Finance
15-5
EPS and ROE Under Current Capital
Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
8/18/2013
3
Corporate Finance
15-6
EPS and ROE Under Proposed Capital
Structure
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
Corporate Finance
15-7
EPS and ROE Under Both Capital Structures
Levered
EBIT $1,000 $2,000 $3,000
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Levered
EBIT $1,000 $2,000 $3,000
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
All-Equity
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
Corporate Finance
15-8
Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
E
P
S
Debt
No Debt
Break-even
point
EBIT in dollars, no taxes
Advantage
to debt
Disadvantage
to debt
8/18/2013
4
Corporate Finance
15-9
Assumptions of the Modigliani-Miller
Model
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes
Corporate Finance
15-10
Homemade Leverage: An Example
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%
We are buying 40 shares of a $50 stock on margin. We get the same
ROE as if we bought into a levered firm.
Our personal debt equity ratio is:
3
2
200 , 1 $
800 $
= =
S
B
Corporate Finance
15-11
Homemade (Un)Leverage:
An Example
Recession ExpectedExpansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
Buying 24 shares of an other-wise identical levered firm along with
the some of the firms debt gets us to the ROE of the unlevered firm.
This is the fundamental insight of M&M
8/18/2013
5
Corporate Finance
15-12
The MM Propositions I & II (No Taxes)
Proposition I
Firm value is not affected by leverage
V
L
= V
U
Proposition II
Leverage increases the risk and return to stockholders
r
s
= r
0
+ (B / S
L
) (r
0
- r
B
)
r
B
is the interest rate (cost of debt)
r
s
is the return on (levered) equity (cost of equity)
r
0
is the return on unlevered equity (cost of capital)
B is the value of debt
S
L
is the value of levered equity
Corporate Finance
15-13
The MM Proposition I (No Taxes)
U L
V V
=
B r EBIT
B
receive firm levered a in rs Shareholde

B r
B
receive s Bondholder
The derivation is straightforward:
B r B r EBIT
B B
+ ) (
is rs stakeholde all to flow cash total the Thus,
The present value of this stream of cash flows is V
L
EBIT B r B r EBIT
B B
= + ) (
Clearly
U
Corporate Finance
15-14
The MM Proposition II (No Taxes)
The derivation is straightforward:
S B WACC
r
S B
S
r
S B
B
r
+
+
+
=
0
set Then r r
WACC
=
0
r r
S B
S
r
S B
B
S B
=
+
+
+ S
S B +
by sides both multiply
0
r
S
S B
r
S B
S
S
S B
r
S B
B
S
S B
S B
+
=
+
+
+
+
+
0
r
S
S B
r r
S
B
S B
+
= +
0 0
r r
S
B
r r
S
B
S B
+ = + ) (
0 0 B S
r r
S
B
r r + =
8/18/2013
6
Corporate Finance
15-15
The Cost of Equity, the Cost of Debt, and the Weighted Average
Cost of Capital: MM Proposition II with No Corporate Taxes
Debt-to-equity Ratio
C
o
s
t

o
f

c
a
p
i
t
a
l
:

r

(
%
)
r
0
r
B
S B WACC
r
S B
S
r
S B
B
r
+
+
+
=
) (
0 0 B
L
S
r r
S
B
r r + =
r
B
S
B
Corporate Finance
15-16
The MM Propositions I & II
(with Corporate Taxes)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
V
L
= V
U
+ T
C
B
Proposition II (with Corporate Taxes)
Some of the increase in equity risk and return is offset by
interest tax shield
r
S
= r
0
+ (B/S)(1-T
C
)(r
0
- r
B
)
r
B
is the interest rate (cost of debt)
r
S
is the return on equity (cost of equity)
r
0
is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
Corporate Finance
15-17
The MM Proposition I (Corp. Taxes)
B T V V
C U L
+ =
) 1 ( ) (
receive firm levered a in rs Shareholde
C B
T B r EBIT
B r
B
receive s Bondholder
B r T B r EBIT
B C B
+ ) 1 ( ) (
is rs stakeholde all to flow cash total the Thus,
L
= + B r T B r EBIT
B C B
) 1 ( ) ( Clearly
The present value of the first term is V
U
The present value of the second term is T
C
B
B r T B r T EBIT
B C B C
+ = ) 1 ( ) 1 (
B r BT r B r T EBIT
B C B B C
+ + = ) 1 (
8/18/2013
7
Corporate Finance
15-18
The MM Proposition II (Corp. Taxes)
Start with M&MProposition I with taxes:
) ( ) 1 (
0 0 B C S
r r T
S
B
r r + =
B T V V
C U L
+ =
Since
B S V
L
+ =
The cash flows from each side of the balance sheet must equal:
B C U B S
Br T r V Br Sr + = +
0
B r T r T B S Br Sr
B C C B S
+ + = +
0
)] 1 ( [
Divide both sides by S
B C C B S
r T
S
B
r T
S
B
r
S
B
r + + = +
0
)] 1 ( 1 [
B T V B S
C U
+ = +
) 1 (
C U
T B S V + =
Which quickly reduces to
Corporate Finance
15-19
The Effect of Financial Leverage on the Cost of Debt and
Equity Capital with Corporate Taxes
Debt-to-equity
ratio (B/S)
Cost of capital: r
(%)
r
0
r
B
) ( ) 1 (
0 0 B C
L
S
r r T
S
B
r r + =
S
L
L
C B
L
WACC
r
S B
S
T r
S B
B
r
+
+
+
= ) 1 (
) (
0 0 B
L
S
r r
S
B
r r + =
Corporate Finance
15-20
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-Equity
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35% $350 $700 $1,050
Total Cash Flow to S/H $650 $1,300 $1,950
Levered
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+T
C
r
B
B $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
Levered
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+T
C
r
B
B $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
8/18/2013
8
Corporate Finance
15-21
The levered firm pays less in taxes than does the all-equity
firm.
Thus, the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
S G S G
B
All-equity firm Levered firm
Corporate Finance
15-22
The sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie
larger: the government takes a smaller slice of the pie!
S G S G
B
All-equity firm Levered firm
Corporate Finance
15-23
Summary: No Taxes
In a world of no taxes, the value of the firm is
unaffected by capital structure.
This is M&M Proposition I:
V
L
= V
U
Prop I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders
) (
0 0 B
L
S
r r
S
B
r r + =
8/18/2013
9
Corporate Finance
15-24
Summary: Taxes
In a world of taxes, but no bankruptcy costs, the value of
the firm increases with leverage.
This is M&M Proposition I:
V
L
= V
U
+ T
C
B
Prop I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
) ( ) 1 (
0 0 B C
L
S
r r T
S
B
r r + =
Corporate Finance
15-25
Prospectus: Bankruptcy Costs
So far, we have seen M&M suggest that financial
leverage does not matter, or imply that taxes cause the
optimal financial structure to be 100% debt.
In the real world, most executives do not like a capital
structure of 100% debt because that is a state known as
bankruptcy.
In the next chapter we will introduce the notion of a
limit on the use of debt: financial distress.
The important use of this chapter is to get comfortable
with M&M algebra.
8/18/2013
1
Corporate Finance
18-0
Corporate Dividend Policy
Chapter 6
Corporate Finance
18-1
Chapter Outline
Different Types of Dividends
Standard Method of Cash Dividend Payment
The Benchmark Case: An Illustration of the Irrelevance of Dividend
Policy
Repurchase of Stock
Personal Taxes, Issuance Costs, and Dividends
Real World Factors Favoring a High Dividend Policy
The Clientele Effect:
A Resolution of Real-World Factors?
What We Know and Do Not Know About Dividend Policy
Corporate Finance
18-2
Different Types of Dividends
Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.
Often companies will declare stock dividends.
No cash leaves the firm.
The firm increases the number of shares outstanding.
Some companies declare a dividend in kind.
Wrigleys Gum sends around a box of chewing gum.
Dundee Crematoria offers shareholders discounted cremations.
8/18/2013
2
Corporate Finance
18-3
Standard Method of Cash
Dividend Payment
Record Date - Person who owns stock on this
date received the dividend.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm
to its shareholders.
Corporate Finance
18-4
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date
Declaration Date: The Board of Directors declares a payment of

dividends.
Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 6 November.
Corporate Finance
18-5
Price Behavior around the Ex-Dividend Date
In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops
by the amount of
the cash
dividend
-t
-2 -1 0 +1 +2
Taxes complicate things a bit. Empirically, the price

drop is less than the dividend and occurs within the first
few minutes of the ex-date.
8/18/2013
3
Corporate Finance
18-6
The Benchmark Case: An Illustration of the
Irrelevance of Dividend Policy
A compelling case can be made that dividend
policy is irrelevant.
Since investors do not need dividends to convert
shares to cash they will not pay higher prices for
firms with higher dividend payouts.
In other words, dividend policy will have no
impact on the value of the firm because investors
can create whatever income stream they prefer by
using homemade dividends.
Corporate Finance
18-7
Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend.
Bobs homemade dividend strategy:
Sell 2 shares ex-dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 78 =
$3,120
$3 Dividend
$240
$0
$240
$39 80 =
$3,120
Corporate Finance
18-8
Dividend Policy is Irrelevant
Since investors do not need dividends to convert shares to cash,
dividend policy will have no impact on the value of the firm.
In the above example, Bob Investor began with total wealth of
$3,360:
Since investors do not need dividends to convert shares to cash,
dividend policy will have no impact on the value of the firm.
In the above example, Bob Investor began with total wealth of
$3,360:
share
42 $
shares 80 360 , 3 $ =
240 $
share
39 $
shares 80 360 , 3 $ + =
80 $ 160 $
share
40 $
shares 78 360 , 3 $ + + =
After a $3 dividend, his total wealth is still $3,360:
After a $2 dividend, and sale of 2 ex-dividend shares,his total
wealth is still $3,360:
8/18/2013
4
Corporate Finance
18-9
Irrelevance of Stock Dividends: Example
Shimano USA has 2 million shares currently outstanding at $15 per
share. The company declares a 50% stock dividend. How many
shares will be outstanding after the dividend is paid?
A 50% stock dividend will increase the number of shares by 50%:
2 million1.5 = 3 million shares
After the stock dividend what is the new price per share and what is
the new value of the firm?
The value of the firm was $2m $15 per share = $30 m. After the
dividend, the value will remain the same.
Price per share = $30m/ 3m shares = $10 per share
Corporate Finance
18-10
Dividends and Investment Policy
Firms should never forgo positive NPV projects
to increase a dividend (or to pay a dividend for
the first time).
Recall that on of the assumptions underlying the
dividend-irrelevance arguments was The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.
Corporate Finance
18-11
Repurchase of Stock
Instead of declaring cash dividends, firms can rid
itself of excess cash through buying shares of
their own stock.
Recently share repurchase has become an
important way of distributing earnings to
shareholders.
8/18/2013
5
Corporate Finance
18-12
Stock Repurchase versus Dividend
$10 = /100,000 $1,000,000
=
Price per share
100,000
=
outstanding Shares
1,000,000 Value of Firm 1,000,000 Value of Firm
1,000,000 Equity 850,000 assets Other
0 Debt $150,000 Cash
sheet balance Original A.
Equity & Liabilities Assets
Consider a firm that wishes to distribute $100,000 to its
shareholders.
Corporate Finance
18-13
$9 = 00,000 $900,000/1 = share per Price
100,000 = g outstanding Shares
900,000 Firm of Value 900,000 Firm of Value
900,000 Equity 850,000 assets Other
0 Debt $50,000 Cash
dividend cash share per $1 After B.
Equity & s Liabilities Assets
If they distribute the $100,000 as cash dividend, the balance
sheet will look like this:
Corporate Finance
18-14
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price per share = $900,000 / 90,000 = $10
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
8/18/2013
6
Corporate Finance
18-15
Share Repurchase
Lower tax (but the IRS is watching)
Tender offers
If offer price is set wrong, some stockholders lose.
Open-market repurchase
Targeted repurchase
Greenmail
Gadflies
Repurchase as investment
Recent studies has shown that the long-term stock price performance of
securities after a buyback is significantly better than the stock price
performance of comparable companies that do not repurchase.
Corporate Finance
18-16
Personal Taxes, Issuance Costs, and
Dividends
To get the result that dividend policy is irrelevant, we
needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends and capital
gains are taxed at a maximum rate of 15 percent.
Since capital gains can be deferred, the tax rate on
dividends is greater than the effective rate on capital
gains.
Corporate Finance
18-17
Firms Without Sufficient Cash to Pay a Dividend
In a world of personal taxes,
firms should not issue stock
to pay a dividend.
Firm
Stock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers
The direct costs of
stock issuance will
add to this effect.
8/18/2013
7
Corporate Finance
18-18
Firms With Sufficient Cash to
Pay a Dividend
The above argument does not necessarily apply to firms
with excess cash.
Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
The firm has several options:
Select additional capital budgeting projects (by assumption,
these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
Corporate Finance
18-19
Taxes, Issuance Costs,
and Dividends
In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative uses
for funds to reduce dividends.
3. Though personal taxes mitigate against the payment
of dividends, these taxes are not sufficient to lead
firms to eliminate all dividends.
Corporate Finance
18-20
Real World Factors Favoring
a High Dividend Policy
Desire for Current Income
Resolution of Uncertainty
Tax Arbitrage
Agency Costs
8/18/2013
8
Corporate Finance
18-21
The homemade dividend argument relies on no
transactions costs.
To put this in perspective, mutual funds can
repackage securities for individuals at very low
cost: they could buy low-dividend stocks and
with a controlled policy of realizing gains, pay
their investors at a specified rate.
Corporate Finance
18-22
Resolution of Uncertainty
It would be erroneous to conclude that increased
dividends can make the firm less risky.
A firms overall cash flows are not necessarily
affected by dividend policyas long as capital
spending and borrowing are not changes.
Thus, it is hard to see how the risks of the overall
cash flows can be changed with a change in
dividend policy.
Corporate Finance
18-23
Tax Arbitrage
Investors can create positions in high dividend-
yield securities that avoid tax liabilities.
Thus, corporate managers need not view
dividends as tax-disadvantaged.
8/18/2013
9
Corporate Finance
18-24
Agency Costs
Agency Cost of Debt
Firms in financial distress are reluctant to cut
dividends. To protect themselves, bondholders
frequently create loan agreements stating dividends
can only be paid if the firm has earns, cash flow and
working capital above pre-specified levels.
Agency Costs of Equity
Managers will find it easier to squander funds if they
have a low dividend payout.
Corporate Finance
18-25
Real World Factors
Reasons for Low Dividend
Personal Taxes
High Issuing Costs
Reasons for High Dividend
Information Asymmetry
Dividends as a signal about firms future performance
Lower Agency Costs
capital market as a monitoring device
reduce free cash flow, and hence wasteful spending
Bird-in-the-hand: Theory or Fallacy?
Uncertainty resolution
Corporate Finance
18-26
The Clientele Effect: A Resolution of Real-
World Factors?
Clienteles for various dividend payout policies are likely
to form in the following way:
Group Stock
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations
Zero to Low payout stocks
Low-to-Medium payout
Medium Payout Stocks
High Payout Stocks
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.
8/18/2013
10
Corporate Finance
18-27
What We Know and Do Not Know
About Dividend Policy
Corporations Smooth Dividends.
Dividends Provide Information to the Market.
Firms should follow a sensible dividend policy:
Dont forgo positive NPV projects just to pay a
dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few better
uses for the cash.
Corporate Finance
18-28
The optimal payout ratio cannot be determined
quantitatively.
In a perfect capital market, dividend policy is irrelevant due
to the homemade dividend concept.
A firm should not reject positive NPV projects to pay a
dividend.
Personal taxes and issue costs are real-world considerations
that favor low dividend payouts.
Many firms appear to have along-run target dividend-payout
policy. There appears to be some value to dividend stability
and smoothing.
There appears to be some information content in dividend
payments.

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Corporate Finance - Slides

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8/18/2013

The cash from

Number of OSO Number of OSO

receive firm levered a in rs Shareholde

Declaration Date: The Board of Directors declares a payment of

Taxes complicate things a bit. Empirically, the price

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