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Chapter One

Introduction to Corporate
Finance

1-1
Chapter Organisation

1.1 Corporate Finance and the Financial Manager


1.2 The Statement of Financial Position and Corporate
Financial Decisions
1.3 The Corporate Form of Business Organisation
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the Corporation
1.6 Financial Markets and the Corporation
1.7 The Two-period Perfect Certainty Model
1.8 Outline of the Text
1.9 Summary and Conclusions

1-2
Chapter Objectives
Understand the basic idea of corporate finance.
Understand the importance of cash flows in financial decision
making.
Discuss the three main decisions facing financial managers.
Know the financial implications of the three forms of business
organisation.
Explain the goal of financial management and why it is
superior to other possible goals.
Explain the agency problem, and how it can be can be
controlled and reduced.
Outline the various types of financial markets.
Discuss the two-period certainty model and Fishers
Separation Theorem.

1-3
What is Corporate Finance?

Corporate finance attempts to find the answers to the


following questions:
What investments should the business take on?
THE INVESTMENT DECISION
How can finance be obtained to pay for the required
investments?
THE FINANCE DECISION
Should dividends be paid? If so, how much?
THE DIVIDEND DECISION

1-4
The Financial Manager

Financial managers try to answer some or all of


these questions.
The top financial manager within a firm is usually
the General ManagerFinance.
Corporate Treasurer or Financial Manageroversees
cash management, credit management, capital
expenditures and financial planning.
Accountantoversees taxes, cost accounting, financial
accounting and data processing.

1-5
The Investment Decision

Capital budgeting is the planning and control of


cash outflows in the expectation of deriving future
cash inflows from investments in non-current
assets.

Involves evaluating the:


size of future cash flows
timing of future cash flows
risk of future cash flows.

1-6
Cash Flow Size

Accounting income does not mean cash flow.

For example, a sale is recorded at the time of sale


and a cost is recorded when it is incurred, not
when the cash is exchanged.

1-7
Cash Flow Timing

A dollar today is worth more than a dollar at some


future date.

There is a trade-off between the size of an


investments cash flow and when the cash flow is
received.

1-8
Cash Flow Timing

Which is the better project?


Future Cash Flows

Year Project A Project B

1 $0 $20 000

2 $10 000 $10 000

3 $20 000 $0

Total $30 000 $30 000

1-9
Cash Flow Risk

The role of the financial manager is to deal with the


uncertainty associated with investment decisions.

Assessing the risk associated with the size and


timing of expected future cash flows is critical to
investment decisions.

1-10
Cash Flow Risk

Which is the better project?

Future Cash Flows

Pessimistic Expected Optimistic

Project 1 $100 000 $300 000 $500 000

Project 2 $200 000 $400 000 $600 000

1-11
Capital Structure

A firms capital structure is the specific mix of debt


and equity used to finance the firms operations.

Decisions need to be made on both the financing


mix and how and where to raise the money.

1-12
Working Capital Management

How much cash and inventory should be kept on


hand?

Should credit terms be extended? If so, what are


the conditions?

How is short-term financing acquired?

1-13
Dividend Decision

Involves the decision of whether to pay a dividend


to shareholders or maintain the funds within the
firm for internal growth.

Factors important to this decision include growth


opportunities, taxation and shareholders
preferences.

1-14
Corporate Forms of Business
Organisation

The three different legal forms of business


organisation are:
sole proprietorship
partnership
company.

1-15
Sole Proprietorship

The business is owned by one person.


The least regulated form of organisation.
Owner keeps all the profits but assumes unlimited
liability for the businesss debts.
Life of the business is limited to the owners life
span.
Amount of equity raised is limited to owners
personal wealth.

1-16
Partnership

The business is formed by two or more owners.


All partners share in profits and losses of the
business and have unlimited liability for debts.
Easy and inexpensive form of organisation.
Partnership dissolves if one partner sells out or
dies.
Amount of equity raised is limited to the combined
personal wealth of the partners.
Income is taxed as personal income to partners.

1-17
Company

A business created as a distinct legal entity


composed of one of more individuals or entities.
Most complex and expensive form of organisation.
Shareholders and management are usually
separated.
Ownership can be readily transferred.
Both equity and debt finance are easier to raise.
Life of a company is not limited.
Owners (shareholders) have limited liability.

1-18
Possible Goals of Financial
Management

Survival
Avoid financial distress and bankruptcy
Beat the competition
Maximise sales or market share
Minimise costs
Maximise profits
Maintain steady earnings growth

1-19
Problems with these Goals

Each of these goals presents problems.


These goals are either associated with increasing
profitability or reducing risk.
They are not consistent with the long-term interests
of shareholders.
It is necessary to find a goal that can encompass
both profitability and risk.

1-20
The Firms Objective

The goal of financial management is to maximise


shareholders wealth.

Shareholders wealth can be measured as the


current value per share of existing shares.

This goal overcomes the problems encountered


with the goals outlined above.

1-21
Agency Relationships

The agency relationship is the relationship


between the shareholders (owners) and the
management of a firm.

The agency problem is the possibility of conflict of


interests between these two parties.

Agency costs refer to the direct and indirect costs


arising from this conflict of interest.

1-22
Do Managers Act in Shareholders
Interests?

The answer to this will depend on two factors:

how closely management goals are aligned with


shareholder goals

the ease with which management can be replaced


if it does not act in shareholders best interests.

1-23
Alignment of Goals

The conflict of interests is limited due to:

management compensation schemes

monitoring of management

the threat of takeover

other stakeholders.

1-24
Cash Flows between the Firm and the
Financial Markets
Total Value of the Firm
Total Value of to Investors in
Firms Assets the Financial Markets

A. Firm issues securities


B. Firm Financial
invests in Markets
assets
E. Retained cash flows F. Dividends and Short-term debt
Current debt payments Long-term debt
Assets Equity shares
Fixed C. Cash flow from
Assets firms assets

D. Government

1-25
Financial Markets

Financial markets bring together the buyers and


sellers of debt and equity securities.
Money markets involve the trading of short-term
debt securities.
Capital markets involve the trading of long-term
debt securities.
Primary markets involve the original sale of
securities.
Secondary markets involve the continual buying
and selling of issued securities.

1-26
Structure of Financial Markets

Financial Markets

Money Market Capital Market

Primary Market Secondary Market Primary Market Secondary Market

1-27
Two-period Perfect Certainty Model

Explains the behaviour of firms and individuals.

Relies on three assumptions:


perfect certainty
perfect capital markets
rational investors.

1-28
Two-period Perfect Certainty Model

The certainty model uses two periodsnow


(period 1) and the future (period 2).

Individuals make consumption choices based on


their tastes and preferences and the investment
opportunities available to them.

Utility curves represent indifference between period


1 (consume now) and period 2 (invest now,
consume later) consumption.

1-29
Utility Curves

Period 2

Utility curves

p Period 1

1-30
Representation of Opportunities

Opportunities facing firms in a two-period world


include:
investment/production
payment of dividends.

The production possibility frontier represents


attainable combinations of period 1 (pay dividend
now) and period 2 (invest now, pay dividend later)
dollars from a given endowment of resources.

1-31
Production Possibility Frontier
Period 2

210
Production possibility
frontier

160

100 150 Period 1

1-32
Utility Maximisation

Firms should invest funds until they reach a point


on the production frontier that is just tangential to
the market line.

This then places the owner on the highest possible


utility curve given the resources available.

At this point, the owners utility is maximised.

However, a problem exists if there is more than


one owner.

1-33
Solution for Multiple Owners

Introduce a capital marketresources can be


transferred between the present and the future.

Add the market line.

This produces an optimal investment policy where


production possibility frontier is tangential to the
market line.

Consumption decisions can be made using the


capital market.

1-34
Optimal Investment Policy
Period 2

Market line

Optimal policy

Period 1

1-35
Fishers Separation Theorem

In a perfect capital market, it is possible to


separate the firms investment decisions from the
owners consumption decisions.

1-36
The Investment Decision

The point of wealth and utility maximisation for all


shareholders can be reached through one of two
rules:
Net present value rule: invest so as to maximise the net
present value of the investment.

Internal rate of return rule: Invest up to the point at which


the marginal return on the investment is equal to the
expected rate of return on equivalent investments in the
capital market.

1-37
Implications of Fishers Analysis

It is only the investment decision that affects firm


value.

Firm value is not affected by how investments are


financed or how the distribution (dividends) are
made to the owners.

1-38
Chapter Two

Financial Statements,
Taxes and Cash Flow

2-39
Chapter Organisation

2.1 The Statement of Financial Position


2.2 The Statement of Financial Performance
2.3 Taxes
2.4 Cash Flow
2.5 Summary and Conclusions

2-40
Chapter Objectives

Understand the difference between book value


(from the Statement of Financial Position) and
market value.
Understand the difference between net profit (from
the Statement of Financial Performance) and cash
flow.
Explain the differences between the average tax
rate, the marginal tax rate and the flat rate.
Explain the calculation of cash flow from assets,
and cash flow to debtholders and shareholders.

2-41
The Statement of Financial Position

Shows a firms accounting value on a particular


date.

Equation:
Assets = Liabilities + Shareholders Equity

Assets are listed in order of liquidity.

Net working capital = Current Assets Current


Liabilities

2-42
The Statement of Financial Position
Net
Current Liabilities
Working
Current Capital
Assets

Non-current
Liabilities

Fixed Assets
1.Tangible
fixed assets
Shareholders Equity
2.Intangible
fixed assets
Total Value of Liabilities
Total Value of Assets and Shareholders Equity

2-43
Liquidity

The speed and ease with which an asset can be


converted to cash without significant loss of value.

Current assets are liquid (e.g. debtors).

The more liquid a business is, the less likely it is to


experience financial distress, but liquid assets are
less profitable to hold.

2-44
Debt versus Equity

Creditors have first claim on a firms cash flow;


equity holders have a residual claim.

Financial leverage is the use of debt in a firms


capital structure.

Financial leverage increases the potential reward


to shareholders, but also increases the potential for
financial distress and business failure.

2-45
Market Value versus Book Value

Generally Accepted Accounting Principles (GAAP)


require audited financial statements to show assets
at historical cost or book value.

Revaluations of assets to fair value are permitted.

The value of a firm relates to market value, or the


price that could be obtained in the current market
place.

2-46
ExampleMarket Value versus Book
Value

ABC Company has fixed assets with a book value


of $1700 but they have been revalued to have a
market value of $2000. Net working capital has a
book value of $1000, but if all current accounts
were liquidated, the company would collect $1400.
ABC Company has $1500 in long-term debtboth
book value and market value.

2-47
ExampleMarket Value versus Book
Value

ABC Company

Book Market Book Market

Assets Liabilities

Net working Long-term


$1000 $1400 $1500 $1500
capital debt

Fixed assets $1700 $2000 Equity $1200 $1900

Total $2700 $3400 Total $2700 $3400

2-48
The Statement of Financial
Performance

Measures a firms performance over a period of


time.

Equation:
Revenues Expenses = Profit

The difference between net profit and cash


dividends is called retained earnings, which is
added to the retained earnings account in the
Statement of Financial Position.

2-49
ExampleStatement of Financial
Performance

Sales $2000
Costs 1400
Depreciation 100
EBIT 500
Interest 100
Taxable Income 400
Tax 200
Net Profit $200
Dividends 80
Addition to R/E $120

2-50
ExampleStatement of Financial
Position

Beg End Beg End


Cash $100 $150 A/P $100 $150
A/R 200 250 N/P 200 200
Inv 300 300 C/L 300 350
C/A $600 $700 NCL $400 $420
NFA 400 500 Cap 50 60
R/E 250 370
$300 $430
Total $1000 $1200 Total $1000 $1200

2-51
Recording of Financial Statement
Entries

The realisation principle is to recognise revenue at


the time of sale.

Costs are recorded according to the matching


principle, that is, revenues are identified and costs
associated with these revenues are matched and
recorded.

2-52
Differences

The figures on the Statement of Financial


Performance may differ from actual cash inflows
and outflows during a period due to:
Revenues and costs being recorded when they are
realised, not when they are received or paid.
The existence of non-cash items such as depreciation.

2-53
Corporate and Personal Tax Rates

Personal rates Marginal


Taxable income Tax rate
06000 Nil
600120 000 17%
20 00150 000 30%
50 00160 000 42%
60 001 + 47%
Company rates Tax rate
Private and public companies 30%

2-54
Tax Rates

The average tax rate is the total tax bill divided by


taxable income, that is, the percentage of income
that goes in taxes.

The marginal tax rate is the extra tax paid if one


more dollar is earned.

A flat rate is where there is only one tax rate that is


the same for all income levels. An example is the
tax rate that applies to companies in Australia.

2-55
ExampleTax Rates

An individual has a taxable income of $28 500.

Total tax liability is $4930 (based on the current tax


scales).

The average tax rate is 17.30 per cent.

The marginal tax rate is 30 per cent.

2-56
Cash Flow from Assets

The total cash flow from assets consists of:


operating cash flowthe cash flow that results from day-
to-day activities of producing and selling; less

capital spendingthe net spending on non-current


assets; less

additions to net working capital (NWC)the amount spent


on net working capital.

2-57
Cash Flow from Assets

Cash flow from assets = cash flow to debtholders +


cash flow to shareholders

The cash flow to debtholders includes any interest


paid less the net new borrowing.

The cash flow to shareholders includes dividends


paid out by a firm less net new equity raised.

2-58
Cash Flow Summary

Operating cash flow = Earnings before interest


and taxes (EBIT) + Depreciation Taxes

Net capital spending = Ending net fixed assets


Beginning net fixed assets + Depreciation

Change in NWC = Ending NWC Beginning


NWC

2-59
Statement of Financial Position
('000s)
Assets (000s) 2003 2004

Current assets
Cash $ 45 $ 50
Accounts receivable 260 310
Inventory 320 385
Total $ 625 $ 745

Fixed assets
Net plant and equipment 985 1 100

TOTAL ASSETS $1 610 $1 845

2-60
Statement of Financial Position
('000s)

Liabilities and equity (000s) 2003 2004


Current liabilities
Accounts payable $ 210 $ 260
Notes payable 110 175
Total $ 320 $ 435
Long-term debt $ 205 $ 225
Shareholders equity
Ordinary shares 290 290
Retained earnings 795 895
Total $1 085 $1 185
TOTAL LIABILITIES AND EQUITY $1 610 $1 845

2-61
Statement of Financial Performance
('000s)

Net sales $710.00


Cost of goods sold 480.00
Depreciation 30.00
DEBIT $200.00
Interest 20.00
Taxable income 180.00
Tax 53.45
Net profit $126.55
Dividends 26.55
Addition to retained earnings $100.00

2-62
Cash Flow From Assets
Operating cash flow:
EBIT $ 200.00
+ Depreciation + 30.00
Taxes 53.45 $176.55
Change in net working capital:
Ending net working capital $ 310.00
Beginning net working capital 305.00 $ 5.00
Net capital spending:
Ending net fixed assets $ 1,100.00
Beginning net fixed assets 985.00
+ Depreciation + 30.00 $145.00

Cash flow from assets: $ 26.55

2-63
Cash Flows to Debtholders and
Shareholders

Cash flow to debtholders:


Interest paid $ 20.00
Net new borrowing 20.00 $ 0.00

Cash flow to shareholders:


Dividends paid $ 26.55
Net new equity raised 0.00 $26.55

Cash flow to debtholders and shareholders $26.55

2-64
Chapter Three

Working with Financial


Statements

3-65
Chapter Organisation

3.1 Cash Flow and Financial Statements: A Closer


Look
3.2 Financial Statements of Publicly Listed Firms
3.3 The Du Pont Identity
3.4 Using Financial Statement Information
3.5 Summary and Conclusions

3-66
Chapter Objectives

Identify the ways that firms obtain and use cash as


reported in the Statement of Cash Flows.
Calculate and interpret key financial ratios.
Discuss the Du Pont identity as a method of
financial analysis.
Understand the use of financial information for
comparative purposes.
Outline the problems associated with using
financial ratios.

3-67
Cash

Cash is generated by selling a product or service,


asset or security.
Cash is spent by paying for materials and labour to
produce a product or service and by purchasing
assets.
Recall:
Cash flow from assets = Cash flow to debtholders
+ Cash flow to shareholders

3-68
Cash Flow

Sources of cash are those activities that bring in


cash.

Uses of cash are those activities that involve


spending cash.

The firms statement of cash flows is the firms


financial statement that summarises its sources
and uses of cash over a specified period.

3-69
Statement of Financial Position
('000s)

Assets (000s) 2003 2004

Current assets
Cash $ 45 $ 50
Accounts receivable 260 310
Inventory 320 385
Total $ 625 $ 745

Fixed assets
Net plant and equipment 985 1 100

TOTAL ASSETS $1 610 $1 845

3-70
Statement of Financial Position
('000s)

Liabilities and equity (000s) 2003 2004


Current liabilities
Accounts payable $ 210 $ 260
Notes payable 110 175
Total $ 320 $ 435
Long-term debt $ 205 $ 225
Shareholders equity
Ordinary shares 290 290
Retained earnings 795 895
Total $1 085 $1 185
TOTAL LIABILITIES AND EQUITY $1 610 $1 845

3-71
Statement of Financial Performance
('000s)
Net sales $710.00
Cost of goods sold 480.00
Depreciation 30.00
EBIT $200.00
Interest 20.00
Taxable income 180.00
Tax 53.45
Net profit $126.55
Dividends 26.55
Addition to retained earnings $100.00

3-72
Statement of Cash Flows

A statement that summarises the sources and uses


of cash.
Changes are divided into three main categories:
Operating activitiesincludes net profit and changes in
most current accounts
Investment activitiesincludes changes in fixed assets
Financing activitiesincludes changes in notes payable,
long-term debt and equity accounts as well as dividends.

3-73
Statement of Cash Flows
Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
Any increase in current assets (except cash)
Decrease in accounts payable
Investment activities
+ Ending fixed assets
Beginning fixed assets
+ Depreciation

3-74
Statement of Cash Flows

Financing activities
Decrease in notes payable
+ Increase in notes payable
Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
Dividends paid

3-75
Statement of Cash Flows

Operating activities
+ Net profit + $ 126.55
+ Depreciation + 30.00
+ Increase in payables + 50.00
Increase in receivables 50.00
Increase in inventory 65.00
$ 91.55
Investment activities
+ Ending fixed assets +$1 100.00
Beginning fixed assets 985.00
+ Depreciation + 30.00
( $ 145.00)

3-76
Statement of Cash Flows

Financing activities
+ Increase in notes payable + $ 65.00
+ Increase in long-term debt + 20.00
Dividends 26.55
$ 58.45

Putting it all together, the net addition to cash for


the period is:

$91.55 145.00 + 58.45 = $5.00

3-77
Players in Accounting Standards

Accountants

Government

Regulators

Other users

3-78
Ratio Analysis

Financial ratios are relationships determined from


a firms financial information.

Used to compare and investigate relationships


between different pieces of financial information,
either over time or between companies.

Ratios eliminate the size problem.

3-79
Categories of Financial Ratios

Liquiditymeasures the firms short-term solvency.


Capital structuremeasures the firms ability to
meet long-run obligations (financial leverage).
Asset management (turnover)measures the
efficiency of asset usage to generate sales.
Profitabilitymeasures the firms ability to control
expenses.
Market valueper-share ratios.

3-80
Liquidity Ratios

Current assets
Current ratio
Current liabilitie s

Current assets Inventory


Quick ratio
Current liabilitie s Bank overdraft

3-81
Capital Structure Ratios

Total financial debt Cash


Net debt/equit y ratio
Total equity Intangible s
Total debt
Debt/equity ratio
Total equity
Total assets
Equity multiplier
Total equity
EBIT
Net interest cover
Interest finance charges
Interest - bearing debt
Debt to gross cash flow
Net profit after tax depreciation amortisation

3-82
Turnover Ratios

Cost of goods sold


Inventory turnover
Inventory

365 days
Days'sales in inventory
Inventory turnover

Sales
Receivable s turnover
Accounts receivable
3-83
Turnover Ratios (continued)

365 days
Days'sales in receivable s
Receivable s turnover

Sales
Fixed asset turnover
Non - current assets

Sales
Total asset turnover
Total assets
3-84
Profitability Ratios

Net profit
Profit margin
Sales

Net profit
Return on assets (ROA) 100%
Total assets

EBIT
Return on investment 100%
Total assets

Net profit
Return on equity (ROE) 100%
Total equity

3-85
Market Value Ratios

Price per share


Price/earn ing ratio
Earnings per share

M arket value per share


M arket - to - book ratio
Book value per share

3-86
The Du Pont Identity
Breaks ROE into three parts:
operating efficiency
asset use efficiency
financial leverage

Net profit Sales Assets


ROE
Sales Assets Equity

Profit margin Total asset turnover Equity multiplier

ROA Equity multiplier

3-87
Uses for Financial Statement
Information

Internal uses:
performance evaluation
planning for the future

External uses:
evaluation by outside parties
evaluation of main competitors
identifying potential takeover targets

3-88
Benchmarks for Comparison

Ratios are most useful when compared to a


benchmark.
Time-trend analysisexamine how a particular
ratio(s) has performed historically.
Peer group analysisusing similar firms
(competitors) for comparison of results.
Global Industry Classification Standard (GICS)
used by ASX is a useful way to find a peer
company.

3-89
Problems with Ratio Analysis

No underlying theory to identify correct ratios to


use or appropriate benchmarks.
Benchmarking is difficult for diversified firms.
Firms may use different accounting procedures.
Firms may have different recording periods.
One-off events can severely affect financial
performance.

3-90
Chapter Four
Long-term Financial Planning
and Corporate Growth

4-91
Chapter Organisation

4.1 What is Financial Planning?


4.2 Financial Planning Models: A First Look
4.3 The Percentage of Sales Approach
4.4 External Financing and Growth
4.5 Some Caveats of Financial Planning Models
4.6 Summary and Conclusions

4-92
Chapter Objectives

Understand what financial planning is and what it


can accomplish.

Outline the elements of a financial plan.

Discuss and be able to apply the percentage of


sales approach.

Understand how capital structure policy and


dividend policy affect a firms ability to grow.

4-93
What is Financial Planning?

Formulates the way financial goals are to be


achieved.

Requires that decisions be made about an


uncertain future.

Recall that the goal of the firm is to maximise the


market value of the owners equitygrowth will
result from this goal being achieved.

4-94
Dimensions of Financial Planning
The planning horizon is the long-range period
that the process focuses on (usually two to five
years).

Aggregation is the process by which the smaller


investment proposals of each of a firms
operational units are added up and treated as one
big project.

Financial planning usually requires three


alternative plans: a worst case, a normal case and
a best case.

4-95
Accomplishments of Planning

Interactionslinkages between investment proposals and


financing choices.

Optionsfirm can develop, analyse and compare different


scenarios.

Avoiding surprisesdevelopment of contingency plans.

Feasibility and internal consistencydevelops a structure for


reconciling different objectives.

4-96
Elements of a Financial Plan

An externally supplied sales forecast (either an explicit sales


figure or growth rate in sales).

Projected financial statements (pro-formas).

Projected capital spending.

Necessary financing arrangements.

Amount of new financing required (plug figure).

Assumptions about the economic environment.

4-97
ExampleA Simple Financial
Planning Model
Recent Financial Statements

Financial performance Financial position


Sales $100 Assets $50 Debt $20
Costs 90 Equity 30
Net Income $ 10 Total $50 Total $50

Assume that:
1. Sales are projected to rise by 25 per cent
2. The debt/equity ratio stays at 2/3
3. Costs and assets grow at the same rate as sales

4-98
ExampleA Simple Financial
Planning Model
Pro-Forma Financial Statements

Financial performance Financial position


Sales $ 125 Assets $ 62.5 Debt $25
Costs 112.5 Equity 37.5
Net $ 12.5 Total $ 62.5 Total $ 62.5

What is the plug?


Notice that projected net income is $12.50, but equity only
increases by $7.50. The difference, $5.00 paid out in cash
dividends, is the plug.

4-99
Percentage of Sales Approach

A financial planning method in which accounts are varied


depending on a firms predicted sales level.

Dividend payout ratio is the amount of cash paid out to


shareholders.

Retention ratio is the amount of cash retained within the firm


and not paid out as a dividend.

Capital intensity ratio is the amount of assets needed to


generate $1 in sales.

4-100
ExampleFinancial Performance
Statement

Sales $1000
Costs 800
Taxable Income 200
Tax (30%) 60
Net profit $ 140

Retained earnings $112


Dividends $28

4-101
ExamplePro-Forma Financial
Performance Statement

Sales (projected) $1 250


Costs (80% of sales) 1 000
Taxable Income 250
Tax (30%) 75
Net profit $ 175

4-102
ExampleSteps

Use the original financial position statement to


create a pro-forma; some items will vary directly
with sales.

Calculate the projected addition to retained


earnings and the projected dividends paid to
shareholders.

Calculate the capital intensity ratio.

4-103
ExampleFinancial Position
Statement

Assets

Current assets ($) (% of sales)


Cash 160 16
Accounts receivable 440 44
Inventory 600 60
Total 1 200 120

Non-current assets
Net plant and equipment 1 800 180
Total assets 3 000 300

4-104
ExampleFinancial Position
Statement

Liabilities and owners equity

Current liabilities ($) (% of sales)


Accounts payable 300 30
Notes payable 100 n/a
Total 400 n/a
Long-term debt 800 n/a
Shareholders equity
Issued capital 800 n/a
Retained earnings 1 000 n/a
Total 1 800 n/a
Total liabilities & sholders equity 3 000 n/a

4-105
ExamplePartial Pro-Forma
Financial Position Statement

Assets
Current assets ($) Change
Cash 200 $ 40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300

Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750

4-106
ExamplePartial Pro-Forma
Financial Position Statement
Liabilities and owners equity
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 100 0
Total 475 $ 75
Long-term debt 800 0
Shareholders equity
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & sholders equity 3 215 $215
External financing needed 535 $535

4-107
ExampleResults of Model

The good news is that sales are projected to


increase by 25 per cent.

The bad news is that $535 of new financing is


required.

This can be achieved via short-term borrowing,


long-term borrowing and new equity issues.

The planning process points out problems and


potential conflicts.

4-108
ExampleResults of Model
(continued)

Assume that $225 is borrowed via notes payable


and $310 is borrowed via long-term debt.

Plug figure now distributed and recorded within


the financial position statement.

A new (complete) pro-forma financial position


statement can be derived.

4-109
ExamplePro-Forma Financial
Position Statement

Assets

Current assets ($) Change


Cash 200 $ 40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300

Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750

4-110
ExamplePro-Forma Financial
Position Statement
Liabilities and owners equity

Current liabilities ($) Change


Accounts payable 375 $ 75
Notes payable 325 $225
Total 700 $300
Long-term debt 1 110 $310
Shareholders equity
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & sholders equity 3 750 $750

4-111
External Financing and Growth

The higher the rate of growth in sales/assets, the


greater the external financing needed (EFN).

Need to establish a relationship between EFN and


growth (g).

4-112
ExampleStatement of Financial
Performance
Sales $ 500
Costs 400
Taxable Income $ 100
Tax (30%) 30
Net profit $ 70

Retained earnings $ 25
Dividends $ 45

4-113
ExampleStatement of Financial
Position

($) (% of ($) (% of
sales) sales)
Assets Liabilities

Current assets 400 80 Total debt 450 n/a

Non-current 600 120 Owners equity 550 n/a


assets
Total assets 1000 200 Total 1000 n/a

4-114
Ratios Calculated

p (profit margin) = 14%

R (retention ratio) = 36%

ROA (return on assets) = 7%

ROE (return on equity) = 12.7%

D/E (debt/equity ratio) = 0.818

4-115
Growth

Next years sales forecasted to be $600.


Percentage increase in sales:

$100
20%
$500
Percentage increase in assets also 20 per cent.

4-116
Increase in Assets
What level of asset investment is needed to
support a given level of sales growth?

For simplicity, assume that the firm is at full


capacity.

The indicated increase in assets required equals:


Ag
where A = ending total assets from the previous period

How will the increase in assets be financed?

4-117
Internal Financing

Given a sales forecast and an estimated profit margin, what


addition to retained earnings can be expected?
This addition to retained earnings represents the level of
internal financing the firm is expected to generate over the
coming period.
The expected addition to retained earnings is:

pS R 1 g
where: S = previous periods sales
g = projected increase in sales
p = profit margin
R = retention ratio

4-118
External Financing Needed

If the required increase in assets exceeds the


internal funding available (that is, the increase in
retained earnings), then the difference is the
external financing needed (EFN).

EFN = Increase in Total Assets


Addition to Retained Earnings
= A(g) p(S)R (1 + g)

4-119
ExampleExternal Financing Needed

Increase in total assets = $1000 20%


= $200
Addition to retained earnings = 0.14($500)(36%) 1.20
= $30

The firm needs an additional $200 in new financing.


$30 can be raised internally.
The remainder must be raised externally (external
financing needed).

4-120
ExampleExternal Financing
Needed (continued)

EFN Increase in total assets Addition to RE


A( g ) p( S ) R (1 g )
$1000 (0.20) 0.14($500)36% 1.20
$170

4-121
Relationship

To highlight the relationship between EFN and g:

EFN pS R A pS R g
0.14$50036% $1000 0.14$500(36%) g
25 975 g

Setting EFN to zero, g can be calculated to be 2.56


per cent.
This means that the firm can grow at 2.56 per cent
with no external financing (debt or equity).

4-122
Financial Policy and Growth

The example so far sees equity increase (via


retained earnings), debt remain constant and D/E
decline.

If D/E declines, the firm has excess debt capacity.

If the firm borrows up to its debt capacity, what


growth can be achieved?

4-123
Sustainable Growth Rate (SGR)

The sustainable growth rate is the growth rate a


firm can maintain given its debt capacity, ROE and
retention ratio.

SGR
ROE R
1 ROE R

4-124
ExampleSustainable Growth Rate

Continuing from the previous example:

(0.127 0.36)
SGR
1 0.127 0.36
4.82%
The firm can increase sales and assets at a rate of
4.82 per cent per year without selling any
additional equity and without changing its debt ratio
or payout ratio.

4-125
Sustainable Growth Rate (SGR)

Growth rate depends on four factors:


profitability (profit margin)
dividend policy (dividend payout)
financial policy (D/E ratio)
asset utilisation (total asset turnover)

Do you see any relationship between the SGR and


the Du Pont identity?

4-126
Summary of Growth Rates

1. Internal growth rate


This growth rate is the maximum growth rate that
can be achieved with no external debt or equity
financing.

2. Sustainable growth rate


The SGR is the maximum growth rate that can be
achieved with no external equity financing while
borrowing to maintain a constant D/E ratio.

4-127
Important Questions

It is important to remember that we are working


with accounting numbers and we should ask
ourselves some important questions as we go
through the planning process.
How does our plan affect the timing and risk of our
cash flows?
Does the plan point out inconsistencies in our
goals?
If we follow this plan, will we maximise owners
wealth?

4-128
Chapter Five

First Principles of Valuation:


The Time Value of Money

5-129
Chapter Organisation
5.1 Future Value and Compounding
5.2 Present Value and Discounting
5.3 More on Present and Future Values
5.4 Present and Future Values of Multiple Cash Flows
5.5 Valuing Equal Cash Flows: Annuities and Perpetuities
5.6 Comparing Rates: The Effect of Compounding Periods
5.7 Loan Types and Loan Amortisation
5.8 Summary and Conclusions

5-130
Chapter Objectives
Distinguish between simple and compound interest.
Calculate the present value and future value of a single amount
for both one period and multiple periods.
Calculate the present value and future value of multiple cash
flows.
Calculate the present value and future value of annuities.
Compare nominal interest rates (NIR) and effective annual
interest rates (EAR).
Distinguish between the different types of loans and calculate the
present value of each type of loan.

5-131
Time Value Terminology

0 1 2 3 4

PV FV

Future value (FV) is the amount an investment is worth after


one or more periods.

Present value (PV) is the current value of one or more future


cash flows from an investment.

5-132
Time Value Terminology

The number of time periods between the present


value and the future value is represented by t.

The rate of interest for discounting or


compounding is called r.

All time value questions involve four values: PV,


FV, r and t. Given three of them, it is always
possible to calculate the fourth.

5-133
Interest Rate Terminology

Simple interest refers to interest earned only on the


original capital investment amount.

Compound interest refers to interest earned on


both the initial capital investment and on the
interest reinvested from prior periods.

5-134
Future Value of a Lump Sum

You invest $100 in a savings account that earns 10 per cent


interest per annum (compounded) for three years.

After one year: $100 (1 + 0.10) = $110


After two years: $110 (1 + 0.10) = $121
After three years: $121 (1 + 0.10) = $133.10

5-135
Future Value of a Lump Sum

The accumulated value of this investment at the


end of three years can be split into two
components:
original principal $100
interest earned $33.10

Using simple interest, the total interest earned


would only have been $30. The other $3.10 is from
compounding.

5-136
Future Value of a Lump Sum

In general, the future value, FVt, of $1 invested


today at r per cent for t periods is:

FVt $1 1 r
t

The expression (1 + r)t is the future value interest


factor (FVIF). Refer to Table A.1.

5-137
ExampleFuture Value of a Lump
Sum
What will $1000 amount to in five years time if interest is 12
per cent per annum, compounded annually?
FV $1000 1 0.12
5

$1000 1.7623
$1 762.30
From the example, now assume interest is 12 per cent per
annum, compounded monthly.
Always remember that t is the number of compounding
periods, not the number of years.
FV $1000 1 0.01
60

$1000 1.8167
$1816.70

5-138
Interpretation

The difference in values is due to the larger


number of periods in which interest can compound.

Future values also depend critically on the


assumed interest ratethe higher the interest rate,
the greater the future value.

5-139
Future Values at Different Interest
Rates

Number of Future value of $100 at various interest rates


periods
5% 10% 15% 20%

1 $105.00 $110.00 $115.00 $120.00

2 $110.25 $121.00 $132.25 $144.00

3 $115.76 $133.10 $152.09 $172.80

4 $121.55 $146.41 $174.90 $207.36

5 $127.63 $161.05 $201.14 $248.83

5-140
Future Value of $1 for Different
Periods and Rates

5-141
Present Value of a Lump Sum

You need $1000 in three years time. If you can earn 10 per
cent per annum, how much do you need to invest now?

Discount one year: $1000 (1 + 0.10) 1 = $909.09


Discount two years: $909.09 (1 + 0.10) 1 = $826.45
Discount three years: $826.45 (1 + 0.10) 1 = $751.32

5-142
Interpretation

In general, the present value of $1 received in t periods of


time, earning r per cent interest is:

PV $1 1 r
t

$1

1 r t

The expression (1 + r)t is the present value interest factor


(PVIF). Refer to Table A.2.

5-143
ExamplePresent Value of a Lump
Sum

Your rich grandmother promises to give you $10 000 in 10 years


time. If interest rates are 12 per cent per annum, how much is
that gift worth today?

PV $10 000 1 0.12


10

$10 000 0.3220


$ 3220

5-144
Present Values at Different Interest
Rates

Number of Present value of $100 at various interest rates


periods
5% 10% 15% 20%

1 $95.24 $90.91 $86.96 $83.33

2 $90.70 $82.64 $75.61 $69.44

3 $86.38 $75.13 $65.75 $57.87

4 $82.27 $68.30 $57.18 $48.23

5 $78.35 $62.09 $49.72 $40.19

5-145
Present Value of $1 for Different
Periods and Rates
Present
value
of $1 ($)
r = 0%
1.00

.90

.80

.70
r = 5%
.60

.50
r = 10%
.40

.30 r = 15%
.20 r = 20%
.10
Time
1 2 3 4 5 6 7 8 9 10 (years)

5-146
Solving for the Discount Rate

You currently have $100 available for investment for a 21-


year period. At what interest rate must you invest this
amount in order for it to be worth $500 at maturity?
Given any three factors in the present value or future value
equation, the fourth factor can be solved.
r can be solved in one of three ways:
Use a financial calculator
Take the nth root of both sides of the equation
Use the future value tables to find a corresponding value. In
this example, you need to find the r for which the FVIF after
21 years is 5 (500/100).

5-147
The Rule of 72

The Rule of 72 is a handy rule of thumb that states:


If you earn r per cent per year, your money will double in
about 72/r per cent years.

For example, if you invest at 6 per cent, your money will


double in about 12 years.

This rule is only an approximate rule.

5-148
Future Value of Multiple Cash Flows

You deposit $1000 now, $1500 in one year, $2000 in two


years and $2500 in three years in an account paying 10 per
cent interest per annum. How much do you have in the
account at the end of the third year?
You can solve by either:
compounding the accumulated balance forward one
year at a time
calculating the future value of each cash flow first and
then totalling them.

5-149
Solutions
Solution 1
End of year 1: ($1000 1.10) + $1500 = $2600
End of year 2: ($2600 1.10) + $2000 = $4860
End of year 3: ($4860 1.10) + $2500 = $ 846

Solution 2
$1000 (1.10)3 = $1331
$1500 (1.10)2 = $1815
$2000 (1.10)1 = $2200
$2500 1.00 = $2500
Total = $7846

5-150
Solutions
Future value calculated by compounding forward one period at a time

0 1 2 3 4 5
Time
(years)
$0 $ 0 $2200 $4620 $7282 $10 210.20
0 2000 2000 2000 2000 2000.00
x 1.1 x 1.1 x 1.1 x 1.1 x 1.1
$0 $2000 $4200 $6620 $9282 $12 210.20

Future value calculated by compounding each cash flow separately


0 1 2 3 4 5
Time
(years)
$2000 $2000 $2000 $2000 $2000.0
x 1.1
2200.0
x 1.12
2420.0
x 1.13
2662.0
x 1.14
2928.2

Total future value $12 210.20

Figures 5.6/5.7 Calculation of FV for Multiple Cash Flow Stream

5-151
Present Value of Multiple Cash Flows

You will deposit $1500 in one years time, $2000 in two years
time and $2500 in three years time in an account paying 10
per cent interest per annum. What is the present value of
these cash flows?

You can solve by either:


discounting back one year at a time
calculating the present value of each cash flow first and
then totalling them.

5-152
Solutions
Solution 1
End of year 2: ($2500 1.101) + $2000 = $4273
End of year 1: ($4273 1.101) + $1500 = $5385
Present value: ($5385 1.101) = $4895

Solution 2
$2500 (1.10) 3 = $1878
$2000 (1.10) 2 = $1653
$1500 (1.10) 1 = $1364
Total = $4895

5-153
Solutions
Present value
0 1 2 3 4 5 calculated by
discounting each
$1000 $1000 $1000 $1000 $1000 Time cash flow separately
x 1/1.06 (years)
$ 943.40
x 1/1.062
890.00
x 1/1.063
839.62
x 1/1.064
792.09
x 1/1.065
747.26

$4212.37 Total present value


r = 6%
Present value
0 1 2 3 4 5 calculated by
discounting back one
$4212.37 $3465.11 $2673.01 $1833.40 $ 943.40 $ 0.00 Time period at a time
0.00 1000.00 1000.00 1000.00 1000.00 1000.00 (years)
$4212.37 $4465.11 $3673.01 $2833.40 $1943.40 $1000.00

Total present value = $4212.37


r = 6%

Figures 5.8/5.9 Calculation of PV for Multiple Cash Flow Stream

5-154
Annuities

An ordinary annuity is a series of equal cash flows


that occur at the end of each period for some fixed
number of periods.

Examples include consumer loans and home


mortgages.

A perpetuity is an annuity in which the cash flows


continue forever.

5-155
Present Value of an Annuity


1 1/ 1 r t
PV C

r

C = equal cash flow

The discounting term is called the present value


interest factor for annuities (PVIFA). Refer to
Table A.3.

5-156
Example 1
You will receive $500 at the end of each of the
next five years. The current interest rate is 9
per cent per annum. What is the present value
of this series of cash flows?

PV $500

1 1/ 1.095


0.09
$500 3.8897
$1 944.85

5-157
Example 2
You borrow $7500 to buy a car and agree to
repay the loan by way of equal monthly
repayments over five years. The current
interest rate is 12 per cent per annum,
compounded monthly. What is the amount of
each monthly repayment?


1 1/ 1.0160
$7 500 C
0.01
C $7 500 39.1961
$191.35

5-158
Future Value of an Annuity

FV C
1 r 1
t

r
The compounding term is called the future value
interest factor for annuities (FVIFA). Refer to Table
A.4.

5-159
ExampleFuture Value of an
Annuity
What is the future value of $200 deposited at the
end of every year for 10 years if the interest rate is
6 per cent per annum?

1.0610 1

FV $200
0.06
$200 13.181
$2636.20

5-160
Perpetuities

The future value of a perpetuity cannot be


calculated as the cash flows are infinite.

The present value of a perpetuity is calculated as


follows:

C
PV
r

5-161
Comparing Rates

The nominal interest rate (NIR) is the interest rate


expressed in terms of the interest payment made
each period.

The effective annual interest rate (EAR) is the


interest rate expressed as if it was compounded
once per year.

When interest is compounded more frequently than


annually, the EAR will be greater than the NIR.

5-162
Calculation of EAR

m
NIR
EAR 1 1
m
m = number of times the interest is compounded

5-163
Comparing EARS

Consider the following interest rates quoted by three banks:

Bank A: 15%, compounded daily

Bank B: 15.5%, compounded quarterly

Bank C:16%, compounded annually

5-164
Comparing EARS
365
0.15
EAR Bank A 1 1 16.18%
365
4
0.155
EAR Bank B 1 1 16.42%
4
1
0.16
EAR Bank C 1 1 16%
1

5-165
Comparing EARS

Which is the best rate? For a saver, Bank B offers


the best (highest) interest rate. For a borrower,
Bank C offers the best (lowest) interest rate.

The highest NIR is not necessarily the best.

Compounding during the year can lead to a


significant difference between the NIR and the
EAR.

5-166
Types of Loans

A pure discount loan is a loan where the borrower


receives money today and repays a single lump
sum in the future.

An interest-only loan requires the borrower to only


pay interest each period and to repay the entire
principal at some point in the future.

An amortised loan requires the borrower to repay


parts of both the principal and interest over time.

5-167
Amortisation of a Loan

Year Beginning Total Interest Principal Ending


Balance Payment Paid Paid Balance

1 $5000.00 $1285.46 $450.00 $835.46 $4164.54

2 $4164.54 $1285.46 $374.81 $910.65 $3253.89

3 $3253.89 $1285.46 $292.85 $992.61 $2261.28

4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33

5 $1179.33 $1285.46 $106.13 $1179.33 $0.00

Totals $6427.30 $1427.30 $5000.00

5-168
Chapter Six
Valuing Shares and Bonds

6-169
Chapter Organisation

6.1 Bonds and Bond Valuation


6.2 Ordinary Share Valuation
6.3 Summary and Conclusions

6-170
Chapter Objectives
Outline the features of bonds.
Calculate the value (price) of a bond assuming annual and
semi-annual coupons.
Understand the implications of interest rate risk for the value
of a bond.
Calculate the value of an ordinary share under different
dividend growth scenarios.
Explain the components of required return.

6-171
Debt Securities

Debt securities are issued when an organisation wishes to


borrow money from the public on a long-term basis.
Bonds are issued by the government.
Debentures are secured and issued by a corporation.
Notes are unsecured debt securities issued by a corporation.
More recently, these are all known as bonds.

6-172
Bond Features
Coupon payments are the stated interest payments.
Payment is constant and payable every year or half-year.
Face value (par value) is the principal amount repayable at
the end of the term.
Coupon rate is the annual coupon divided by the face value.
Maturity is the specified date at which the principal amount is
payable.

6-173
Bond Yields
Yield to maturity is the market interest rate that equates a
bonds present value of interest payments and principal
repayment with its price.
There is an inverse relationship between market interest
rates and bond price.

6-174
Bond Price Sensitivity to Interest
Rates (YTM)
Bond price

$1 800
Coupon = $100
20 years to maturity
$1 600
$1000 face value

$1 400 Key Insight: Bond prices and


YTMs are inversely related.
$1 200

$1 000

$ 800

$ 600 Yield to maturity, YTM


4% 6% 8% 10% 12% 14% 16%

6-175
Bond Value

V PV of coupon payments PV of face value

1 1/ 1 r t
C
F
r 1 r t

6-176
Example 1Bond Value

A bond with a face value of $1000 and a coupon rate of 6 per


cent has 10 years to maturity. What is the market price of
this bond if the market interest rate is 10 per cent?

V $60

1 1/ 1.1010

$1000
0.10 1.1010
$60 6.1446
$1000
2.5937
$771.10

6-177
Example 2Bond Value

Assume now that the bonds coupons are paid half-yearly.

1 1/ 1.0520
V $30
$1000
0.05 1.0520
$30 12.4622
$1000
2.6533
$750.76

6-178
Interest Rate Risk

Interest rate risk is the risk that arises for bond holders from
changes in interest rates.
All other things being equal, the longer the time to maturity,
the greater the interest rate risk.
All other things being equal, the lower the coupon rate, the
greater the interest rate risk.

6-179
Interest Rate Risk and Time to
Maturity
Time to Maturity
Interest rate 1 year 30 years
5% $1 047.62 $1 768.62
10 1 000.00 1 000.00
15 956.52 671.70
20 916.67 502.11

6-180
Computing Yield to Maturity

Yield to maturity (YTM) is the rate implied by the


current bond price.
Finding the YTM requires trial and error if you do
not have a financial calculator and is similar to the
process for finding r with an annuity.
If you have a financial calculator, enter N, PV, PMT
and FV, remembering the sign convention (PMT
and FV need to have the same sign, PV the
opposite sign).

6-181
YTM with Annual Coupons

Consider a bond with a 10 per cent annual coupon


rate, 15 years to maturity and a par value of $1000.
The current price is $928.09.
Will the yield be more or less than 10 per cent?
N = 15; PV = 928.09; FV = 1000; PMT = 100
CPT I/Y = 11%

6-182
Ordinary Share Valuation

Share valuation is more difficult than debenture


valuation for a number of reasons:
uncertainty of promised cash flows
shares have no maturity
observing the market rate of return is not easy.

6-183
Ordinary Share Valuation

The market value of a share is the present value of all


expected net cash flows to be received from the share,
discounted at a rate of return that reflects the riskiness of
those cash flows.
The expected net cash flows to be received from a share are
all future dividends.
Dividend growth is an important aspect of share valuation.

6-184
Zero Growth Dividend

Shares have a constant dividend into perpetuity, with no


growth in dividends.
The value of a share is then the same as the value of an
ordinary perpetuity.

D
P0
r

6-185
Constant Growth Dividend

Dividends grow at a constant rate each time period.


Called the constant dividend growth model.

Dt D0 1 g
t

D0 1 g D1
P0
rg rg

6-186
ExampleConstant Growth Dividend

Company XYZ has just paid a dividend of 15 cents per share,


which is expected to grow at 5 per cent per annum. What price
should you pay for the share if the required rate of return on the
investment is 10 per cent?

0.151.05
P0
0.10 0.05
$3.15

6-187
Non-constant Growth Dividend

The growth rate cannot exceed the required rate of return


indefinitely but can do so for a number of years.
Allows for super normal growth rates over some finite length
of time.
The dividends have to grow at a constant rate at some point
in the future.

6-188
ExampleNon-constant Growth
Dividend

A company has just paid a dividend of 15 cents per share and


that dividend is expected to grow at a rate of 20 per cent per
annum for the next three years, and at a rate of 5 per cent per
annum forever after that.
Assuming a required rate of return of 10 per cent, calculate
the current market price of the share.

6-189
SolutionNon-constant Growth
Dividend

Year Expected Dividend

1 $0.180

2 $0.216

3 $0.259

4 $0.272

6-190
SolutionNon-constant Growth
Dividend (continued)

D
P 4
3 rg
$0.272

0.10 0.05
$5.44

6-191
SolutionNon-constant Growth
Dividend (continued)

D1 D2 D3 P3
P0
1 r 1 r 1 r 1 r
1 2 3 3

$0.180 $0.216 $0.259 $5.44



1.10 1.10 1.10 1.10
2 3 3

$0.164 $0.179 $0.195 $4.087


$4.63

6-192
Share Price Sensitivity to Dividend
Growth, g
Share price ($)

50

45
D1 = $1
Required return, R, = 12%
40

35

30

25

20

15

10

5 Dividend growth
0 2% 4% 6% 8% 10% rate, g

6-193
Share Price Sensitivity to Required
Return, r
Share price ($)

100

90

80
D1 = $1
70 Dividend growth rate, g, = 5%

60

50

40

30

20

10 Required return, R
6% 8% 10% 12% 14%

6-194
Components of Required Return
D
P 1
0 r g
D
r g 1
P
0
D
r 1g
P
0
r dividend yield capital gains yield

6-195
Chapter Seven

Net Present Value and Other


Investment Criteria

7-196
Chapter Organisation
7.1 Net Present Value
7.2 The Payback Rule
7.3 The Discounted Payback Rule
7.4 The Accounting Rate of Return
7.5 The Internal Rate of Return
7.6 The Present Value Index
7.7 The Practice of Capital Budgeting
7.8 Summary and Conclusions

7-197
Chapter Objectives
Discuss the various investment evaluation
techniques, including their advantages and
disadvantages.

Apply these techniques to the evaluation of


projects.

Interpret the results of the application of these


techniques in accordance with their respective
decision rules.

Understand the importance of net present value.

7-198
Net Present Value (NPV)

Net present value is the difference between an


investments market value (in todays dollars) and
its cost (also in todays dollars).

Net present value is a measure of how much value


is created by undertaking an investment.

Estimation of the future cash flows and the


discount rate are important in the calculation of the
NPV.

7-199
Net Present Value

Steps in calculating NPV:

The first step is to estimate the expected future


cash flows.
The second step is to estimate the required return
for projects of this risk level.
The third step is to find the present value of the
cash flows and subtract the initial investment.

7-200
NPV Illustrated
0 1 2

Initial outlay Revenues $1000 Revenues $2000


($1100) Expenses 500 Expenses 1000
Cash flow $500 Cash flow $1000

$1100.00
1
$500 x
1.10
+454.55
1
$1000 x
1.102
+826.45

+$181.00 NPV

7-201
NPV

An investment should be accepted if the NPV is


positive and rejected if it is negative.

NPV is a direct measure of how well the


investment meets the goal of financial
managementto increase owners wealth.

A positive NPV means that the investment is


expected to add value to the firm.

7-202
Payback Period
The amount of time required for an investment to generate
cash flows to recover its initial cost.

Estimate the cash flows.

Accumulate the future cash flows until they equal the initial
investment.

The length of time for this to happen is the payback period.

An investment is acceptable if its calculated payback is less


than some prescribed number of years.

7-203
Payback Period Illustrated
Initial investment = $1000
Year Cash flow
1 $200
2 400
3 600

Accumulated
Year Cash flow
1 $200
2 600
3 1200

Payback period = 2 2/3 years

7-204
Advantages of Payback Period

Easy to understand.

Adjusts for uncertainty of later cash flows.

Biased towards liquidity.

7-205
Disadvantages of Payback Period

Time value of money and risk ignored.

Arbitrary determination of acceptable payback


period.

Ignores cash flows beyond the cut-off date.

Biased against long-term and new projects.

7-206
Discounted Payback Period

The length of time required for an investments


discounted cash flows to equal its initial cost.

Takes into account the time value of money.

More difficult to calculate.

An investment is acceptable if its discounted


payback is less than some prescribed number of
years.

7-207
ExampleDiscounted Payback
Initial investment = $1000
R = 10%
PV of
Year Cash flow Cash flow
1 $200 $182
2 400 331
3 700 526
4 300 205

7-208
ExampleDiscounted Payback
(continued)

Accumulated
Year discounted cash flow
1 $182
2 513
3 1039
4 1244

Discounted payback period is just under three years

7-209
Ordinary and Discounted Payback
Initial investment = $300
R = 12.5%
Cash Flow Accumulated Cash Flow
Year Undiscounted Discounted Undiscounted Discounted

1 $ 100 $ 89 $ 100 $89


2 100 79 200 168
3 100 70 300 238
4 100 62 400 300
5 100 55 500 355

Ordinary payback?
Discounted payback?

7-210
Advantages and Disadvantages of
Discounted Payback

Advantages Disadvantages

- Includes time value of - May reject positive NPV


money investments
- Easy to understand - Arbitrary determination of
- Does not accept negative acceptable payback period
estimated NPV investments - Ignores cash flows beyond
- Biased towards liquidity the cutoff date
- Biased against long-term
and new products

7-211
Accounting Rate of Return (ARR)

Measure of an investments profitability.

average net profit


ARR
average book value
A project is accepted if ARR > target average
accounting return.

7-212
ExampleARR
Year
1 2 3

Sales $440 $240 $160


Expenses 220 120 80
Gross profit 220 120 80
Depreciation 80 80 80
Taxable income 140 40 0
Taxes (25%) 35 10 0
Net profit $105 $30 $0

Assume initial investment = $240

7-213
ExampleARR (continued)

$105 $30 $0
Average net profit
3
$45

Initial investment Salvage value


Average book value
2
$240 $0

2
$120

7-214
ExampleARR (continued)

Average net profit


ARR
Average book value
$45

$120
37.5%

7-215
Disadvantages of ARR

The measure is not a true reflection of return.

Time value is ignored.

Arbitrary determination of target average return.

Uses profit and book value instead of cash flow


and market value.

7-216
Advantages of ARR

Easy to calculate and understand.

Accounting information almost always available.

7-217
Internal Rate of Return (IRR)
The discount rate that equates the present value of
the future cash flows with the initial cost.

Generally found by trial and error.

A project is accepted if its IRR is > the required


rate of return.

The IRR on an investment is the required return


that results in a zero NPV when it is used as the
discount rate.

7-218
ExampleIRR
Initial investment = $200
Year Cash flow
1 $ 50
2 100
3 150

n Find the IRR such that NPV = 0

50 100 150
0 = 200 + + +
(1+IRR) 1 (1+IRR)2 (1+IRR)3

50 100 150
200 = + +
(1+IRR) 1 (1+IRR)2 (1+IRR)3

7-219
ExampleIRR (continued)
Trial and Error
Discount rates NPV
0% $100
5% 68
10% 41
15% 18
20% 2

IRR is just under 20%about 19.44%

7-220
NPV Profile
Net present value

120 Year Cash flow


0 $275
100 1 100
2 100
80 3 100
4 100
60

40

20

20

40 Discount rate
2% 6% 10% 14% 18% 22%
IRR

7-221
Problems with IRR

More than one negative cash flow multiple rates


of return.

Project is not independent mutually exclusive


investments. Highest IRR does not indicate the
best project.

Advantages of IRR
Popular in practice
Does not require a discount rate

7-222
Multiple Rates of Return
Assume you are considering a project for
which the cash flows are as follows:

Year Cash flows

0 $252

1 1431
2 3035
3 2850
4 1000

7-223
Multiple Rates of Return
n Whats the IRR? Find the rate at which
the computed NPV = 0:

at 25.00%: NPV = 0
at 33.33%: NPV = 0
at 42.86%: NPV = 0
at 66.67%: NPV = 0

n Two questions:
u 1. Whats going on here?
u 2. How many IRRs can there be?

7-224
Multiple Rates of Return
NPV
$0.06

$0.04

IRR = 25%
$0.02

$0.00

($0.02) IRR = 33.33% IRR = 66.67%

IRR = 42.86%
($0.04)

($0.06)

($0.08)

0.2 0.28 0.36 0.44 0.52 0.6 0.68


Discount rate

7-225
IRR and Non-conventional Cash
Flows

When the cash flows change sign more than once,


there is more than one IRR.
When you solve for IRR you are solving for the root
of an equation and when you cross the x axis more
than once, there will be more than one return that
solves the equation.
If you have more than one IRR, you cannot use
any of them to make your decision.

7-226
IRR, NPV and Mutually-exclusive
Projects
Net present value
Year
160 0 1 2 3 4
140 Project A: $350 50 100 150 200
120
100 Project B: $250 125 100 75 50
80
60
40
Crossover Point
20
0
20
40
60
80
100 Discount rate
0 2% 6% 10% 14% 18% 22% 26%

IRR A IRRB

7-227
Present Value Index (PVI)

Expresses a projects benefits relative to its initial


cost.
PV of inflows
PVI
Initial cost
Accept a project with a PVI > 1.0.

7-228
ExamplePVI

Assume you have the following information on Project X:


Initial investment = $1100 Required return = 10%

Annual cash revenues and expenses are as follows:


Year Revenues Expenses
1 $1000 $500
2 2000 1000

7-229
ExamplePVI (continued)
500 1 000
NPV 1100
1.10 1.10 2

$181

181 1100
PVI
1100
1.1645

Net Present Value Index


= 181
1100
= 0.1645

7-230
ExamplePVI (continued)

Is this a good project? If so, why?

This is a good project because the present value of


the inflows exceeds the outlay.

Each dollar invested generates $1.1645 in value or


$0.1645 in NPV.

7-231
Advantages and Disadvantages of
PVI (and NPVI)

Advantages Disadvantages

- Closely related to NPV, - May lead to incorrect


generally leading to decisions in comparisons of
identical decisions. mutually exclusive
investments.
- Easy to understand.

- May be useful when


available investment funds
are limited.

7-232
Capital Budgeting in Practice

We should consider several investment criteria


when making decisions.

NPV and IRR are the most commonly used primary


investment criteria.

Payback is a commonly used secondary


investment criteria.

7-233
Chapter Eight
Making Capital Investment
Decisions

8-234
Chapter Organisation

8.1 Project Cash Flows: A First Look


8.2 Incremental Cash Flows
8.3 Project Cash Flows
8.4 More on Project Cash Flows
8.5 Some Special Cases of Discounted Cash Flow
Analysis
8.6 Summary and Conclusions

8-235
Chapter Objectives

Identify incremental cash flows relevant to


investment evaluation.
Calculate depreciation expense for tax purposes.
Apply incremental analysis to project evaluation.
Determine how to set the bid price and how to
value options.
Compare mutually-exclusive projects using annual
equivalent costs.

8-236
Incremental Cash Flows

Any and all changes in the firms future cash flows


that are a direct consequence of undertaking the
project.

The only relevant cash flows in capital project


evaluation.

Stand-alone principle: we can evaluate the project


on its own.

8-237
Types of Cash Flows

Sunk costs a cost that has already been


incurred and cannot be removed incremental
cash flow

Opportunity costs the most valuable alternative


that is given up by the investment = incremental
cash flow

Side effects erosion = incremental cash flow

8-238
Types of Cash Flows (continued)

Financing costs incorporated in discount rate


incremental cash flow

Always use after-tax incremental cash flow

8-239
Investment Evaluation

Step 1 Calculate the taxable income.

Step 2 Calculate the cash flows.

Step 3 Discount the cash flows.

Step 4 Decision.

8-240
ExampleInvestment Evaluation

Purchase price $42 000


Salvage value $1000 at end of Year 3
Net cash flows Year 1 $31 000
Year 2 $25 000
Year 3 $20 000
Tax rate is 30%
Depreciation 20% reducing balance
Required rate of return 12%

8-241
SolutionDepreciation Schedule

Initial cost $42 000


Depn Yr 1 (20% 42 000) 8 400
Depreciated value 33 600
Depn Yr 2 (20% 33 600) 6 720
Depreciated value 26 880
Depn Yr 3 (20% 26 880) 5 376
Depreciated value 21 504
Salvage value 1 000
Loss on disposal 20 504

8-242
SolutionTaxable Income

Year 0 Year 1 Year 2 Year 3


Net cash flows 31 000 25 000 20 000
Depreciation (8 400) (6 720) (5 376)
Loss on sale (20 504)
Taxable income 22 600 18 280 (5 880)

8-243
SolutionCash Flows

Year 0 Year 1 Year 2 Year 3


Tax paid (6 780) (5 484) 1 764
Net cash flow 31 000 25 000 20 000
Salvage value 1 000
Outlay (42 000)
Cash flow (42 000) 24 220 19 516 22 764

8-244
SolutionNPV and Decision

Year 0 Year 1 Year 2 Year 3


Cash flow (42 000) 24 220 19 516 22 764
Discount 1 0.8929 0.7972 0.7118
PV cash flow (42 000) 21 626 15 558 16 203
NPV $11 387

Decision: NPV > 0, therefore ACCEPT.

8-245
Interest
As the projects NPV is positive, the cash flows
from the investment will cover interest costs (as
long as the interest cost is less than the required
rate of return).

Interest costs should not therefore be included as


an explicit cash flow.

Interest costs are included in the required rate of


return (discount rate) used to evaluate the project.

8-246
Depreciation

The depreciation expense used for capital


budgeting should be the depreciation schedule
required for tax purposes.
Depreciation itself is a non-cash expense;
consequently, it is only relevant because it affects
taxes.
Prime cost vs diminishing value methods
Depreciation tax shield = DT
-D = depreciation expense
-T = marginal tax rate

8-247
Disposal of Assets

If the salvage value > book value, a profit/gain is


made on disposal. This profit/gain is subject to tax
(excess depreciation in previous periods).

If the salvage value < book value, the ensuing loss


on disposal is a tax deduction (insufficient
depreciation in previous periods).

8-248
Capital Gains

Capital gains made on the sale of assets such as


rental property are subject to taxation.

Capital losses are not a tax deduction but can be


offset against future capital gains.

8-249
ExampleIncremental Cash Flows

A firm is currently considering replacing a machine purchased two


years ago with an original estimated useful life of five years. The
replacement machine has an economic life of three years. Other
relevant data is summarised below:

Existing Machine New Machine


Initial cost $240 000 $360 000
Annual revenues $100 000 $150 000
Annual costs $60 000 $70 000
Annual depreciation $48 000 $120 000
Salvage value $80 000 (now) $100 000 (End year 3)
Tax rate 30%
Required rate of return 10%

8-250
SolutionTaxable Income

Year 0 Year 1 Year 2 Year 3


Increased revenues 50 000 50 000 50 000
Increased costs (10 000) (10 000) (10 000)
Depn Existing 48 000 48 000 48 000
Depn New (120 000) (120 000) (120 000)
Loss on sale (existing) (64 000)
Gain on sale (new) 100 000
Taxable income (64 000) (32 000) (32 000) 68 000

8-251
SolutionCash Flows

Year 0 Year 1 Year 2 Year 3


Tax 19 200 9 600 9 600 (20 400)
Increased revenues 50 000 50 000 50 000
Increased costs (10 000) (10 000) (10 000)
Salvage values 80 000 100 000
Outlay (360 000)
Cash flow (260 800) 49 600 49 600 160 400

8-252
SolutionNPV and Decision

Year 0 Year 1 Year 2 Year 3


Cash flow (260 800) 49 600 49 600 160 400
Discount 1 0.9091 0.8264 0.7513
PV of cash flow (260 800) 45 091 40 989 120 508
NPV ($54 212)

Decision: NPV < 0, therefore REJECT.

8-253
Setting the Bid Price

How to set the lowest price that can be profitably


charged.

Cash outflows are given.

Determine cash inflows that result in zero NPV at


the required rate of return.

From cash inflows, calculate sales revenue and


price per unit.

8-254
Setting the Option Value

Option value =
Asset value Probability of the Value

Present value of the exercise price
Probability the exercise price will be paid.

8-255
Annual Equivalent Cost (AEC)

When comparing two mutually-exclusive projects


with different lives, it is necessary to make
comparisons over the same time period.

AEC is the present value of each projects costs to


infinity calculated on an annual basis.

Select the project with the lowest AEC.

8-256
ExampleAEC

Project A costs $3000 and then $1000 per annum


for the next four years.
Project B costs $6000 and then $1200 for the next
eight years.
Required rate of return for both projects is 10 per
cent.
Which is the better project?

8-257
SolutionProject A
NPV C PVIFA 4, 0.10 C0
$1000 3.1699 $3000
$3170 $3000
$6170
PV of costs
AEC
PVIFA 4, 0.10
$6 170

3.1699
$1 946

8-258
SolutionProject B
NPV C PVIFA 8, 0.10 C0
$1 200 5.3349 $6000
$6402 $6000
$12 402
PV of costs
AEC
PVIFA 8, 0.10
$12 402

5.3349
$2325

8-259
SolutionInterpretation

Project A is better because it costs $1946 per year


compared to Project Bs $2325 per year.

8-260
Chapter Nine
Project Analysis and Evaluation

9-261
Chapter Organisation

9.1 Evaluating NPV Estimates


9.2 Scenario and Other What If Analysis
9.3 Break-even Analysis
9.4 Operating Cash Flow, Sales Volume and Break-even
9.5 Operating Leverage
9.6 Additional Considerations in Capital Budgeting
9.7 Summary and Conclusions

9-262
Chapter Objectives
Understand and apply scenario analysis, sensitivity analysis
and simulation analysis to capital project evaluation.

Apply break-even analysis, distinguishing between accounting


break-even, cash break-even and financial break-even.

Measure the degree of operating leverage of a firm.

Discuss the various managerial options in capital budgeting.


Outline capital rationing and the difference between soft and
hard rationing.

9-263
Evaluating NPV Estimates

The basic problem: How reliable is our NPV estimate?

Projected cash flows are based on a distribution of possible


outcomes each period: resulting in an average cash flow.

Forecasting risk: the possibility of an incorrect decision due to


errors in cash flow projections (GIGO system).

Ask: What sources of value create the estimated NPV?

9-264
Scenario and Other What If Analysis
Base case estimation
Estimated NPV based on initial cash flow projections.

Scenario analysis
Examine effect on NPV of best-case and worst-case
scenarios.

Sensitivity analysis
Examine effect on NPV by changing only one input
variable.

Simulation analysis
Vary several input variables simultaneously to construct a
distribution of possible NPV estimates.

9-265
Fairways Driving Range Example

Fairways Driving Range expects annual rentals to be 20 000


buckets at $3 per bucket. Equipment costs $20 000 and is
depreciated using the straight-line method over five years to a
zero salvage value. Variable costs are 10 per cent of rentals
income and fixed costs are $40 000 per year. Assume no
increase in working capital and no additional capital outlays.
The required rate of return is 15 per cent and the tax rate is
30 per cent.

9-266
Fairways ExampleNet Profit

Revenues $60 000


Variable costs 6 000
Fixed costs 40 000
Depreciation 4 000
EBIT 10 000
Taxes (@ 30%) 3 000
Net profit $7 000

9-267
Fairways ExampleBase Case NPV

Estimated annual cash flow:


$10 000 + $4000 $3000 = $11 000

At 15%, the 5-year annuity factor is 3.3522.

The base case NPV is then:

NPV = $20 000 + ($11 000 3.3522)


= $16 874

9-268
Fairways ExampleScenario
Analysis
Inputs for scenario analysis:
Base case: Rentals are 20 000 buckets p.a., variable costs
are 10 per cent of rental income, fixed costs are $40 000,
depreciation is $4000 p.a.

Best case: Rentals are 25 000 buckets p.a., variable costs


are 8 per cent of rental income, fixed costs are $40 000,
depreciation is $4000 p.a.

Worst case: Rentals are 18 000 buckets p.a., variable


costs are 12 per cent of rental income, fixed costs are
$40 000, depreciation is $4000 p.a.

9-269
Fairways ExampleScenario Analysis

Scenario Rentals Revenues Profit Cash Flow NPV


Base case 20 000 60 000 7 000 11 000 $16 874
Best case 25 000 75 000 17 500 21 500 $52 072
Worst case 18 000 54 000 2 464 6 464 $1 668

9-270
Fairways ExampleSensitivity
Analysis

Inputs for sensitivity analysis:


Base case: Rentals are 20 000 buckets p.a., variable costs
are 10 per cent of rental income, fixed costs are $40 000,
depreciation is $4000 p.a.

Best case: Rentals are 25 000 buckets p.a. All other variables
are unchanged.

Worst case: Rentals are 18 000 buckets p.a. All other


variables are unchanged.

9-271
Fairways ExampleSensitivity
Analysis

Scenario Rentals Revenues Profit Cash Flow NPV


Base case 20 000 60 000 7 000 11 000 $16 874
Best case 25 000 75 000 16 450 20 450 $48 552
Worst case 18 000 54 000 3 220 7 220 $4 202

9-272
Fairways ExampleSensitivity
Analysis

NPV Best case


$60 000 NPV = $48 552 x
Base case
NPV = $16 874
Worst case x

0
NPV = $4 202 x

$60 000
15 000 20 000 25 000
Rentals per Year

9-273
Break-even Analysis
Useful for analysing the relationship between sales volume
and profitability.

Break-even point is the sales volume at which the present


value of the projects cash inflows and outflows are equal
NPV = 0.

Important distinction between variable costs and fixed costs.

Accounting break-even is the sales volume that results in a


zero net profit.

9-274
Fixed and Variable Costs
There are two types of costs that are important in break-even
analysis: variable and fixed.
-Variable costs change when the quantity of output changes
-Total variable costs= quantity cost per unit
-Fixed costs are constant, regardless of output, over some
time period
-Total Costs = fixed + variable = FC + vQ

Example:
Your firm pays $3000 per month in fixed costs. You also pay $15
per unit to produce your product.

(Total cost if you produce 1000 units = 3000 + 15(1000) = 18 000)


(Total cost if you produce 5000 units = 3000 + 15(5000) = 78 000)

9-275
Average versus Marginal Cost
Average Cost
- TC/number of units
- Will decrease as number of units increases
Marginal Cost
- The cost to produce one more unit
- Same as variable cost per unit

Example: What is the average cost and marginal cost under


each situation in the previous example?
- Produce 1000 units: Average = 18 000/1000 = $18
- Produce 5000 units: Average = 78 000/5000 = $15.60

9-276
Fairways ExampleAccounting
Break-even Analysis

Total cost variable cost fixed cost


Total accounting costs variable cost fixed cost dep' n

Rentals Revenue Variable Fixed Total Depn Total


Costs Costs Costs Acct
Costs
0 0 0 40 000 40 000 4 000 44 000
15 000 45 000 4 500 40 000 44 500 4 000 48 500
20 000 60 000 6 000 40 000 46 000 4 000 50 000
25 000 75 000 7 500 40 000 47 500 4 000 51 500

9-277
Fairways ExampleAccounting
Break-even Analysis
Total revenues
$80 000
Accounting
Total accounting
break-even point
16 296 buckets costs

$50 000
Fixed costs
+ Depn =

Net Net $44 000

Income < 0 Income > 0

$20 000
15 000 20 000 25 000
Rentals per Year

9-278
Fairways ExampleAccounting
Break-even Analysis
Solve algebraically for break-even quantity (Q):

Q
Fixed costs FC Depreciation D
Price per unit P Variable cost per unit v

$40 000 $4000
$3.00 $0.30
16 296 buckets
If sales do not reach 16 296 buckets, Fairways will
incur losses in both the accounting sense and the
financial sense.

9-279
Accounting of Break-even Point

General expression

Q = (FC + D)/(P v)
where:
Q = total units sold
FC = total fixed costs
D = depreciation
P = price per unit
v = variable cost per unit

9-280
Using Accounting Break-even
Accounting break-even is often used as an early-
stage screening number.

If a project cannot break even on an accounting


basis, then it is not going to be a worthwhile
project.

Accounting break-even gives managers an


indication of how a project will impact accounting
profit.

9-281
Summary of Break-even Measures
Accounting break-even
Q = (FC + D)/(P v)
At accounting break-even, net income = 0, NPV is
negative and IRR =0.
Cash break-even
Q = FC/(p v)
At cash break-even, OCF = 0, NPV is negative and IRR =
100%.
Financial break-even
Q = (FC + OCF)/(P v)
At financial break-even, NPV = 0 and IRR = required
return.

9-282
Fairways ExampleBreak-even
Measures
Accounting break - even
$40 000 $4000
16 296 units
$3.00 $0.30
IRR 0 NPV $6 591

$40 000
Cash break - even 14 815 units
$3.00 $0.30
IRR 100% NPV $20 000

Financial break - even


$40 000 $5966 17 024 units
$3.00 $0.30
IRR 15% NPV 0

9-283
Operating Leverage
The degree to which a firm is committed to its fixed costs.
The higher the degree of operating leverage, the greater the
danger from forecasting risk.
The lower the degree of operating leverage, the lower the
break-even point.

% in OCF DOL % in Q
FC
DOL 1
OCF

DOL depends on the current sales level.

9-284
Fairways ExampleDOL

Let Q = 20 000 buckets and, ignoring taxes, OCF = $14 000


and FC = $40 000.
$40 000
DOL 1 3.857
$14 000
A 10 per cent increase (decrease) in quantity sold will result
in a 38.57 per cent increase (decrease) in OCF.
Note: Higher DOL equals greater volatility (risk) in OCF and
leverage is a two-edged swordsales decreases will be
magnified as much as increases.

9-285
Managerial Options and Capital
Budgeting
A static DCF analysis ignores managements ability
to modify the project as events occur.

Contingency planning
The option to expand.
The option to abandon.
The option to wait.

Strategic options
Toe hold investments.
Research and development.

9-286
Capital Rationing

A condition which prevents management from


undertaking all acceptable projects because of a
shortage of funds.

Soft rationing occurs when management limits the


amount that can be invested in new projects during
some specified time period.

Hard rationing occurs when the firm is unable to


raise the financing for a project.

9-287
Chapter Ten
Some Lessons from Capital
Market History

10-
288
Chapter Organisation

10.1 Returns
10.2 Inflation and Returns
10.3 The Historical Record
10.4 Average Returns: The First Lesson
10.5 The Variability of Returns: The Second Lesson
10.6 Capital Market Efficiency
10.7 Summary and Conclusions

10-
289
Chapter Objectives

Distinguish between dollar returns and percentage returns.


Examine the effect of inflation on returns.
Gain an appreciation of historical returns and their variability
for different assets.
Calculate average return and standard deviation.
Discuss market efficiency and its three forms.

10-
290
Dollar Returns

The gain (or loss) from an investment.

Made up of two components:


income (e.g. dividends, interest payments)
capital gain (or loss).

Not necessary to sell investment to include capital gain or


loss in return.

10-
291
Percentage Returns

Dividends paid at Change in market


+
end of period value over period
Percentage return =
Beginning market value

Dividends paid at Market value


+
end of period at end of period
1 + Percentage return =
Beginning market value

10-
292
Percentage Return Example
Pt = $37.00 Pt+1 = $40.33 Dt+1 = $1.85

$1.85 $40.33 $37.00


% Return
$37.00
0.14 or 14%

Per dollar invested we get 5 cents in dividends and 9


cents in capital gainsa total of 14 cents or a return of
14 per cent.

10-
293
Percentage Returns
Total
$42.18
Inflows
Dividends
$1.85

Ending
$40.33 market value

Time t t=1

Outflows $37

10-
294
Inflation and Returns

Real return is the return after taking out the effects of


inflation.
Real return shows the percentage change in buying power.
Nominal return is the return before taking out the effects of
inflation.
The Fisher effect explores the relationship between real
returns (r), nominal returns (R) and inflation (h).

1 R 1 r 1 h
Rr+h
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295
Average Equivalent Returns
& Risk Premiums 19782002

Investment Average Risk


Equivalent Premium
Returns
Ordinary shares 15.50% 5.15%
Small shares 18.36% 8.01%
90-day bank bills 10.23% -0.12%
10-year govt bonds 10.35% 0.0%

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296
Average Returns: The First Lesson

Risky assets on average earn a risk premium (i.e. there is a


reward for bearing risk).

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297
Frequency of Returns on Ordinary
Shares 19782002

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298
Variance

Measure of variability.

The mean of the squared deviations from the average return.

Var R
1
T 1

R1 R .... RT R
2 2

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299
ExampleVariance
ABC Co. have experienced the following returns in the last
five years:

Year Returns
1998 -10%
1999 5%
2000 30%
2001 18%
2002 10%

Calculate the average return and the standard deviation.

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300
ExampleVariance

Year Actual Average Deviation Squared


Return Return Deviation
1998 0.10 0.106 0.206 0.042436
1999 0.05 0.106 0.056 0.003136
2000 0.30 0.106 0.194 0.037636
2001 0.18 0.106 0.074 0.005476
2002 0.10 0.106 0.006 0.000036
0.53 0 0.088720

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301
ExampleVariance

0.08872
Variance 0.02218
5 1

Std deviation 0.02218 0.1489 or 14.89%

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302
The Historical Record

Series Average Standard


Annual Deviation
Returns
Ordinary shares 15.5% 37.55%
Small shares 18.36% 48.03%
Bank bills 10.23% 4.53%
Govt bonds 10.35% 3.17%
Inflation 5.34% 3.99%

Conclusion: Historically, the riskier the asset, the


greater the return.

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303
The Normal Distribution

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304
Variability: The Second Lesson

The greater the risk, the greater the potential reward.

This lesson holds over the long term but may not be valid for
the short term.

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305
Capital Market Efficiency

The efficient market hypothesis (EMH) asserts that the price


of a security accurately reflects all available information.

Implies that all investments have a zero NPV.

Implies also that all securities are fairly priced.

If this is true then investors cannot earn abnormal or excess


returns.

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306
Price Behaviour in Efficient and
Inefficient Markets
Price ($) Overreaction and
correction

220

180

140 Delayed reaction

Efficient market reaction


100

Days relative
8 6 4 2 0 +2 +4 +6 +7 to announcement day

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307
What Makes Markets Efficient?

There are many investors out there doing research:


- As new information comes into the market, this
information is analysed and trades are made
based on this information.
- Therefore, prices should reflect all available
public information.
If investors stop researching stocks, then the
market will not be efficient.

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308
Common misconceptions about EMH

Efficient markets do not mean that you cant make


money.
They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken
and that there is not a bias in prices that can be
exploited to earn excess returns.
Market efficiency will not protect you from making
the wrong choices if you do not diversifyyou still
dont want to put all your eggs in one basket

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309
Price Behaviour in Efficient and
Inefficient Markets

Efficient market reaction: The price instantaneously


adjusts to and fully reflects new information. There
is no tendency for subsequent increases and
decreases.
Delayed reaction: The price partially adjusts to the
new information. Several days elapse before the
price completely reflects the new information.
Overreaction: The price over-adjusts to the new
information. It overshoots the new price and
subsequently corrects itself.

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310
Forms of Market Efficiency

Weak form efficiency: Current prices reflect information


contained in the past series of prices.

Semi-strong form efficiency: Current prices reflect all publicly


available information.

Strong form efficiency: Current prices reflect all information of


every kind.

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311
Chapter Eleven
Return, Risk and the Security
Market Line

11-
312
Chapter Organisation

11.1 Expected Returns and Variances


11.2 Portfolios
11.3 Announcements, Surprises and Expected Returns
11.4 Risk: Systematic and Non-systematic
11.5 Diversification and Portfolio Risk
11.6 Systematic Risk and Beta
11.7 The Security Market Line
11.8 The Capital Market Line
11.9 Portfolio Characteristics
11.10 The SML and the Cost of Capital: A Preview

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313
Chapter Organisation (continued)

11.11 Problems with the CAPM


11.12 Summary and Conclusions

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314
Chapter Objectives

Calculate the expected return and risk (standard deviation) of


both a single asset and a portfolio.
Distinguish between systematic and non-systematic risk.
Explain the principle of diversification.
Explain the capital asset pricing model (CAPM).
Distinguish between the security market line (SML) and the
capital market line (CML).

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315
Expected Return and Variance

Expected returnthe weighted average of the distribution of


possible returns in the future.

Variance of returnsa measure of the dispersion of the


distribution of possible returns.

Rational investors like return and dislike risk.

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316
ExampleCalculating Expected
Return

St at e o f Pi Ri
Eco no my Pro ba bilit y Ret urn in
o f St at e i St at e i
Boo m 0.25 35%
No rma l 0.50 15%
Recessio n 0.25 5%

Expected return
0.25 35% 0.50 15% 0.25 5%
15%
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317
ExampleCalculating Variance
State of (Ri R) (Ri R)2 Pi x (Ri R)2
Economy
Boom 0.20 0.04 0.01
Normal 0 0 0
Recession 0.20 0.04 0.01
2= 0.02

0.02
0.1414 or 14.14%

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318
ExampleExpected Return and
Variance
State of Pi Return on Return on
Economy Asset A Asset B
Boom 0.40 30% 5%
Bust 0.60 10% 25%

Expected Returns:
E RA 0.40 0.30 0.60 0.10 0.06 6%
E RB 0.40 0.05 0.60 0.25 0.13 13%

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319
ExampleExpected Return and
Variance
Variances:
Var RA 0.40 0.30 0.06 0.60 0.10 0.06
2 2

0.0384
Var RB 0.40 0.05 0.13 0.60 0.25 0.13
2 2

0.0216
Standard deviations:
RA 0.0384 0.196 19.6%
RB 0.0216 0.147 14.7%

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320
Portfolios

A portfolio is a collection of assets.

An assets risk and return is important in how it


affects the risk and return of the portfolio.

The riskreturn trade-off for a portfolio is measured


by the portfolios expected return and standard
deviation, just as with individual assets.

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321
Portfolio Expected Returns

The expected return of a portfolio is the weighted


average of the expected returns for each asset in
the portfolio.
m
E(Rp) = wjE (Rj)
j =1

You can also find the expected return by finding


the portfolio return in each possible state and
computing the expected value as we did with
individual securities.
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322
ExamplePortfolio Return and
Variance

Assume 50 per cent of portfolio in asset A and


50 per cent in asset B.

State of Pi RA RB R
Economy
Boom 0.40 30% 5% 12.
Bust 0.60 10% 25% 7.5

E R p 0.40 0.125 0.60 0.075


0.095 or 9.5%

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323
ExamplePortfolio Return and
Variance

Var(Rp) (0.50 x Var(RA)) + (0.50 x Var(RB)).


By combining assets in a portfolio, the risks faced by the
investor can significantly change.

Var R p 0.40 0.125 0.095 0.60 0.075 0.095


2 2

0.0006

R p 0.0006
0.0245 or 2.45%

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324
The Effect of Diversification on
Portfolio Variance
Portfolio returns:
Asset A returns Asset B returns
50% A and 50% B
0.05 0.05

0.04 0.04 0.04

0.03 0.03 0.03

0.02 0.02 0.02

0.01 0.01 0.01

0 0 0

-0.01 -0.01 -0.01

-0.02 -0.02 -0.02

-0.03 -0.03 -0.03

-0.04

-0.05
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325
Announcements, Surprises and
Expected Returns
Key Issues
What are the components of the total return?
What are the different types of risk?

Expected and Unexpected Returns


Total return (R) = expected return (E(R))+ unexpected
return (U)

Announcements and News


Announcement = expected part + surprise
It is the surprise component that affects a stocks price
and, therefore, its return.
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326
Risk

Systematic risk: that component of total risk which is due to


economy-wide factors.
Non-systematic risk: that component of total risk which is
unique to an asset or firm.

Total return Expected return Unexpected return


R E R U
E R systematicportion non - systematicportion

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327
Standard Deviations of Monthly
Portfolio Returns

Number of Average Standard Ratio of Standard


Shares Deviation Deviations
1 11.49% 1.00
5 7.91% 0.69
10 6.61% 0.58
15 6.08% 0.53
20 5.71% 0.50
25 5.60% 0.49
30 5.50% 0.48
35 5.50% 0.48
40 5.26% 0.46
45 5.12% 0.45

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328
Diversification

The process of spreading investments across different


assets, industries and countries to reduce risk.

Total risk = systematic risk + non-systematic risk

Non-systematic risk can be eliminated by diversification;


systematic risk affects all assets and cannot be diversified
away.

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329
The Principle of Diversification

Diversification can substantially reduce the


variability of returns without an equivalent reduction
in expected returns.
This reduction in risk arises because worse than
expected returns from one asset are offset by
better than expected returns from another.
However, there is a minimum level of risk that
cannot be diversified away and that is the
systematic portion.

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330
Portfolio Diversification

11-
331
Systematic Risk

The systematic risk principle states that the expected return


on a risky asset depends only on the assets systematic risk.
The amount of systematic risk in an asset relative to an
average risky asset is measured by the beta coefficient.
Std Deviation Beta
Security A 30% 0.60
Security B 10% 1.20

Security A has greater total risk but less systematic risk (more
non-systematic risk) than Security B.

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332
Measuring Systemic Risk

What does beta tell us?


- A beta of 1 implies the asset has the same
systematic risk as the overall market.
- A beta < 1 implies the asset has less
systematic risk than the overall market.
- A beta > 1 implies the asset has more
systematic risk than the overall market.

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333
Beta Coefficients for Selected
Companies

Company Beta Coefficent


Amcor 0.78
BHP 1.33
Boral 0.85
Caltex Australia 1.38
CSR 0.96
Coles Myer 0.45
Mayne Nickless 0.68
NAB 1.27

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334
ExamplePortfolio Beta Calculations

Amount Portfolio
Share Invested Weights Beta
(1) (2) (3) (4) (3) (4)

ABC Company $6 000 50% 0.90 0.450


LMN Company 4 000 33% 1.10 0.367
XYZ Company 2 000 17% 1.30 0.217

Portfolio $12 000 100% 1.034

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335
ExamplePortfolio Expected
Returns and Betas

Assume you wish to hold a portfolio consisting of asset A and


a riskless asset. Given the following information, calculate
portfolio expected returns and portfolio betas, letting the
proportion of funds invested in asset A range from 0 to 125
per cent.
Asset A has a beta of 1.2 and an expected return of 18 per
cent.
The risk-free rate is 7 per cent.
Asset A weights: 0 per cent, 25 per cent, 50 per cent, 75 per
cent, 100 per cent and 125 per cent.

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336
ExamplePortfolio Expected
Returns and Betas
Proportion Proportion Portfolio
Invested in Invested in Expected Portfolio
Asset A (%) Risk-free Asset (%) Return (%) Beta

0 100 7.00 0.00


25 75 9.75 0.30
50 50 12.50 0.60
75 25 15.25 0.90
100 0 18.00 1.20
125 25 20.75 1.50

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337
Return, Risk and Equilibrium

Key issues:
What is the relationship between risk and return?
What does security market equilibrium look like?

The ratio of the risk premium to beta is the same for every
asset. In other words, the reward-to-risk ratio for the market
is constant and equal to:

E Ri R f
Reward/ris k ratio
i

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338
ExampleAsset Pricing
Asset A has an expected return of 12 per cent and a beta of
1.40. Asset B has an expected return of 8 per cent and a
beta of 0.80. Are these two assets valued correctly relative to
each other if the risk-free rate is 5 per cent?

0.12 0.05
A: 0.05
1.40
0.08 0.05
B: 0.0375
0.80

Asset B offers insufficient return for its level of risk, relative to


A. Bs price is too high; therefore, it is overvalued (or A is
undervalued).

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339
Security Market Line

The security market line (SML) is the


representation of market equilibrium.
The slope of the SML is the reward-to-risk ratio:
(E(RM) Rf)/M
But since the beta for the market is ALWAYS equal
to one, the slope can be rewritten.
Slope = E(RM) Rf = market risk premium

11-
340
Security Market Line (SML)
Asset expected
return (E (Ri))

= E (RM) Rf
E (RM)

Rf

Asset
M = 1.0 beta (i)

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341
The Capital Asset Pricing
Model (CAPM)

An equilibrium model of the relationship between risk and


return.
What determines an assets expected return?
The risk-free ratethe pure time value of money.
The market risk premiumthe reward for bearing
systematic risk.
The beta coefficienta measure of the amount of
systematic risk present in a particular asset.


CAPM E Ri R f E RM R f i
11-
342
Calculation of Systematic Risk

~ ~

i Cov Ri , RM /M
Where:Cov = covariance
~ = random distribution of return for asset i
Ri
~
R M = random distribution of return for the
market
M = standard deviation of market return

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343
Covariance and Correlation

The covariance term measures how returns change


togethermeasured in absolute terms.
The correlation coefficient measures how returns change
togethermeasured in relative terms.
Correlation coefficient ranges between 1.0 and +1.0.

~ ~

iM Cov Ri , RM /i M
Where i = standard deviation of the return on asset i.

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344
Security Market Line versus Capital
Market Line


CML E R p R f E RM R f / M p
SML E Ri R f E R M Rf i

* SML explains the expected return for all assets.


* CML explains the expected return for efficient portfolios.

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345
Risk of a Portfolio

Variance of a two-asset portfolio is calculated as:

weighted variance of the expected return for


each asset in the portfolio
+
twice the weighted covariance of the expected
return on the first asset with the expected
return on the second

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346
ExampleRisk of a Portfolio
Weighting Std Deviation
Asset A 0.3 0.26
Asset B 0.7 0.13

The covariance of the expected returns between A and B is


0.017.

Variance 0.3 0.26 0.7 0.13 2 0.3 0.7 0.017


2 2

0.006084 0.008281 0.00714


0.0215
Std dev 0.1466

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347
Problems with CAPM

Difficulties in estimating beta


- thin trading
- non-constant beta
Using CAPM
- adding explanatory variables
- measure of market return

11-
348
Chapter Twelve
Current Investment Decisions

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349
Chapter Organisation
12.1 The Investments Involved
12.2 The Operating Cycle and the Cash Cycle
12.3 Some Aspects of Short-term Financial Policy
12.4 The Cash Budget
12.5 A Short-term Financial Plan
12.6 Summary and Conclusions

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350
Chapter Objectives
Understand the components of the operating cycle and the
cash cycle.

Explain the key issues in a firms short-term financial policy.

Understand and apply the inventory model.

Prepare a cash budget.

12-
351
Current Investment Decisions

Involve the administration of the companys current


assets (cash and marketable securities,
receivables and inventory), and the financing
needed to support these assets.

Problems in using discounted cash flow techniques


to evaluate these decisions:
identification of all relevant cash inflows and outflows
determining the size and timing of these cash flows
determining the correct discount rate.

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352
Operating Cycle versus Cash Cycle

Operating cyclethe time period between the


acquisition of inventory and the collection of cash
from receivables.
Operating cycle = Inventory period + A/cs receivable period

Cash cyclethe time period between the outlay of


cash for purchases and the collection of cash from
receivables.
Cash cycle = Operating cycle A/cs payable period

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353
Cash Flow Time Line

Inventory Cash
sold received
Inventory
purchased
Inventory Accounts receivable
period period
Time
Accounts
payable period
Cash paid
for inventory

Operating cycle

Cash cycle

12-
354
ExampleOperating Cycle
The following information has been provided for Overcredit
Co.:

Item Beginning Ending


Inventory $90 000 $102 000
Accounts receivable $72 000 $78 000
Accounts payable $49 000 $55 000

Sales for the year were $510 000 (assume all credit) and
the cost of goods sold was $350 000.

Calculate the operating cycle and cash cycle.


12-
355
ExampleOperating Cycle (continued)
a) Find the inventory period:

COGS
Inventory turnover
Avg. inventory
350 000

90 000 102 000
2
3.65 times
365
Inventory period
Inventory turnover
365

3.65 times
100 days

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356
ExampleOperating Cycle (continued)
b) Find the accounts receivable period:

Credit sales
Receivable s t/o
Avg. receivable s
510 000

72 000 78 000
2
6.8 times
365
Receivable s period
Receivable s t/o
365

6.8 times
53.7 days
12-
357
ExampleOperating Cycle (continued)

Operating cycle Inventory period Receivable s period


100 53.7
153.7 days

12-
358
ExampleCash Cycle
a) Find the payables period:
COGS
Payables t/o
Avg. payables
350 000

49 000 55 000
2
6.73 times
365
Payables period
Payables turnover
365

6.73 times
54.2 days
12-
359
ExampleCash Cycle (continued)

Cash cycle Operating cycle Payables period


153.7 54.2
99.5 days

12-
360
Short-term Financial Policy
Size of investments in current assets
-Flexible policymaintain a high ratio of current assets to
sales
-Restrictive policymaintain a low ratio of current assets to
sales
Financing of current assets
- Flexible policyless short-term debt and more long-term
debt
- Restrictive policymore short-term debt and less long-term
debt

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361
Short-term Financial Policy
The size of the firms investment in current assets is
determined by its short-term financial policies.

Flexible policy actions include:


keeping large cash and securities balances
keeping large amounts of inventory
granting liberal credit terms.

Restrictive policy actions include:


keeping low cash and securities balances
keeping small amounts of inventory
allowing few or no credit sales.

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362
Costs of Investments

Need to manage the trade-off between carrying costs and


shortage costs.

Carrying costs increase with the level of investment in current


assets, and include the costs of maintaining economic value
and opportunity costs.

Shortage costs decrease with increases in the level of


investment in current assets, and include trading costs and
the costs related to being short of the current asset. For
example, sales lost as a result of a shortage of finished goods
inventory.

12-
363
Carrying Costs and Shortage Costs

12-
364
Carrying Costs and Shortage Costs

12-
365
Carrying Costs and Shortage Costs

12-
366
The Inventory Model
The economic quantity (EOQ) is the optimal quantity of
inventory ordered that minimises the costs of purchasing
and holding the inventory.

TC YP Y/X A X/2 C
EOQ 2YA/C
Where TC = total cost X = order size
EOQ = economic order qty A = acquisition costs
Y = total demand C = carrying costs
P = price per unit

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367
ExampleEOQ

Smile Camera Shop sells 10 000 rolls of film per year, each
with a wholesale price of $3.20. The cost of processing each
order placed is $10.00 and carrying costs are 20 cents per
roll per year. Calculate the EOQ.

EOQ 2YA/C
2 10 000 $10.00

$0.20
1000 rolls

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368
EOQ Example With Quantity
Discounts

Smile Camera Shop is offered a 2-cent-per-roll


discount if 20003500 rolls of film are ordered, and
a 3-cent-per-roll discount if more than 3500 rolls
are ordered at a time. Determine the optimal order
quantity.

12-
369
EOQ Example With Quantity
Discounts (continued)
Calculate the total cost for each quantity:

1 000 units 10 000 $3.20 10 000/1 000 $10 1 000/2 $0.20


$32 200
2 000 units 10 000 $3.18 10 000/2 000 $10 2 000/2 $0.20
$32 050
3 500 units 10 000 $3.17 10 000/3 500 $10 3 500/2 $0.20
$32 080

Smile Camera Shop would be better off purchasing in lots of 2000


to reduce the total cost.

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370
Inventory Management Under
Uncertainty
Inventory management requires two decisions:
quantity to be ordered
reorder point

Safety stock is the additional inventory held when demand is


uncertain so as to reduce the probability of a stock out.

Reorder point takes into account the lead time from


placement of an order to receipt of the goods.

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371
EOQ Example Under Uncertainty

Smile Camera Shops EOQ (with quantity discounts)


is 2000 rolls of film and five orders are placed each
year. Determine the reorder point if it takes 30 days
to fill an order, a safety stock of 100 is desired and
daily usage is 30 rolls.

12-
372
EOQ Example Under Uncertainty
Reorder point
Qty

2 100 Reorder
points

1 000

100
Safety stock

Time

12-
373
Cash Budget

Forecast of cash receipts and disbursements over


the next short-term planning period.
Primary tool in short-term financial planning.
Helps determine when the firm should experience
cash surpluses and when it will need to borrow to
cover working-capital costs.
Allows a company to plan ahead and begin the
search for financing before the money is actually
needed.

12-
374
ExampleCash Budget

Projected sales for the first six months of 2004:


Jan. $130 000 Apr. $140 000
Feb. $125 000 May $155 000
Mar. $145 000 Jun. $145 000
Analysis of collection of accounts receivable:
collected in month of sale 20%
collected in month following sale 60%
collected in second month following sale 20%
Actual sales for November and December were $125 000
and $120 000 respectively.

12-
375
ExampleCash Budget (continued)

Wages and other expenses are 30 per cent of total monthly


sales.
Purchases are 50 per cent of the months estimated sales, all
paid for in the month of purchase.
Monthly interest payments are $15 000 (interest rate is 1.5
per cent per month).
An annual dividend of $60 000 is payable in March.
The beginning cash balance is $30 000.
The minimum cash balance is $20 000.

12-
376
Cash Collections

Jan Feb Mar Apr May Jun


Cash from current month 26 25 29 28 31 29
Cash from previous month 72 78 75 87 84 93
Cash from 2 months ago 25 24 26 25 29 28
Total collections 123 127 130 140 144 150

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377
Cash Disbursements

Jan Feb Mar Apr May Jun


Wages/Other 39 37.5 43.5 42 46.5 43.5
Purchases 65 62.5 72.5 70 77.5 72.5
Interest 15 15 15 15 15 15
Dividend 60
Total disbursements 119 115 191 127 139 131

12-
378
Cash Budget

Jan Feb Mar Apr May Jun


Beginning cash balance 30 34 46 15 2 3
+ Cash receipts 123 127 130 140 144 150
Cash payments 119 115 191 127 139 131
Ending cash balance 34 46 15 2 3 22
Minimum cash balance 20 20 20 20 20 20
Cumulative 14 26 35 22 17 2
surplus/deficit

12-
379
Short-term Financial Planning

Jan Feb Mar Apr May Jun


Beginning cash balance 30 34 46 20 20 20
Net Cash Inflow 4 12 -61 13 5 29
New short-term borrowing - - 35
Interest on short-term - - -0.5 -0.3 -0.3
borrowing
Short-term borrowing - 12.5 4.7 17.8
repaid
Ending cash balance 34 46 20 20 20 30.9
Cumulative surplus/deficit 14 26 - - - 10.9
Beginning short-term - - 0 35 22.5 17.8
borrowing
Change in short-term debt - - 35 12.5 -4.7 -17.8
Ending short-term debt - - 35 22.5 17.8 -

12-
380
Chapter Thirteen
Cash and Liquidity Management

13-
381
Chapter Organisation

13.1 Reasons for Holding Cash


13.2 Determining the Target Cash Balance
13.3 Managing the Collection and Disbursement of Cash
13.4 Investing Idle Cash
13.5 Regulation of Financial Intermediaries
13.6 Summary and Conclusions

13-
382
Chapter Objectives

Understand the various reasons for holding cash.


Explain and apply both the BAT model and the MillerOrr
model.
Explain what float is and the different types of float.
Discuss various ways of managing float.
Outline ways that firms overcome temporary surpluses/deficits
of cash.
Discuss the role of the various regulators of financial markets.

13-
383
Reasons for Holding Cash
Speculative motivethe need to hold cash to take advantage
of additional investment opportunities, such as bargain
purchases.
Precautionary motivethe need to hold cash as a safety
margin to act as a financial reserve.
Transaction motivethe need to hold cash to satisfy normal
disbursement and collection activities associated with a firms
ongoing operations.
Compensating balance requirementscash balances kept at
commercial banks to compensate for banking services the
firm receives.

13-
384
Target Cash Balance

Key issues:

What is the trade-off between carrying a large cash


balance versus a small cash balance? That is,
carrying costs versus shortage costs.

What is the proper management of the cash


balance? BAT model versus MillerOrr model.

13-
385
The BAT Model
Starting cash
C=$2 000 000

Average cash
$500 000=C/4

0 4 8 Weeks

13-
386
The BAT Model
Assumptions
-Cash is spent at the same rate every day
-Cash expenditures are known with certainty

Optimal cash balance is where opportunity cost of holding


cash ([C/2]*R) = trading cost ([T/C]*F):

C
2T F /R
F = fixed cost of making a securities trade to replenish cash
T = total amount of new cash needed for transactions purposes over
the relevant planning period
R = the opportunity cost of holding cash (the interest rate on
marketable securities)
13-
387
MillerOrr Model

Assumes that, if left unmanaged, a companys cash balance


would follow a random walk with zero drift.

Cash balance is allowed to wander freely between an upper


limit (U*) and a lower limit (L).

If cash holdings reach U*, management intervenes by


withdrawing U* C* dollars to return the cash balance to the
target level C*.

If cash balance reaches L, management intervenes by


injecting C* L dollars to return the cash balance to the
target level C*.

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388
MillerOrr Model
Cash

U*

C*

Time
X Y

U* is the upper control limit. L is the lower control limit. The target
cash balance is C*. As long as cash is between L and U*, no
transaction is made.
13-
389
MillerOrr Model

L set by thefirm
1
3 2 3
C L F
4 R
U 3 C 2 L


Avg. cash balance 4 C L / 3

13-
390
ExampleMillerOrr Model
Assume L = $0, F = $10, i = 0.5 per cent per month and
the standard deviation of monthly cash flows is $2000.
1
3 2 3
C $0 $10 $2000
4 0.005
$1 817
U 3 $1 817 2 $0
$5451
Avg. cash balance 4 $1 817 $0/3
$2423

13-
391
MillerOrr Model Implications

Considers the effect of uncertainty (through 2 in


net cash flows).
The higher the 2, the greater the difference between C*
and L.
The higher the 2, the higher is the upper limit and the
average cash balance.

All things being equal:


the greater the interest rate, the lower is the C*
the greater the order costs, the higher is the C*.

13-
392
MillerOrr Model With Overdraft

Yield on short-term investments < cost of bank overdraft <


yield on long-term investments.

A dollar invested in short-term assets earns less than the


costs saved by applying that dollar to reduce overdraft usage.

The company invests nothing in short-term assets and as


much as possible in long-term assets, while meeting its
liquidity needs through using the overdraft facility.

13-
393
MillerOrr Model With Overdraft

U 0
1
3 2 3
C F / R d

4
L 3 C
Target overdrawn level 2 C

Where:
d = cost of bank overdraft

13-
394
Understanding Float
What is float?
The difference between book cash and bank cash,
representing the net effect of cheques in the process of
being cleared.
Types of float:
Disbursement floatthe result of cheques written;
decreases book balance but does not immediately
change available balance.
Collection floatthe result of cheques received; increases
book balance but does not immediately change available
balance.
Net floatthe overall difference between the firms
available balance and its book balance.

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395
Float Management
Objectives:
In cash collectionspeed up cheque collections (reduce
float components).
In cash disbursementcontrol payments and minimise
costs (increase float components).
Components of float:
Mail floatcheques trapped in postal system.
Processing floatuntil receiver of cheque deposits
cheque.
Availability floatuntil cheque clears in the banking
system.
Mail float + processing float + availability float = total time
delay.
13-
396
Measuring and Costing the Float

Total float
Average daily float
Total days
or
Average daily float Avg. daily receipts weighted avg. delay

The cost of collection float to the firm is the


opportunity cost from not being able to use that
cash.

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397
Managing the Float

Factoringthe selling of receivables to a financial


institution (the factor), usually without recourse.

Credit insuranceprotection against the risk of bad


debt losses.

Delaying disbursementsincreases the


disbursement float.

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398
Investing Idle Cash

Temporary cash surpluses can be invested in


marketable securities.

Temporary cash deficitssell marketable


securities or use short-term bank financing.

The temporary surpluses/deficits are a result of:


seasonal or cyclical activities
planned or possible expenditures.

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399
The Securities Markets

Temporary cash surplus

Futures Long-term Financial


market debt market intermediaries

Options Short-term
market money market

Sharemarket Foreign exchange


market

13-
400
Short-term Securities

Characteristics of short-term securities include:

Maturity maturities usually less than 90 days. Investments


then avoid interest rate risk but have low returns.
Default risk idle cash generally invested in less risky
securities (e.g. government issues).
Marketability idle funds usually invested in highly liquid
securities.

13-
401
Investing Cash

Temporary Cash Surpluses

-Seasonal or cyclical activitiesbuy marketable


securities with seasonal surpluses, convert
securities back to cash when deficits occur.

-Planned or possible expendituresaccumulate


marketable securities in anticipation of upcoming
expenses.

13-
402
Financing Seasonal or Cyclical
Activities

13-
403
Regulation of Financial
Intermediaries
Australian Prudential Regulation Authority (APRA)
Prudential supervision of all deposit-taking entities,
insurance and superannuation funds.
Council of
Financial
Australian Securities and Investments Commission
Regulators (ASIC)
Corporate regulation, consumer protection, market
integrity.

Reserve Bank of Australia (RBA)


Payments system, monetary policy, stability of the
financial system.
Source: Australian Financial Review, 18 March 1998, p.4.
13-
404
Regulation of Financial
Intermediaries

Terminology to know:
CGS Commonwealth Government Securities
ESAs exchange settlement accounts
RTGS real-time gross settlement
ADIs authorised deposit-taking institutions
CAR capital adequacy ratio
PAR prime assets ratio

13-
405
Chapter Fourteen
Credit Management

14-
406
Chapter Organisation

14.1 Credit and Receivables


14.2 Terms of the Sale
14.3 Analysing Credit Policy
14.4 More on Credit Policy Analysis
14.5 Optimal Credit Policy
14.6 Credit Analysis
14.7 Collection Policy
14.8 Summary and Conclusions

14-
407
Chapter Objectives
Understand the components of credit policy and the cash
flows associated with granting credit.
Identify the factors that influence the length of the credit
period.
Calculate the cost of forgoing discounts in credit periods.
Outline the various credit policy effects.
Calculate the cost and NPV of switching policies.
Determine the optimal credit policy.
Discuss the five Cs of credit.

14-
408
Components of Credit Policy
Terms of sale
The conditions on which a firm sells its goods and services
for cash or credit.

Credit analysis
The process of determining the probability that customers will
not pay.

Collection policy
Procedures that are followed by a firm in collecting accounts
receivable.

Accounts receivable = Average daily sales average


collection period
14-
409
Cash Flows from Granting Credit

Credit Customer Firm deposits Bank credits


sale is mails cheque in firms
made cheque bank account

Time

Cash collection

Accounts receivable

14-
410
Terms of the Sale

Credit period
The length of time that credit is granted, usually between 30
and 120 days.

Cash discount
A discount that is given for a cash purchase to speed up the
collection of receivables.

Credit instrument
Evidence of indebtedness such as an invoice or promissory
note.

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411
Length of the Credit Period

Factors that influence the length of the credit period include:

buyers inventory period and operating cycle


perishability and collateral value of goods
consumer demand for the product
cost, profitability and standardisation
credit risk of the buyer
the size of the account
competition in the product market
customer type.

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412
Cost of the Credit

2/10, net 30 = buyer pays in 10 days to get a 2 per cent


discount, or within 30 days for no discount.
Buyer has an order for $1500 and ignores the credit period
gives up $30 discount.

365
30 20
EAR 1 1 44.59%
1 470

The benefit obviously lies in paying early.

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413
Credit Policy Effects
Revenue effectsPayment is received later, but price and
quantity sold may increase.
Cost effectsCost of sale is still incurred even though the
cash from the sale has not been received.
The cost of debtThe firm must finance receivables and,
therefore, incur financing costs.
The probability of non-paymentThe firm always gets paid if
it sells for cash, but risks losses due to customer default if it
sells on credit.
The cash discountDiscounts induce buyers to pay early;
the size of the discount affects payment patterns and
amounts.

14-
414
Evaluating a Proposed Credit Policy
P = price per unit Q = new quantity expected to be sold
v = variable cost per unit Q = current quantity sold per period
R = periodic required return

The benefit of switching is the change in cash flow:

New cash flow old cash flow


P v Q' P v Q
rearrangin g
P v Q' Q
14-
415
Evaluating a Proposed Credit Policy

The present value of switching is:


PV = [(P v) (Q Q)]/R

The cost of switching is the amount uncollected for the period


plus the additional variable costs of production:
Cost = PQ + v(Q Q)

And the NPV of the switch is:


NPV = [PQ + v(Q Q)] + [(P v)(Q Q)]/R

14-
416
ExampleEvaluating a Proposed
Credit Policy

ABC Co. is thinking of changing from a cash-only policy to a


net 30 days on sales policy. The company has estimated
the following:

P = $55 v = $32 Q = 160

Q = 175 R = 2%

14-
417
SolutionEvaluating a Proposed
Credit Policy

Cash flow (old policy) P v Q


55 32 160
$3680
Cash flow (new policy) P v Q'
55 32 175
$4025

14-
418
SolutionEvaluating a Proposed
Credit Policy

Benefit of switching P v Q' Q


55 32 175 160
$345

PV of switching
P v Q' Q
R
345

0.02
$17 250

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419
SolutionEvaluating a Proposed
Credit Policy

Cost of switching PQ v Q' Q


55 160 32 175 160
$8320

NPV of switching PQ v Q' Q P v Q' Q /R


8320 17 250
$8930

Therefore, the switch is very profitable.

14-
420
Break-even Point

Q' Q
PQ
P v /R v

55 160
55 32/ 0.02 32
7.87 units

The switch is a good idea as long as the


company can sell an additional 7.87 units.

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421
Discounts and Default Risk

ABC Co. currently has a cash price of $55 per unit. If the
company extends the 30 day credit policy, the price will
increase to $56 per unit on credit sales. ABC Co. expects
0.5 per cent of credit to go uncollected (). All other
information remains unchanged. Should the company switch
to the credit policy?

Percentage discount allowed for cash customers d


$56 $55 1.79%
$56

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422
Discounts and Default Risk
NPV of changing credit terms:

NPV PQ P' Q d /R
$55 160 $56 160 0.0179 0.005/ 0.02
$3020.80

As the NPV of the change is negative, ABC Co.


should not switch.

14-
423
The Costs of Granting Credit

Opportunity costs are lost sales from refusing credit. These


costs go down when credit is granted.

Carrying costs are the cash flows that must be incurred when
credit is granted. They are positively related to the amount of
credit extended.
The required return on receivables.
The losses from bad debts.
The costs of managing credit and credit collections.

14-
424
Optimal Credit Policy

14-
425
Credit Analysis

Process of deciding which customers receive


credit.
One-time salerisk is variable cost only.
Repeat customersbenefit is gained from one-
time sale in perpetuity.
Grant credit to almost all customers once as long
as variable cost is low relative to price (high
markup).

14-
426
The Five Cs of Credit

Character
Customers willingness to pay.
Capacity
Customers ability to pay.
Capital
Financial reserves/borrowing capacity.
Collateral
Pledged assets.
Conditions
Relevant economic conditions.

14-
427
Collection Policy
Monitoring receivables:
- Keep an eye on average collection period relative to your
credit terms.
Ageing schedulecompilation of accounts receivable by the
age of each account; used to determine the percentage of
payments that are being made late.
Collection procedures include:
delinquency letters
telephone calls
employment of collection agency
legal action.

14-
428
Chapter Fifteen
Australian Financial Markets:
Short-term Financing

15-
429
Chapter Organisation

15.1 The Financial System

15.2 Financial Markets

15.3 Financial Intermediaries

15.4 Short-term Financing

15.5 Short-term Financing Sources

15.6 Summary and Conclusions

15-
430
Chapter Objectives
Understand the operations of the Australian financial system.
Outline the assets traded in the listed and unlisted markets.
Discuss the role of individual financial intermediaries.
Understand the different current asset financing policies.
Discuss the various short-term financing sources.

15-
431
The Financial System

Saving Financial markets Borrowing

Financial Productive
Lenders intermediaries investment

15-
432
Financial Markets
Financial Markets

Primary Secondary
Market Market

Foreign exchange market


Futures & options markets
Long-term debt market
Short-term debt market
Share markets

15-
433
The Listed Market
The listed market

Equity investments Debt securities Other listed


investments

Ordinary shares Bonds Exchange-traded


Contributing shares Debentures options
Preference shares and Financial futures
Rights
Notes
Company options
Property and equity
trusts

15-
434
Financial Intermediaries
Type of Main Number of Total assets
Institution Supervisor Institutions ($b)
Banks APRA 52 835
Building societies APRA 17 12
Credit unions APRA 201 25
Merchant banks ASIC 40 86
Finance companies ASIC 73 88
Securitisers ASIC 113 97
Life insurance APRA 33 188
Friendly societies APRA 38 6
Super funds APRA 11 702 331
Public unit trusts ASIC 97 152
General insurance APRA 97 64
Source: Council of Financial Supervisors Annual Report 2001, RBA.

15-
435
Banks

Trading banks includes activities such as deposits, loans,


insurance, superannuation and stockbroking, usually through
subsidiaries and affiliated companies.

Retail banking involves transactions with the general


public.

Wholesale banking involves transactions with companies


or businesses.

Hold approximately 44 per cent of market share.

15-
436
Merchant Banks

Primarily concerned with wholesale finance.

Responsible for the development of CMTs, rebatable


preference shares, the commercial bills market, the
promissory note market, the currency hedge market and the
unofficial deposit market.

Activities now include investment banking.

Market share has decreased dramatically since the 1980s,


now approximately 5 per cent.

15-
437
Superannuation and Life Insurance
Companies

Crucial for the saving and provision of funds for retirement


(superannuation) or one-off events such as death, disability
or trauma (insurance).

Diversified operations to include general insurance, short-


term money market dealing and merchant banking.

Hold approximately 30 per cent of market share.

15-
438
Finance Companies

Initially responsible for the provision of hire purchase and


instalment credit, financing of vehicles and home loans, lease
financing and factoring.

Funds obtained mainly through the issue of debentures.

Deregulation in 1980s led to many finance companies


activities being absorbed by their large parent banks.

Market share now only approximately 6 per cent.

15-
439
Building Societies and Credit Unions

Building societies
Traditionally provide housing finance to small savers.
Diversified activities to include lending for other purposes.

Credit unions
Pool the funds of people with common interests to provide
consumer-type financing and lending to members.

Both have very small market share, totalling approximately 2


per cent.

15-
440
Unit Trusts

Pool funds of small investors with the aim of earning a greater


return collectively than that achieved individually.

Cash management trusts, equity trusts, property trusts,


mortgage trusts.

15-
441
Other Intermediaries

Authorised foreign exchange dealers perform a full range


of foreign exchange transactions.

Australian Stock Exchange (ASX) and share brokers


provide the medium for buying and selling shares and other
listed securities.

Friendly societies non-profit, state-controlled


intermediaries for small groups to pool funds to be used for
funerals, sickness or, simply, savings.

15-
442
Financing Policy for an Ideal
Economy

Long-term debt
plus ordinary shares

Time

In an ideal world, net working capital is always


zero because short-term assets are financed by
short-term debt.

15-
443
Optimal Amount of Short-term
Borrowing

Factors to consider:
Cash reservesreducing the probability of financial distress
vs investments in zero NPV securities.

Maturity hedgingmatch maturity of asset with maturity of


liability.

Relative interest ratescheaper to have short-term borrowing


than long-term borrowing.

15-
444
Alternative Asset Financing Policies

15-
445
A Compromise Financing Policy

With a compromise policy, the firm keeps a reserve of liquidity which it uses to initially
finance seasonal variations in current asset needs. Short-term borrowing is used when the
reserve is exhausted.

15-
446
Short-term Financing
Used for:

Working capital requirements in the day-to-day


operations of the business.
Transactions that are self-financing over short periods.

Main providers are trading banks, merchant banks and


finance companies.

15-
447
Short-term Financing Sources

Overdrafts
A credit arrangement where the bank permits the
customer to draw more money from the bank account
than has been put in it, up to an agreed limit.
Repayable on demand although this is rarely required.
Interest rate is variable and account balance fluctuates
between positive (deposit) and negative (loan) over the
business cycle.

Short-term loans
An advance of funds made by a financial institution for a
specific purpose, repayable over a fixed period.

15-
448
Short-term Financing Sources

Bills of exchange
A negotiable instrument requiring the payment of a specific
sum of money, either on demand or at a specified time.
Trade bills versus accommodation bills.
Three parties to a bill: drawer (borrower), acceptor (endorser)
and payee (owner).
Discounted value (price) of a bill:


365 Face value
365 Yield days to maturity/100
15-
449
Short-term Financing Sources

Promissory notes
A negotiable instrument whereby the borrower promises
to repay the face value to the holder at maturity.

Different to bills of exchange because they are


unsecured (no acceptor).

Most borrowers are well-known large organisations.


There is an active secondary market.

15-
450
Short-term Financing Sources
Inventory loans
A short-term loan used specifically to purchase inventory,
including a blanket inventory lien, a trust receipt and field
warehouse financing.

Letters of credit
Irrevocable and unconditional undertaking by a bank to
repay a loan if the borrower defaults.

Short-term eurocurrency funding


Financing in a currency outside the country of issue.
Factoring
Selling of accounts receivables to a factor.
15-
451
Chapter Sixteen
Long-term Financing: An
Introduction

16-
452
Chapter Organisation

16.1 Corporate Long-term Debt


16.2 Debt Ratings
16.3 Some Different Types of Debenture
16.4 Callable Debentures and Debenture Refunding
16.5 Preference Shares
16.6 Ordinary Shares
16.7 Size of the Capital Market
16.8 Summary and Conclusions

16-
453
Chapter Objectives
Explain the characteristics of debt.
Identify the various sources of long-term debt.
Outline the provisions of a debenture trust deed.
Understand debt ratings.
Identify the different types of debentures.
Calculate the cost, value and NPV of callable debentures.
Discuss the different features of both preference shares and
ordinary shares.
Understand the various definitions of financial distress.

16-
454
What is Debt?

An obligation to pay a specific amount of money to another


party.

Characteristics of debt:
short-term vs long-term
fixed vs floating interest rate loans
secured vs unsecured
domestic vs foreign

16-
455
Types of Long-term Debt

Debentures Leasing
Secured and unsecured Project finance
notes Transferable loan
Convertible notes certificates
Fixed deposit loans Derivative debt products
Mortgages
Eurobonds
Eurocurrency term loans

16-
456
Sources of Long-term Financing

Debenturessecure, fixed-term loan instruments issued by


companies.
Secured notessame as debentures with lower security.
Unsecured notesshorter-term loans to a company offering
no assets as security.
Convertible notesdebt that provides an option to convert to
equity at maturity.
Fixed depositsunsecured loans at fixed rates for definite
terms.

16-
457
Sources of Long-term Financing

Mortgagesthe conveyance of property for the security of


debt.
Eurobondsunsecured fixed-interest borrowings
denominated in a currency of a country other than its country
of issue.
Eurocurrency FRNsa foreign currency borrowing whose
rates adjust to reflect market interest rates.
Leasingpurchaser of equipment leases the asset to another
party.
Project financingsyndicate financing of very large (and
expensive) projects.

16-
458
Sources of Long-term Financing

Transferable loan certificatesmarketable evidence of the


existence of a debt.

Derivative debt productsinstruments used to manage


interest rate risk:
interest rate swaps
forward rate agreements (FRAs)
interest rate futures
options on futures contracts.

16-
459
Debt versus Equity

Corporations try to create debt securities that are really equity


to get the tax benefits of debt and the bankruptcy benefits of
equity.
Interest on debt is fully tax deductible, so the distinction is
important for tax purposes.
Hybrid securities have characteristics of both debt and equity:
convertible notes
subordinated debt
preference shares.

16-
460
The Debenture Trust Deed

Legal document binding the corporation and its creditors.

Provisions in a trust deed include:


the basic terms of the issue
the amount of the debentures issued
property used as security
repayment arrangements
call provisions
any protective covenants.

16-
461
Debt Ratings

Letter grades that designate investment quality.

Assigned to a debt issue by independent rating agencies


such as Moodys and Standard & Poors.

Long-term ratings range from Aaa to C; short-term ratings


range from Prime-1 to Prime-3.

Ratings relieve individual investors of the task of evaluating


the investment quality of an issue.

16-
462
Different Types of Debentures

Zero coupon debenturesinitially priced at a deep discount


as they make no coupon payments.
Floating-rate debenturescoupon payments are tied to an
interest rate index and are therefore adjustable. Usually
contain a put provision, together with coupon ceilings and
floors.
Income debenturescoupons dependent on company
income.
Put debenturesholder can force the buy back of debt at a
stated price.

16-
463
Securitisation
The process of transforming financial institutions assets such
as mortgages, into marketable securities, by pooling and
selling the rights to the income streams.

Advantages:
Investornegotiable security provides both regular
income and final payout.
Mortgage agencyconversion of an illiquid asset into a
marketable security.

16-
464
Debenture Refunding

Process of replacing all or part of an issue of outstanding


debentures.
Used to refinance a higher-interest loan with a lower-interest
one.
Call provision allows a company to repurchase or call part or
all of the debt issue at stated prices over a specified period.
Debtholders demand a coupon that exactly compensates
them for the possibility of a call.
Cost of call provision = Value of call position

16-
465
ExampleDebentures
Assume:
Current interest rate on debentures is 10 per cent
Probability of interest rate changes by the end of
the year:
fall to 5 per cent (50 per cent probability)
rise to 15 per cent (50 per cent probability)
Call premium = $20
Call period = by the end of the year
Face value of debenture = $100
Debentures are perpetual

16-
466
SolutionDebentures

Market price of debenture (if not callable):

First - year coupon Expected price at year end


PNC
1.10
$10 $100

1.10
$100 sells at par

16-
467
SolutionDebentures

If issue is callable, what coupon (C) must be


offered?

First - year coupon Expected price at year end


PC
1.10
$C 0.50 $C/0.15 0.50 $120
$100
1.10
$C $11.54
This is higher than the non-callable coupon.

16-
468
SolutionDebentures
What is the cost of the call provision?

First - year coupon Expected price at year end


PNC
1.10
$11.54 0.50 $11.54/0.15 0.50 $11.54/0.0 5

1.10
$150.00

The call provision effectively costs $50.

16-
469
SolutionDebentures

What is the NPV per debenture of the refunding if


interest rates fall to 5 per cent?

NPV Co C N /C N $100 C p
0.1154 0.05/0.05 $100 $20
1.308 $100 $20
$110
As NPV is positive, refunding should commence.

16-
470
Reasons for Issuing Callable
Debentures

Superior interest rate forecastingcompany insiders may


think they know more about interest rate decreases than
debtholders.

Taxescall provisions provide tax advantages to both


debtholders and the company.

Future investment opportunitiesallows the company to buy


back debentures to take advantage of superior investment
opportunities.

16-
471
Preference Shares

Shares with dividend priority over ordinary shares, normally


with a fixed dividend rate, sometimes without voting rights.
Cumulative vs non-cumulative dividends.
Irredeemable vs redeemable shares.
Non-participating vs participating shares.

Most preference shares issued are cumulative, irredeemable


and non-participating.

16-
472
Reasons for Issuing Preference
Shares

Redeemable preference shares can be used to enhance the


balance sheet by increasing the equity base.
As subordinate debt, they can be included in a banks capital
base.
They can be used to avoid the threat of bankruptcy that exists
for debt.
Companies unable to take advantage of the tax deductibility
of debt favour preference shares.
A means of raising equity without surrendering control.

16-
473
Ordinary Shares

Equity without priority for dividends or in bankruptcy.


Types of companies:
companies limited by shares
companies limited by guarantee
companies limited by both shares and guarantee
unlimited companies
no liability companies.

16-
474
Shareholders Rights
The right to share proportionally in dividends paid.

The right to share proportionally in assets remaining after


liabilities have been paid in liquidation.

The right to elect the directors and to vote on important


shareholder matters (one share = one vote).

The right to share proportionally in any new shares sold (pre-


emptive right).

16-
475
Dividends
Payment by a corporation to shareholders; made in either
cash or shares.

The return on capital to shareholders.

They are not a liability of the company unless declared by the


board of directors.

They are not a business expense and are therefore not tax
deductible.

They are fully taxable in the hands of the shareholder.


However, an imputation credit may be allowed.
16-
476
Classes of Ordinary Shares
Different classes of ordinary shares may be distinguished by:
voting rights
dividend entitlement
priority to dividend payment
priority to capital repayment and surplus asset
distribution in the event of liquidation.

Reasons for different classes:


debt characteristics for some shares
retain control in small/newly listed firms
taxation issues
nature of company (e.g. home units).

16-
477
Size of the Capital Market

16-
478
Financial Distress

The disadvantage of using debt is the possibility of financial


distress, which can be defined as:
business failure
legal bankruptcy
technical insolvency
accounting insolvency.

16-
479
Chapter Seventeen

Issuing Securities to the Public

17-
480
Chapter Organisation

17.1 The Public Issue


17.2 The Cash Offer
17.3 New Equity Sales and the Value of the Firm
17.4 The Costs of Issuing Securities
17.5 Rights
17.6 Dilution
17.7 Issuing Long-term Debt
17.8 Summary and Conclusions

17-
481
Chapter Objectives
Outline the advantages and disadvantages of public company
listing.
Discuss the process of underwriting and the associated costs.
Identify the costs associated with issuing securities.
Explain the process of a rights issue and calculate the value of
a right.
Discuss the dilution effect of new issues.
Understand the reasons for recent growth in the corporate
debt market.

17-
482
Issuing Securities to the Public
Analyse funding needs and how they can be met.

Approval from board of directors for a public issue.

Outside expert opinions sought for support of


issue.

Pricing, time-tabling, prospectus prepared,


marketing.

Prospectus filed with ASIC and ASX.

17-
483
Issuing Securities to the Public
Underwriting agreement executed.

Prospectus registered.

Public announcement of offering.

Funds received.

Shares allotted, holdings registered.

Shares listed for trading on ASX.

17-
484
New Issues
Flotation is the initial offering of securities to the
public.

Primary issues used to:


convert from a private company to a public company
spin-off a portion of the business of a listed company
form a new public company
privatise a public organisation, or demutualise a mutual
society.

17-
485
Advantages of Public Company
Listing

Access to additional capital.


Increased negotiability of capital.
Growth not limited by cash resources.
Enhancement of corporate image.
Can attract and retain key personnel.
Gain independence from a spin-off.

17-
486
Disadvantages of Public Company
Listing

Dilution of control of existing owners.

Additional responsibilities of directors.

Greater disclosure of information.

Explicit costs.

Insider trading implications.

17-
487
Secondary Issues
Private placementssecurities are offered and sold to a
limited number of investors who are often the current major
investors in the business.
Rights issuesissue of shares made to all existing
shareholders, who are entitled to take up the new shares in
proportion to their present holdings.
Terms are determined by:
amount of funds required by the company
the market price of the companys securities
general economic conditions
desire to benefit shareholders
nature of the companys shareholders.

17-
488
Underwriting

Firm underwriting
A guarantee that funds will be made available to a company
at a specific time on agreed terms and conditions.
Standby underwriting
Where the bidding company has insufficient cash in a
successful bid or if cash is offered as an alternative to a share
bid.
Best efforts underwriting
Underwriter must use best efforts to sell the securities at the
agreed offering rate.

17-
489
Underwriting

Role of underwriter
pricing the issue
marketing the issue
engaging sub-underwriters
placing the shortfall

Sub-underwriter
A group of underwriters formed to reduce the risk and to
help to sell an issue.

17-
490
Underwriting Fees

The underwriters fee is a reflection of the:


size of the issue
issue price
general market conditions
market attitude towards shares
time period required for underwriting.

Fees also include brokerage and management fees.

17-
491
Average Initial Returns

Annual sales of Number Average


issuing firm ($) of firms initial return (%)
0 386 42.9
1 999 999 678 31.4
1 000 000 4 999 999 353 14.3
5 000 000 14 999 999 347 10.7
15 000 000 24 999 999 182 6.5
25 000 000 or larger 493 5.3
All 2 439 20.7

Source: Ibbotson, Sindelar and Ritter (1988)

17-
492
New Equity SalesResearch
Findings

Shares prices tend to decline after a new equity issue


announcement, but rise following a debt announcement.

Why?
Management has superior information about firm value
and knows when the firm is overvalued sell equity.
Excessive debt usage.
Substantial issue costs.
Management needs to understand the signals that an
equity issue sends.

17-
493
The Cost of Issuing Securities

Underwriters commission This consists of direct fees paid by the issuer to the
underwriting syndicate.
Other direct expenses These are direct costs, incurred by the issuer, that are
not part of the compensation to underwriters. These
costs include filing fees, legal fees, and taxesall
reported on the prospectus.
Indirect expenses These costs are not reported on the prospectus and
include the costs of management time spent working on
the new issue.
Abnormal returns In a seasoned issue of shares, the price drops on
average by 3 per cent upon the announcement of the
issue.
Underpricing For initial public offerings, losses arise from selling the
shares below the correct value.

17-
494
Rights OfferingsBasic Concepts

Rights offering
Issue of ordinary shares to existing shareholders.

Allows current shareholders to avoid the dilution that can occur


with a new share issue.

Rights are given to the shareholders specifying:


number of shares that can be purchased
purchase price
time frame.

Shareholders can either exercise their rights or sell them. They


neither win nor lose either way.

17-
495
Rights OfferingsBasic Concepts

Subscription price
The dollar cost of one of the shares to be issued, generally
less than the current market price.
Ex-rights date
Beginning of the period when shares are sold without a
recently declared right, normally four trading days before the
holder-of-record date. The share price will drop by the value
of the right.
Holder-of-record date
Date on which existing shareholders are designated as the
recipients of share rights.

17-
496
Ex-rights Share Prices
Rights-on Ex rights

Announcement Ex-rights Record


date date date

30 September 13 October 15 October

Rights-on
price
$20.00 $3.33 =Value of a right
Ex-rights
price
$16.67

17-
497
Theoretical Rights Price

M S
n
nr
Where:
n number of shares held to obtain a right
M market price
S subscription or issue price of the rights issue
r number of additional shares offered

17-
498
ExampleRights Issue

Lemon Co. currently has 5 million shares on issue


with a market price of $8 each. To finance new
projects, the company needs to raise an additional
$6 million. To raise the finance, the company
makes a rights issue at a subscription price of $6
per share.

17-
499
ExampleRights Issue (continued)
The number of new shares to be sold:
funds to be raised

subscription price
$6 000 000

$6
1 000 000 shares
The holder of one right is entitled to subscribe to one new
share at $6 per share.
To issue 1 million shares, the company would have to issue
1 million rights.
The company has 5 million shares on issue, which means
that for every 5 shares held, a shareholder is entitled to
receive one right (1-for-5 rights issue).
17-
500
ExampleRights Issue (continued)
Calculate the theoretical rights price:

M S
n
nr
$8 $6
5
5 1
$1.67

If an outsider buys a right, it will cost $1.67.


The right can be exercised at a subscription price of $6.
Total cost of a new share = $1.67 + $6 = $7.67.

17-
501
The Value of Rights

Initial position No. of shares 5 million


Share price $8
Value of firm $40 million
Terms of offer Subscription price $6
No. new shares issued 1 million
After issue No. of shares 6 million
Value of firm $46 million
Share price $7.67
Value of right per share $0.33*
Value of a right $1.65**

*$8.00 7.67 = 0.33


**$0.33 5 = $1.65

17-
502
New Issues and Dilution
Dilution
Loss in existing shareholders value in terms of either
ownership, market value, book value or EPS.

Types of dilution
Dilution of proportionate ownershipa shareholders
reduction in proportionate ownership due to less-than-
proportionate purchase of new shares.
Dilution of market valueloss in share value due to use
of proceeds to invest in negative NPV projects.
Dilution of book value and earnings per share (EPS)
reduction in EPS due to sale of additional shares. This
has no economic consequences.

17-
503
Corporate Debt
The late 1980s saw a major growth in the Australian
corporate debt market due to:
the substantial cutback in the level of government
borrowing
the fall in interest rates from extremely high levels
the flight to quality
the shortage of government bonds
the attractiveness of raising funds in the domestic market
relative to that of the euromarket.

17-
504
Long-term Debt
Differences between direct, private long-term financing and
public issues of debt include:
direct loans avoid ASIC registration costs
direct loans have more restrictive covenants
term loans and private placements are easier to
renegotiate than public issues
private placements are dominated by life insurance
companies and pension funds, whereas commercial
banks dominate the term-loan market.

17-
505
Chapter Eighteen
Cost of Capital

18-
506
Chapter Organisation

18.1 The Cost of Capital: Some Preliminaries


18.2 The Cost of Equity
18.3 The Costs of Debt and Preference Shares
18.4 The Weighted Average Cost of Capital
18.5 Divisional and Project Costs of Capital
18.6 Flotation Costs and the Weighted Average Cost
of Capital
18.7 Summary and Conclusions

18-
507
Chapter Objectives
Apply the dividend growth model approach and the SML
approach to determine the cost of equity.
Estimate values for the costs of debt and preference shares.
Calculate the WACC.
Discuss alternative approaches to estimating a discount rate.
Understand the effects of flotation costs on WACC and the
NPV of a project.

18-
508
The Cost of Capital: Preliminaries
Vocabularythe following all mean the same thing:
required return
appropriate discount rate
cost of capital.
The cost of capital is an opportunity costit depends on
where the money goes, not where it comes from.
The assumption is made that a firms capital structure is
fixeda firms cost of capital then reflects both the cost of
debt and the cost of equity.

18-
509
Cost of Equity

The cost of equity is the return required by


equity investors given the risk of the cash
flows from the firm.
There are two major methods for determining the
cost of equity:
Dividend growth model
SML or CAPM.

18-
510
The Dividend Growth Model
Approach
According to the constant growth model:

D0 (1 g )
P0
RE g
Rearranging:

D1
RE g
P0

18-
511
ExampleCost of Equity Capital:
Dividend Approach
Reno Co. recently paid a dividend of 15 cents per
share. This dividend is expected to grow at a rate
of 3 per cent per year into perpetuity. The current
market price of Renos shares is $3.20 per share.
Determine the cost of equity capital for Reno Co.

$0.15 1.03
RE 0.03
$3.20
0.078 or 7.8%

18-
512
Estimating g
One method for estimating the growth rate is to use the historical
average.

Year Dividend Dollar Change % Change


2000 $4.00 - -
2001 $4.40 $0.40 10.00%
2002 $4.75 $0.35 7.95%
2003 $5.25 $0.50 10.53%
2004 $5.65 $0.40 7.62%

Average growth rate 10.00 7.95 10.53 7.62/4


9.025%

18-
513
The Dividend Growth Model
Approach

Advantages
Easy to use and understand.

Disadvantages
Only applicable to companies paying dividends.
Assumes dividend growth is constant.
Cost of equity is very sensitive to growth estimate.
Ignores risk.

18-
514
The SML Approach
Required return on a risky investment is dependent on three
factors:

the risk-free rate, Rf


the market risk premium, E(RM) Rf
the systematic risk of the asset relative to the average,

RE R f E RM R f
18-
515
ExampleCost of Equity Capital:
SML Approach

Obtain the risk-free rate (Rf) from financial press


many use the 1-year Treasury note rate, say, 6 per cent.
Obtain estimates of market risk premium and security beta:
historical risk premium = 7.94 per cent (Officer, 1989)
betahistorical
investment information services

estimate from historical data

Assume the beta is 1.40.

18-
516
ExampleCost of Equity Capital:
SML Approach (continued)


RE R f E RM R f
6% 1.40 7.94%
17.12%

18-
517
The SML Approach

Advantages
Adjusts for risk.
Accounts for companies that dont have a constant dividend.

Disadvantages
Requires two factors to be estimated: the market risk
premium and the beta co-efficient.
Uses the past to predict the future, which may not be
appropriate.

18-
518
The Cost of Debt
The cost of debt, RD, is the interest rate on new borrowing.

RD is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds.

The historic cost of debt is irrelevantwhy?

18-
519
ExampleCost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 years
ago at par. The bond is currently priced at $86.
What is our cost of debt?
I PV NP/n
RD
PV NP/2
$12 $100 $86/10

$100 $86/2
14.4%
The yield to maturity is 14.4 per cent, so this is used
as the cost of debt, not 12 per cent.
18-
520
The Cost of Preference Shares
Preference shares pay a constant dividend every period.
Preference shares are a perpetuity, so the cost is:

D
Rp
P0

Notice that the cost is simply the dividend yield.

18-
521
ExampleCost of Preference Shares

An $8 preference share issue was sold 10 years ago. It sells


for $120 per share today.

The dividend yield today is $8.00/$120 = 6.67 per cent, so


this is the cost of the preference share issue.

18-
522
The Weighted Average Cost of Capital
Let: E = the market value of equity = no.
of outstanding shares share
price
D = the market value of debt = no. of
outstanding bonds price
Then: V=E+D
So: E/V + D/V = 100%
That is: The firms capital structure weights
are E/V and D/V.

18-
523
The Weighted Average Cost of
Capital

Interest payments on debt are tax deductible, so the after-tax


cost of debt is:

After - tax cost of debt RD 1 TC

Dividends on preference shares and ordinary shares are not


tax-deductible so tax does not affect their costs.
The weighted average cost of capital is therefore:

WACC E V R DV R
E D 1 TC
18-
524
ExampleWeighted Average Cost of
Capital

Zeus Ltd has 78.26 million ordinary shares on


issue with a book value of $22.40 per share and a
current market price of $58 per share. The
market value of equity is therefore $4.54 billion.
Zeus has an estimated beta of 0.90. Treasury
bills currently yield 4.5 per cent and the market
risk premium is assumed to be 7.94 per cent.
Company tax is 30 per cent.

18-
525
ExampleWeighted Average Cost of
Capital (continued)
The firm has four debt issues outstanding:

Bond Coupon Book Market Yield to


Value Value Maturity
1 6.375% $499m $501m 6.32%
2 7.250% $495m $463m 7.83%
3 7.635% $200m $221m 6.76%
4 7.600% $296m $289m 7.82%
Total $1 490m $1 474m

18-
526
ExampleCost of Equity
(SML Approach)


RE R f E RM R f
4.5% 0.90 7.94%
11.65%

18-
527
ExampleCost of Debt

Bond Market Weight Yield to Weighted


Value Maturity YTM
1 $501m 0.3399 6.32% 2.1482%
2 $463m 0.3141 7.83% 2.4594%
3 $221m 0.1499 6.76% 1.0133%
4 $289m 0.1961 7.82% 1.5335%
$1 474m 1.0000 7.1544%

The weighted average cost of debt is 7.15 per cent.

18-
528
ExampleCapital Structure Weights
Market value of equity = 78.26 million $58 = $4.539 billion.
Market value of debt = $1.474 billion.

V $4.539 billion $1.474 billion $6.013 billion


D $1.474b 0.245 or 24.5%
V $6.013b
E $4.539b 0.755 or 75.5%
V $6.013b
WACC 0.755 0.1165 0.245 0.0715 1 0.30
0.0932 or 9.32%

18-
529
WACC

The WACC for a firm reflects the risk and the target capital
structure to finance the firms existing assets as a whole.

WACC is the return that the firm must earn on its existing
assets to maintain the value of its shares.

WACC is the appropriate discount rate to use for cash flows


that are similar in risk to the firm.

18-
530
Divisional and Project Costs of
Capital
When is the WACC the appropriate discount rate?
When the projects risk is about the same as the firms
risk.

Other approaches to estimating a discount rate:


divisional cost of capitalused if a company has more
than one division with different levels of risk
pure play approacha WACC that is unique to a
particular project is used
subjective approachprojects are allocated to specific
risk classes which, in turn, have specified WACCs.

18-
531
The SML and the WACC

Expected
return (%)

SML

= 8%
Incorrect
16 B acceptance
15 WACC = 15%
14 A
Incorrect
rejection

Rf =7

Beta
A = .60 firm = 1.0 B = 1.2

If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky
projects.

18-
532
ExampleUsing WACC for all
Projects
What would happen if we use the WACC for all
projects regardless of risk?
Assume the WACC = 15 per cent

Project Required Return IRR Decision


A 15% 14% Reject
B 15% 16% Accept

Project A should be accepted because its risk is low (Beta =


0.60), whereas Project B should be rejected because its risk
is high (Beta = 1.2).

18-
533
The SML and the Subjective
Approach
Expected
return (%)

SML
= 8%
20

High risk
A (+6%)
WACC = 14

10

Rf = 7 Moderate risk
Low risk (+0%)
(4%)

Beta
With the subjective approach, the firm places projects into one of several risk classes. The discount
rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk)
an adjustment factor to or from the firms WACC.

18-
534
Flotation Costs

The issue of debt or equity may incur flotation costs such as


underwriting fees, commissions, listing fees.

Flotation costs are relevant expenses and need to be


reflected in any analysis.

f A E fE D fD
V V

18-
535
ExampleProject Cost including
Flotation Costs
Saddle Co. Ltd has a target capital structure of 70
per cent equity and 30 per cent debt. The
flotation costs for equity issues are 15 per cent of
the amount raised and the flotation costs for debt
issues are 7 per cent. If Saddle Co. Ltd needs
$30 million for a new project, what is the true
cost of this project?

f A 0.70 0.15 0.30 0.07


12.6%
The weighted average flotation cost is 12.6 per
cent.
18-
536
ExampleProject Cost including
Flotation Costs (continued)

Project cost ignoring flotation costs $30 million

$30m
True cost of project
1 0.126

$34.32 million

18-
537
ExampleFlotation Costs and NPV
Apollo Co. Ltd needs $1.5 million to finance a new project
expected to generate annual after-tax cash flows of $195 800
forever. The company has a target capital structure of 60 per
cent equity and 40 per cent debt. The financing options
available are:
An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new
equity is 15 per cent.
An issue of long-term debentures. Flotation costs of debt
are 5 per cent of the capital raised. The return on new
debt is 10 per cent.

Assume a corporate tax rate of 30 per cent.

18-
538
ExampleNPV (No Flotation Costs)

WACC 0.6 15% 0.4 0.1 1 0.30


0.118 or 11.8%

$195 800
NPV $1 500 000
0.118
$159 322

18-
539
ExampleNPV (With Flotation Costs)
f A 0.6 0.12 0.4 0.05
0.092 or 9.2%
$1 500 000
True cost $1 651 982
1 0.092
$195 800
NPV - $1 651 982
0.118
$7340
Flotation costs decrease a projects NPV and
could alter an investment decision.
18-
540
Chapter Nineteen
Dividends and Dividend Policy

19-
541
Chapter Organisation
19.1 Cash Dividends and Dividend Payment
19.2 Does Dividend Policy Matter?
19.3 Real-world Factors Favouring a Low Payout
19.4 Real-world Factors Favouring a High Payout
19.5 A Resolution of Real-world Factors?
19.6 Establishing a Dividend Policy
19.7 Share Repurchase: An Alternative to Cash
Dividends
19.8 Share Dividends and Share Splits
19.9 Employee Share Ownership Plans
19.10 Summary and Conclusions

19-
542
Chapter Objectives
Know the different forms of dividends and the appropriate
dividend payment terminology.
Outline the arguments supporting the case for dividend
irrelevance.
Discuss factors favouring a low or a high payout.
Explain the residual dividend policy.
Illustrate the situation of share repurchases vs paying a cash
dividend.
Understand both bonus issues and share splits.
Outline the various employee share ownership plans.

19-
543
Types of Dividends
A dividend is a payment made out of a firms
earnings to its owners (shareholders).
Dividends are usually paid in the form of cash.
Types of cash dividends include:
regular cash dividends
extra dividends
special dividends
liquidating dividends.

Share dividends are also paid, and share


repurchases are a dividend alternative.
19-
544
Procedure for Dividend Payment

Days
Thursday, Wednesday, Friday, Monday,
January January January February
15 28 30 16

Declaration Ex-dividend Record Payment


date date date date

19-
545
Procedure for Dividend Payment

Declaration date: the board of directors declares a payment


of dividends.
Ex-dividend date: if you buy the share on or after this date
the seller is entitled to keep the dividend. Under ASX rules,
shares are traded ex-dividend on and after the seventh
business day before the record date.
Record date: declared dividends are distributable to
shareholders of record on a specific date.
Payment date: the dividend cheques are mailed to
shareholders of record.

19-
546
The Ex-date Price Drop
Ex date

-t . . . 2 1 0 +1 +2 . . . t
Price =$10

Price =$9

The share price will fall by the amount of the dividend on the ex
date (Time 0). If the dividend is $1 per share, the price will be
equal to $10 1 = $9 on the ex date.

Before ex date (Time 1) Dividend = $0 Price = $10


On ex date (Time 0) Dividend = $1 Price = $9

19-
547
Do Dividends Matter?

Yes: the value of a share is based on the present


value of expected future dividends.
No: the value of a share is not affected by a switch
in dividend policy.

19-
548
Does Dividend Policy Matter?

Dividend policy versus cash dividends


n An illustration of dividend irrelevance
u Original dividends

0 1 2

$1000 $1000

If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $1527.78

19-
549
Does Dividend Policy Matter?
Assume an additional $200 of dividends is offered,
financed by an issue of debt or shares. New dividend
plan:

0 1 2

$1000 $1000
+200 240
$1200 $760

P0 = $1200/1.2 + $760/1.22 = $1 527.78

19-
550
Dividend Policy Irrelevance

Any increase in dividends at one point is offset exactly by a


decrease somewhere else.
An alternative explanation is home-made dividends.
Individual investors can undo corporate dividend policy by
reinvesting dividends or selling shares.
Companies may help with creating home-made dividends by
offering shareholders automatic dividend reinvestment plans
(DRIPs).

19-
551
Dividends and the Real World
A low payout is better if one considers:
Taxes: Optimal dividend policy is determined by various
shareholder situations. Some shareholders prefer high
franked dividends, others prefer the company to pay no
dividend and retain the funds for reinvestment (tax on
dividend income vs capital gains tax).
Flotation costs: Higher dividend payouts may require a new
share issue, which could be expensive and decrease the
value of the firm.
Dividend restrictions: Debt contracts might limit the
percentage of income that can be paid out as dividends.

19-
552
Dividends and the Real World

A high payout is better if one considers:


Desire for current income instead of capital gain.
Uncertainty resolution: bird-in-hand story.
Tax benefits: There are some investors who do receive
favourable tax treatment from holding high dividends (e.g.
corporate investors).
Legal benefits.

19-
553
Examples of Imputed Tax Credits
Shareholders level 6 001 20 001 50 001 60 000
of taxable income to to to +
20 000 50 000 60 000
Marginal tax rate 17% 30% 42% 47%
(1 July 2000)
Corporate tax $30 $30 $30 $30
Dividend paid 70 70 70 70
Taxpayers additional
assessable income $100 $100 $100 $100
Tax on assessable income $17 $30 $42 $47
Credit for company tax 30 30 30 30
Net credit (payment) $13 nil ($12) ($17)
Tax to be paid
on dividends ($13) nil $12 $17
19-
554
To Date

Based on the home-made dividend argument, dividend policy


is irrelevant.

Because of high taxation of some individual investors, a high-


dividend policy may be best.

Because of new issue costs, a low-dividend policy is best.

19-
555
Dividends and Signals
Changes in dividends convey information
Dividend increases:
Management believes it can be sustained.

Expectation of higher future dividends, increasing

present value.
Signal of a healthy, growing firm.

Dividend decreases:
Management believes it can no longer sustain the

current level of dividends.


Expectation of lower dividends indefinitely; decreasing

present value.
Signal of a firm that is having financial difficulties.

The information content makes it difficult to interpret the


effect of the dividend policy of the firm.
19-
556
Clientele Effect

Shares attract particular groups based on dividend


yield and the resulting tax effects.
Some investors prefer low dividend payouts and
will buy shares in those companies that offer low
dividend payouts.
Some investors prefer high dividend payouts and
will buy shares in those companies that offer high
dividend payouts.

19-
557
Residual Dividend Policy

Issue costs eliminate any indifference between


financing by internal capital and new shares.

Dividends are paid only if profits are not completely


used for investment purposes.

Desired debt-to-equity ratio is maintained.

19-
558
Residual Dividend Policy

Row (1) (2) (3) (4) (5) (6)


After-tax New Additional Retained Additional
earnings investment debt earnings shares Dividends
1 1 000 3 000 1 000 1 000 1 000 0
2 1 000 2 000 667 1 000 333 0
3 1 000 1 500 500 1 000 0 0
4 1 000 1 000 333 667 0 333
5 1 000 500 167 333 0 667
6 1 000 0 0 0 0 1 000

19-
559
Relationship Between Dividends and
Investment
Dividends

999

666

333

-333
0 500 1000 1500 2000 2500 3000
New investment

19-560
Key Concepts in Dividend Policy
Dividend stabilitydividends are only increased if the
increase is sustainable.

Dividend streamingshareholders can choose different


dividend schemes to suit their tax position (franked vs
unfranked dividends)

Special dividendsone-off extra dividends.

Dividend reinvestment schemescompany reinvests


individuals dividends into fully paid shares of the company.
Avoids transactions costs and need for prospectus, and
shares are usually offered at a discount.
19-
561
Australian Equity Raisings 2001

Source: Australian Stock Exchange

19-
562
Share Repurchases

Company buys back its own shares.

Similar to a cash dividend in that it returns cash


from the firm to the shareholders.

This is another argument for dividend policy


irrelevance in the absence of taxes or other
imperfections.

19-
563
Share Repurchases
Equal access purchase
Offer made by company to all shareholders to purchase
shares in the same proportion as their holdings.
On-market purchase
Purchase by a company of its own shares on the open
market.
Employee share purchase
Repurchase shares from employees that were issued under
employee incentive scheme.
Selective purchase
Repurchase of shares from specific shareholders.
Odd-lot purchase
Repurchase of small parcels of shares.

19-
564
Cash Dividend versus Share
Repurchase

Assume no taxes, commissions or other market


imperfections.
Consider a firm with 50 000 shares outstanding, net
profit of $100 000 and the following balance sheet.

Cash $ 100 000 $ 0 Debt


Other Assets 900 000 1 000 000 Equity
Total $1 000 000 $1 000 000 Total

19-
565
Cash Dividend versus Share
Repurchase (continued)

Price per share is $20 ($1 000 000/50 000).

EPS = $2.00 ($100 000/50 000).

PE ratio = 10.

The firm is considering either:


Paying a $1 per share cash dividend.
OR
Repurchasing 2500 shares at $20 a share.

19-
566
Cash Dividend versus Share
Repurchase (continued)

Cash Dividend Option

Cash $ 50 000 $ 0 Debt


Other Assets 900 000 950 000 Equity
Total $ 950 000 $ 950 000 Total

Price per share is $19.00 ($950 000/50 000).


EPS = $2.00 ($100 000/50 000).
PE ratio = 10.

19-
567
Cash Dividend versus Share
Repurchase (continued)

Share Repurchase Option

Cash $ 50 000 $ 0 Debt


Other Assets 900 000 950 000 Equity
Total $ 950 000 $ 950 000 Total

Price per share is $20.00 ($950 000/47 500).


EPS = $2.10 ($100 000/47 500).
PE ratio = 9.5.

19-
568
Share Dividends and Share Splits

Bonus shares and share splits:


involve issuing new shares on a pro-rata basis to the current
shareholders
do not change the firms assets, earnings, risk assumed and
investors percentage of ownership in the company
increase the number of shares outstanding
reduce the value per share

A common explanation is to adjust the share price to a more


desirable trading range.

19-
569
Reverse Splits

The firm reduces the number of shares outstanding.

Reasoning:
reduction in transaction costs
increase in share marketability (trading range)
regain respectability.

19-
570
Share Ownership Plans

Encourage the financial participation of employees in the


company, including:
fully paid shares
partly paid shares
special classes of shares
options
phantom or shadow shares
employee share trusts.

19-
571
Chapter Twenty

Financial Leverage and


Capital Structure Policy

20-
572
Chapter Organisation

20.1 The Capital Structure Question


20.2 The Effect of Financial Leverage
20.3 Capital Structure and the Cost of Equity Capital
20.4 M&M Propositions I & II With Corporate Taxes
20.5 Bankruptcy Costs
20.6 Optimal Capital Structure
20.7 The Pie Again
20.8 Corporate versus Personal Borrowing
20.9 Observed Capital Structures
20.10 Summary and Conclusions

20-
573
Chapter Objectives
Understand the impact of financial leverage on a firms capital
structure.
Illustrate the concept of home-made leverage.
Outline both M&M Proposition I and M&M Proposition II.
Discuss the impact of corporate taxes on M&M Propositions I
and II.
Understand the impact of bankruptcy costs on the value of a
firm.
Identify a firms optimal capital structure.

20-
574
The Capital Structure Question

Key issues
What is the relationship between capital structure and
firm value?
What is the optimal capital structure?

Cost of capital
A firms capital structure is chosen if WACC is
minimised.
This is known as the optimal capital structure or target
capital structure.

20-
575
ExampleComputing Break-even
EBIT

ABC Company currently has no debt in its capital structure. The


company has decided to restructure, raising $2.5 million debt at
10 per cent. ABC currently has 500 000 shares on issue at a
price of $10 per share. As a result of the restructure, what is the
minimum level of EBIT the company needs to maintain EPS (the
break-even EBIT)? Ignore taxes.

20-
576
ExampleComputing Break-even
EBIT (continued)

With no debt:
EPS = EBIT/500 000

With $2.5 million in debt @ 10%:


EPS = (EBIT $250 0001)/250 0002
1 Interest expense = $2.5 million 10% = $250 000
2 Debt raised will refund 250 000 ($2.5 million/$10)shares, leaving
250 000 shares outstanding

20-
577
ExampleComputing Break-even
EBIT (continued)

These are then equal:


EPS = EBIT/500 000 = (EBIT $250 000)/250 000

With a little algebra:


EBIT = $500 000
EPSBE = $1.00 per share

20-
578
Financial Leverage, EPS and EBIT
EPS ($)

3 D/E = 1
2.5

2
D/E = 0
1.5

0.5

0.5

1 EBIT ($ millions, no taxes)


0 0.2 0.4 0.6 0.8 1

20-
579
ExampleHome-made Leverage and
ROE

Home-made leverage is the use of personal borrowing to


alter the degree of financial leverage. Investors can replicate
the financing decisions of the firm in a costless manner.
Example
Original capital structure and home-made leverage
investor uses $500 of their own and borrows $500 to
purchase 100 shares.
Proposed capital structure investor uses $500 of their own,
together with $250 in shares and $250 in bonds.

20-
580
Original Capital Structure and Home-
made Leverage

Recession Expected Expansion

EPS of unlevered firm $0.60 $1.30 $1.60


Earnings for 100 shares $60.00 $130.00 $160.00
Less interest on $500 $50.00 $50.00 $50.00
@ 10%

Net earnings $10.00 $80.00 $110.00


ROE 2% 16% 22%

20-
581
Proposed Capital Structure

Recession Expected Expansion

EPS of levered firm $0.20 $1.60 $2.20


Earnings for 25 shares $5.00 $40.00 $55.00
Plus interest on $250 $25.00 $25.00 $25.00
@ 10%

Net earnings $30.00 $65.00 $80.00


ROE 6% 13% 16%

20-
582
Capital Structure Theory

Modigliani and Miller Theory of Capital Structure


Proposition Ifirm value
Proposition IIWACC
The value of the firm is determined by the cash
flows to the firm and the risk of the assets
Changing firm value:
Change the risk of the cash flows
Change the cash flows

20-
583
M&M Proposition I

Value of firm Value of firm


Debt
40%
Shares
40%

Debt
60% Shares
60%

(The size of the pie does not depend on how it is sliced.)


The value of the firm is independent of its capital structure.

20-584
M&M Proposition II

Because of Proposition I, the WACC must be constant, with


no taxes:

WACC = RA = (E/V) RE + (D/V) RD

where RA is the required return on the firms assets

Solve for RE to get M&M Proposition II:

RE = RA + (RA RD) (D/E)

20-
585
The Cost of Equity and the WACC
Cost of capital

RE = RA + (RA RD ) x (D/E)

WACC = RA

RD

Debt-equity ratio, D/E

The firms overall cost of capital is unaffected by its capital structure.


20-
586
Business and Financial Risk

By M&M Proposition II, the required rate of return on equity


arises from sources of firm risk. Proposition II is:

RE = RA + [RA RD] [D/E]

Business riskequity risk arising from the nature of the firms


operating activities (measured by RA).
Financial riskequity risk that comes from the financial policy
(i.e. capital structure) of the firm (measured by [RA RD]
[D/E]).

20-
587
The SML and M&M Proposition II

How do financing decisions affect firm risk in both M&Ms


Proposition II and the CAPM?
Consider Proposition II: All else equal, a higher debt/equity
ratio will increase the required return on equity, RE.

RE = RA + (RA RD) (D/E)

20-
588
The SML and M&M Proposition II

Substitute RA = Rf + (RM Rf)A


and by replacement RE = Rf + (RM Rf)E

The effect of financing decisions is reflected in the equity


beta, and, by the CAPM, increases the required return on
equity.
E = A(1 + D/E)

Debt increases systematic risk (and moves the firm along the
SML).

20-
589
Corporate Taxes

The interest tax shield is the tax saving attained by


a firm from interest expense.

Assumptions:
perpetual cash flows
no depreciation
no fixed asset or NWC spending.

For example, a firm is considering going from $0


debt to $400 debt at 10 per cent.

20-
590
Corporate Taxes

Firm U Firm L
EBIT $200 $200
Interest 0 40
Taxable income $200 $160
Tax (@ 40%) 80 64
Net profit $ 120 $ 96
Cash flow from assets $ 120 $136

Tax saving = $16 = 0.40 x $40 = TC RD D

20-
591
Corporate Taxes

What is the link between debt and firm value?


Since interest creates a tax deduction, borrowing creates a
tax shield. The value added to the firm is the present value of
the annual interest tax shield in perpetuity.
M&M Proposition I (with taxes):

PV tax saving $16 $160


0.10
TC RD D /RD
TC D

Key result VL = VU + TCD

20-
592
M&M Proposition I with Taxes
Value of the
firm (VL)
VL = VU + TC x D

= TC

VL= VU + $160 TC x D

VU VU

VU

Total debt (D)


$400

20-
593
Taxes, the WACC and Proposition II

Taxes and firm value: an example


EBIT = $100
TC = 30%
RU = 12.5%

Suppose debt goes from $0 to $100 at 10 per cent. What


happens to equity value, E?

VU = $100 (1 0.30)/0.125 = $560


VL = $560 + (0.30 $100) = $590
E = $490

20-
594
Taxes, the WACC and Proposition II

WACC and the cost of equity (M&M Proposition II with taxes):


RE = RU + (RU RD) (D/E) (1 TC)


RE 0.125 0.125 0.10 $100
$490
1 0.30
12.86%


WACC $490
$590
0.1286 $100
$590
0.10 1 0.30
11.86%

20-
595
Taxes, the WACC and
Propositions I and IIConclusions

The WACC decreases as more debt financing is used.

Optimal capital structure is all debt.

20-
596
Taxes, the WACC and Proposition II

Cost of capital (%)

RE

RE
RU RU
WACC WACC
RD (1 RD (1 TC)
TC)

Debt-equity ratio, D/E

20-
597
Bankruptcy Costs

Borrowing money is a good news/bad news


proposition.
The good news: interest payments are deductible and
create a debt tax shield (TCD).
The bad news: all else equal, borrowing more money
increases the probability (and therefore the expected
value) of direct and indirect bankruptcy costs.

Key issue: The impact of financial distress on firm


value.

20-
598
Direct versus Indirect Bankruptcy
Costs
Direct costs
Those costs directly associated with bankruptcy,
(e.g. legal and administrative expenses).
Indirect costs
Those costs associated with spending resources to
avoid bankruptcy.
Financial distress:
significant problems in meeting debt obligations
most firms that experience financial distress do recover.

20-
599
Direct versus Indirect Bankruptcy
Costs
The static theory of capital structure:
A firm borrows up to the point where the tax benefit
from an extra dollar in debt is exactly equal to the
cost that comes from the increased probability of
financial distress. This is the point at which WACC
is minimised and the value of the firm is
maximised.

20-
600
The Optimal Capital Structure and the
Value of the Firm
Value of
the firm
(VL )
VL = VU + TC D

Present value of tax Financial


Maximum shield on debt distress costs
firm value VL*

Actual firm value


VU VU = Value of firm
with no debt

Debt-equity ratio, D/E


D/E Optimal amount of debt

20-
601
The Optimal Capital Structure and the
Cost of Capital
Cost of
capital
(%)
RE

RU RU
WACC
Minimum RD (1 TC)
cost of capital WACC*

Debt/equity ratio
D*/E*
(D/E)
The optimal debt/equity ratio

20-
602
The Capital Structure Question

Value of
the firm
( VL )
Case II
M&M (with taxes)

PV of bankruptcy costs
VL*
Case III
Net gain from leverage Static Theory
VU Case I
M&M (no taxes)

Total
D* debt (D)

20-
603
Managerial Recommendations

The tax benefit is only important if the firm has a


large tax liability.
Risk of financial distress:
The greater the risk of financial distress, the less debt will
be optimal for the firm.
The cost of financial distress varies across firms and
industries.

20-
604
The Extended Pie Model

Lower financial leverage Higher financial leverage

Bondholder Bondholder
claim claim

Shareholder Bankruptcy
claim Shareholder
claim Bankruptcy
claim
claim
Tax
claim Tax
claim

20-
605
The Value of the Firm

Value of the firm = marketed claims + non-


marketed claims:
Marketed claims are the claims of shareholders and
bondholders.
Non-marketed claims are the claims of the government
and other potential stakeholders.
The overall value of the firm is unaffected by
changes in the capital structure.
The division of value between marketed claims and
non-marketed claims may be impacted by capital
structure decisions.

20-
606
Corporate Borrowing and Personal
Borrowing

Without tax, corporate and personal borrowing are


interchangeable.
With corporate and personal tax, there is an
advantage to corporate borrowing because of the
interest tax shield.
With corporate and personal tax, and dividend
imputation, shareholders are again indifferent
between corporate and personal borrowing.

20-
607
Dynamic Capital Structure Theories

Pecking order theory


Investment is financed first with internal funds, then debt,
and finally with equity.
Information asymmetry cost
Management has superior information on the prospects of
the firm.
Agency costs of debt
These occur when equity holders act in their own best
interests rather than the interests of the firm.

20-
608
Chapter Twenty-one

Options, Corporate Securities


and Futures

21-
609
Chapter Organisation

21.1 Options: The Basics


21.2 Fundamentals of Options Valuation
21.3 Valuing a Call Option
21.4 BlackScholes Option Pricing Model
21.5 Equity as a Call Option on the Firms Assets
21.6 Types of Equity Option Contracts
21.7 Futures Contracts
21.8 Term Structure of Interest Rates
21.9 Summary and Conclusions

21-
610
Chapter Objectives
Understand the key terminology associated with
options.
Outline the five factors that determine option
values.
Price call options using the BlackScholes option
pricing model.
Discuss the types of equity option contracts offered.
Outline the types of warrants available to investors.
Discuss the characteristics of future contracts.
Understand the term structure of interest rates.
21-
611
Option Terminology
Call option
Right to buy a specified asset at a specified price on or
before a specified date.
Put option
Right to sell a specified asset at a specified price on or
before a specified date.
European option
An option that can only be exercised on a particular date
(on expiry).
American option
An option that can be exercised at any time up to its
expiry date.

21-
612
Option Terminology
Striking price
The contracted price at which the underlying asset can be
bought (call) or sold (put).
Expiration date
The date at which an option expires.
Option premium
The price paid by the buyer for the right to buy or sell an
asset.
Exercising the option
The act of buying or selling the underlying asset via the
option contract.

21-
613
Option Contract Characteristics

Expiration month

Option type

Contract size

Expiry

Exercise price

21-
614
Option Valuation

S1 = share price at expiration

S0 = share price today

C1 = value of call option on expiration

C0 = value of call option today

E = exercise price on the option

21-
615
Value of Call Option at Expiration

Call option value


at expiration (C1)

S1 E S1 > E
Share price
45
Exercise price (E) at expiration (S1)

21-
616
Value of Call Option at Expiration

C1 0 if S1 E 0
Option is out of the money.

C1 S1 E if S1 E 0
Option is in the money.

21-
617
Value of a Call Option Before
Expiration

Call price Upper bound Lower bound


(C0) C0 S0 C0 S0 E
C0 0

45
Share price (S0)
Exercise price (E)

21-
618
Call Option Boundaries

Upper bounda call option will never be worth more than the
share itself:

C0 S0

Lower boundshare price cannot fall below 0 and to prevent


arbitrage, the call value must be (S0 E):

The larger of 0 or (S0 E)

Intrinsic valueoptions value if it was about to expire = lower


bound.

21-
619
Factors Determining Option Values

Call option value Share price PV of exercise price


C0 S0 E/ 1 R f
t

The value of a call option depends on four factors:


share price
exercise price
time to expiration
risk-free rate.

21-
620
Another Factor to Consider?

The above four factors are relevant if the option is to finish in


the money.

If the option can finish out of the money, another factor to


consider is volatility.

The greater the volatility in the underlying share price, the


greater the chance the option has of expiring in the money.

21-
621
The Factors that Determine Option
Value

Factor Calls Puts

Current value of the underlying asset (+) ()


Exercise price on the option () (+)
Time to expiration on the option (+) (+)
Risk-free rate (+) ()
Variance of return on underlying asset (+) (+)

21-
622
BlackScholes Option Pricing Model

C0 S 0 N d1 E N d 2
1 R
f
t

C0 option value
S 0 share price
N d1 some probability the share price is relevant
E/ 1 R f PV exercise price
t

N d 2 some probabilit y the exercise price is paid

21-
623
BlackScholes Option Pricing Model

2
1n S 0 /E R f 2 t
1

d1
t
d 2 d1 t

Note: The risk-free rate, the standard deviation and the


time to maturity must all be quoted using the same time
units.

21-
624
ExampleBlackScholes Option
Pricing Model

S0 = $25 = 30%

E = $20 t = 0.5 years

Rf = 8%

21-
625
ExampleBlackScholes Option
Pricing Model (continued)

2
1n 25 / 20 0.08 2 0.3 0.5
1

d1
0.3 0.5
0.223 0.0625/ 0.212
1.34


d 2 1.34 0.3 0.5
1.34 0.212
1.13
21-
626
ExampleBlackScholes Option
Pricing Model (continued)

From the cumulative normal distribution table:


N(d1) = N(1.34) = 0.9099
N(d2) = N(1.13) = 0.8708

Therefore, the value of the call option is:

C0 25 0.9099 0.8708
20
0 .080 .5
e
22.7475 16.7331
$6.01

21-
627
Equity: A Call Option

Equity can be viewed as a call option on the


companys assets when the firm is leveraged.
The exercise price is the value of the debt.
If the assets are worth more than the debt when it
becomes due, the option will be exercised and the
shareholders retain ownership.
If the assets are worth less than the debt, the
shareholders will let the option expire and the
assets will belong to the bondholders.

21-
628
Equity Option Contracts

Types of equity option contracts offered in


Australia:
Exchange traded put and call options on company shares
Exchange traded long dated contracts issued by a
financial institution that can then trade them (warrants)
Over-the-counter options on company shares
Convertible notes issued by companies, comprising both
a debt and an equity component.

21-
629
Warrants

A long-lived option that gives the holder the right to


buy shares in a company at a specified price.

Types of warrants available:


equity warrants low exercise price warrants
fractional warrants endowment warrants
basket warrants currency warrants
fully covered warrants
index warrants
instalment warrants

21-
630
Company Options

A holder is given the right to purchase shares in a


company at a specified price over a given period of
time.

Usually offered as a sweetener to a debt issue.

These options are often detached and sold


separately.

21-
631
Company Options versus Exchange-
traded Options

Company options have longer maturity periods and


are often European-type options.

Company options are issued as part of a capital-


raising program and are therefore limited in
number.

The clearing house has no role in the trading of


company options.

Company options are issued by firms.

21-
632
Earnings Dilution

Put and call options have no effect on the value of


the firm.
Company options do affect the value of the firm.
Company options cause the number of shares on
issue to increase when:
the options are exercised
the debts are converted.
This increase does not lower the price per share
but EPS will fall.

21-
633
Forward Contracts

A contract where two parties agree on the price of an asset


today to be delivered and paid for at some future date.
Forward contracts are legally binding on both parties.
They can be tailored to meet the needs of both parties and
can be quite large in size.
Positions
Longagrees to buy the asset at the future date
Shortagrees to sell the asset at the future date
Because they are negotiated contracts and there is no
exchange of cash initially, they are usually limited to large,
creditworthy corporations.

21-
634
Forward Contracts
V V

Payoff
profile

Poil Poil

Payoff
profile

A. Buyers perspective B. Sellers perspective


21-
635
Futures Contracts

An agreement between two parties to exchange a


specified asset at a specified price at a specified
time in the future.
Do not need to own an asset to sell a future
contract.
Either buy before delivery or close out position with
an opposite market position.

21-
636
Futures Markets

Enable buyers and sellers to avoid risk in


commodities (and other) markets with high price
variability hedging.
Involves standardised contracts.
Deposit required by all traders to guarantee
performance.
Adverse price movements must be covered daily
by further deposits called margins (marked to
market).
Futures also available for short-term interest rates,
to protect against interest rate movements.
21-
637
Futures Quotes
Commodity, exchange, size, quote units
The contract size is important when determining the daily
gains and losses for marking-to-market.
Delivery month
Open price, daily high, daily low, settlement price, change
from previous settlement price, contract lifetime high and
low prices, open interest
The change in settlement price multiplied by the contract
size determines the gain or loss for the day:
Longan increase in the settlement price leads to a gain
Shortan increase in the settlement price leads to a loss
Open interest is how many contracts are currently
outstanding.

21-
638
Term Structure of Interest Rates

21-
639
Term Structure of Interest Rates

Yield curve shows the different interest rates


available for investments of different maturities, at
a point in time.
The relationship between interest rates of different
maturities is called the term structure.

21-
640
Factors Determining the Term
Structure

Risk preferencesborrowers prefer long-term


credit whereas lenders prefer short-term loans
(explains upward-sloping yield curve only).
Supplydemand conditionssegmented capital
markets can cause supplydemand imbalances
(explains all yield curve shapes).
Expectations about future interest rates (most
favoured explanation)

21-
641
Chapter Twenty-two

Mergers, Acquisitions and


Takeovers

22-
642
Chapter Organisation

22.1 The Legal Forms of Acquisitions


22.2 Regulation of Business Combination
22.3 Taxes and Acquisitions
22.4 Gains from Acquisition
22.5 Some Financial Side-effects of Acquisitions
22.6 The Cost of an Acquisition
22.7 Defensive Tactics
22.8 Some Evidence on Acquisitions
22.9 Summary and Conclusions

22-
643
Chapter Objectives

Discuss the legal forms of acquisitions.


Understand the legal framework for mergers,
acquisitions and takeovers.
Discuss the gains from acquisition.
Explain the financial side-effects of acquisitions.
Calculate the costs and NPV of an acquisition.
Identify and discuss possible defensive tactics to a
takeover attempt.

22-
644
Legal Forms of Acquisitions
Merger complete absorption of one company by
another.
Consolidation creation of a new firm by
combining two existing firms.
Advantages of mergers and consolidations:
simplicity (buyer assumes all assets and liabilities)
inexpensive.
Disadvantages of mergers and consolidations:
shareholders of both firms must approve
difficulty in obtaining cooperation of target companys
management.

22-
645
Legal Forms of Acquisitions

Acquisition of assets transfer of assets and


liabilities of the target company to the acquiring
company.

Acquisition of shares (tender offer) acquire


sufficient voting shares to gain management
control via a direct public offer for the shares.

Majority control versus effective control.

22-
646
Acquisition Classifications

Horizontal acquisition between two firms in the


same industry.

Vertical acquisition the buyer expands


backwards by acquiring a firm with the source of
raw materials or forwards by acquiring a firm that is
closer in the direction of the ultimate consumer.

Conglomerate acquisition involves companies in


unrelated industries.

22-
647
A Note on Takeovers
Merger or consolidation

Acquisition Acquisition of stock

Takeovers Proxy contest Acquisition of assets

Going private
(leveraged buyouts)

22-
648
Takeover Situations

Creeping takeover
Holdings in a target company can be increased by no
more than 3 per cent every six months.
Off market bid
A formal written offer is made to acquire the shares of a
target company.
Market bid
An announcement by a stockbroker that a broking firm will
stand in the market to purchase the target companys
shares for a specified price for a specified period.

22-
649
The Legal Framework
Common law Enacted law Stock Exchange
(legislation) Rules

Contract law Law of tort

Trade Practices Corporations Act Australian Securities


Act 1974 2001 Commission Act
1989

Corporations
Regulations

22-
650
Taxes and Acquisitions

Generally, assets purchased after 19 September


1985 are subject to capital gains tax (CGT) when
sold.
CGT can be deferred under rollover provisions.
CGT still applies when the consideration is shares,
and when more than 50 per cent of pre-19
September 1985 shareholders have changed
(regardless of purchase date).

22-
651
Gains from Acquisition

Synergy the value of the combined companies


is higher than the sum of the value of the individual
companies.

VAB VA VB

V VAB VA VB

Need to determine incremental cash flows.

22-
652
Incremental Cash Flows

= Revenue Cost Tax Capital requirements

A. Increased revenues
1. Gains from better marketing efforts.
2. Strategic benefitsbeachhead into new markets.
3. Increased market powermonopoly.

B. Decreased costs
1. Economies of scale.
2. Economies of vertical integration.
3. Complementary resources.

22-
653
Incremental Cash Flows

C. Tax gains
1. Use of net operating losses.
2. Use of excess or unused franking credits.
3. Use of unused debt capacity.
4. Asset revaluations.

D. Changing capital requirements


1. Reduced investment needs.
2. More efficient asset management.
3. Sell redundant assets.

22-
654
Mistakes to Avoid

Do not ignore market values.


Estimate only incremental cash flows.
Use the correct discount rate.
Be aware of transactions costs.

22-
655
Acquisitions and EPS Growth

Pizza Shack and Checkers Pizza are merging to form


Stop n Go Pizza. The merger is not expected to
create any additional value. Stop n Go, valued at
$1 875 000, is to have 125 000 shares outstanding at
$15 per share.

22-
656
Acquisitions and EPS Growth

Before and after merger financial positions


100 000 Stop n Go shares to Pizza Shack holders
25 000 Stop n Go shares to Checkers holders

Pizza Shack Checkers Pizza Stop n Go

EPS $1.50 $1.50 $1.80


Price per share $15.00 $7.50 $15.00
P/E ratio 10 5 8.33
No. of shares 100 000 50 000 125 000
Total earnings $150 000 $75 000 $225 000
Total value $1 500 000 $375 000 $1 875 000

22-
657
Acquisitions and EPS Growth

EPS has increased (and the P/E ratio has


decreased) because the total number of shares is
less.
The merger has not created value.

22-
658
Diversification

Does not create value in a merger.


Is not, in itself, a good reason for a merger.
Reduces unsystematic risk.
BUT
Shareholders can do this for themselves more
easily and less expensively.

22-
659
The Cost of an Acquisition

The net incremental gain from a merger of Firms A and B is:


V = VAB (VA + VB)

The total value of Firm B to Firm A is:


VB* = VB + V

The NPV of the merger is:


NPV = VB* Cost to Firm A of the acquisition

The cost of the acquisition to Firm A depends on the medium


of exchange used to acquire Firm Bcash or shares.

22-
660
The Cost of an Acquisition

Whether cash or shares are used to finance the


acquisition depends on the following factors:
Sharing gains: If cash is used, the selling firms
shareholders will not participate in the potential gains (or
losses) from the merger.
Control: Control of the acquiring firm is unaffected in a
cash acquisition. Acquisition with voting shares may have
implications for control of the merged firm.

22-
661
ExampleCash or Shares?
Pre-merger information for Firm A and Firm B:

Firm A Firm B
Price per share $15 $8
No. of shares 120 70
Total market value $1 800 $560

Both firms are 100 per cent equity financed.


The estimated incremental value of the acquisition is
$500.

22-
662
ExampleCash or Shares?
(Continued)

Firm B has agreed to a sale price of $675, payable


in cash or shares.

The value of Firm B to Firm A is:

VB V VB
$500 $560
$1060
How much does Firm A have to give up?

22-
663
ExampleCash Acquisition
Cost of acquiring Firm B is $675.
NPV of the cash acquisition is:
NPV VB * Cost
$1060 $675 $385
The value of Firm A after the merger is:
VAB VA VB Cost
$1800 $1060 $675 $2185
Price per share after the merger is $18.20.

22-
664
ExampleShare Acquisition

The value of the merged firm:

VAB VA VB V
$1800 $560 $500 $2860

Firm A must give up $675/$15 = 45 shares.

After the merger there will be 165 shares


outstanding, valued at $17.33 per share.

22-
665
ExampleShare Acquisition

True cost of the acquisition:

45 shares $17.33 = $779.85

NPV of the merger to Firm A:

NPV VB * Cost
$1060 $779.85 $280.15

Cash acquisition preferred (higher NPV).

22-
666
Defensive Tactics
Managers who believe their firms are likely to
become takeover targets and who wish to fend off
unwanted acquirers often implement one or more
takeover defences. These defensive tactics take
several forms:
Friendly shareholders offer the best defence.
Poison pillsdesigned to repel takeover attempts.
Share rights plansallow existing shareholders to
purchase shares at some fixed price in the event of a
takeover bid.
Going private and leveraged buyoutsthe publicly owned
shares in a firm are replaced with complete equity
ownership by a private group (often financed by debt).

22-
667
Terminology of Defensive Tactics
Golden parachutescompensation to top-level
management.
Poison putspurchase securities back at a set
price.
Crown jewelsselling off of major assets.
White knightsacquisition by a friendly firm.
Lockupsoption for a friendly firm to purchase
shares or assets at a fixed price.
Shark repellantdesigned to discourage unwanted
mergers.

22-
668
Evidence on Acquisitions

Shareholders of target companies involved in


successful takeovers gain substantially.
Abnormal gains of around 25 per cent reflect
merger premium.

22-
669
Evidence on Acquisitions

Shareholders of bidding firms involved in


successful takeovers only experience gains of 5
per cent. There are a variety of explanations for
this:
Overestimated anticipated gains
Scale effect (bidders usually larger than targets)
Agency problem
Competitive market for takeovers
Gains already reflected in bidders price (no new
information)

22-
670
Chapter Twenty-three

International Corporate Finance

23-
671
Chapter Organisation

23.1 Terminology
23.2 Foreign Exchange Markets and Exchange Rates
23.3 Purchasing Power Parity
23.4 Interest Rate Parity, Unbiased Forward Rates and the
International Fisher Effect
23.5 International Capital Budgeting
23.6 Exchange Rate Risk
23.7 Political Risk
23.8 Summary and Conclusions

23-
672
Chapter Objectives
Be familiar with international finance terminology.
Apply exchange rates and cross rates.
Understand triangle arbitrage and covered interest
arbitrage.
Distinguish between purchasing power parity,
interest rate parity, unbiased forward rates,
uncovered interest parity and the international
Fisher effect.
Calculate the NPV of a foreign operation in home
currency terms.
Explain exchange rate risk and political risk.

23-
673
Domestic versus International
Financial Management

Whenever transactions involve more than one currency, the


levels of, and possible changes in, exchange rates need to be
considered.
The risk of loss associated with actions taken by foreign
governments also needs to be considered. This political risk
can be difficult to assess and difficult to hedge against.
Financing opportunities encompass international capital
markets and instruments, which can reduce the firms cost of
capital.

23-
674
International Finance Terminology
Cross rate
The implicit exchange rate between two currencies
quoted in some third currency.
Euro
The monetary unit for the European Monetary System
(EMS).
Eurobonds
International bonds issued in multiple countries but
denominated in the issuers currency.

23-
675
International Finance Terminology

Eurocurrency
Money deposited in a financial centre outside the country
whose currency is involved.
Foreign bonds
International bonds issued in a single country usually
denominated in that countrys currency.
Foreign exchange market
The market in which one countrys currency is traded for
another.

23-
676
International Finance Terminology

Gilts
British and Irish government securities.
London Interbank Offer Rate (LIBOR)
The rate most international banks charge one another for
overnight Eurodollar loans.
Swaps
Agreements to exchange two securities or currencies.

23-
677
Global Capital Markets
Asia/Pacific Region Americas

Australian Stock Exchange New York Stock Exchange


Sydney Futures Exchange American Stock Exchange
New Zealand Stock Exchange Boston Stock Exchange
Cincinnati Stock Exchange
Hong Kong Stock Exchange Chicago Stock Exchange
Hong Kong Futures Exchange Pacific Stock Exchange
Philadelphia Stock Exchange
Shanghai Securities Exchange Chicago Board of Trade
Shenzen Stock Exchange Kansas City Board of Trade
Toronto Stock Exchange
Osaka Stock Exchange
Europe and the UK
Tokyo Stock Exchange
Tokyo Intl Financial Futures Exchange Frankfurt Stock Exchange
London Stock Exchange
Singapore Stock Exchange Paris Bourse
Kuala Lumpur Stock Exchange Swiss Stock Exchange
Nasdaq

23-
678
Participants in Foreign Exchange
Market

Importers
Exporters
Portfolio managers
Foreign exchange brokers
Traders
Speculators

23-
679
Exchange Rates

Q: If you wish to exchange $100 for British pounds at an


exchange rate of $A1/0.337, how many pounds will you
receive?
A: $A100 (0.337) = 33.7

Q: You paid 20 French francs for a croissant in France. If the


exchange rate is $A1/FF4.1184, how much did it cost in
dollars?
A: FF20 4.1184 = $A4.8563

23-
680
Exchange Rate Quotations

$US 0.5215 0.5190

Rate at which dealer Rate at which dealer


BUYS $US or SELLS $A SELLS $US or BUYS $A

23-
681
ExampleExchange Rates
If you wish to convert $A1000 to $US at the above
exchange rates:
you SELL $A; therefore, the dealer BUYS $A
$A1000 0.5190 = $US519

If you now convert $US519 back to $A:


you BUY $A; therefore, the dealer SELLS $A
$US519 0.5215 = $A995.21

The difference is the dealer fee ($A1000 995.21


= $A4.79).

23-
682
Triangle Arbitrage

You have observed the following exchange rates:


$A1/FF10 $A1/DM2.00 DM/FF4.00

Step 1
Buy 1000 francs for $100

Step 3 Step 2
Exchange DM250 for $A125 Buy DM250 for FF1000

You have just made $A25!

23-
683
Cross Rates

To prevent triangle arbitrage:


the $A can be exchanged for FF10 or DM2.00

Cross rate must be:

FF10
FF5/DM1
DM2.00

23-
684
ExampleCross Rates

The exchange rates for the British pound and the Japanese
yen are:

$A1 = 0.3538
$A1 = 63.74

0.3538
Cross rate 0.0056/
63.74
63.74
or 180.16/
0.3538
23-
685
Types of Transactions

Spot deal an agreement to trade currencies


based on the exchange rate today for settlement
within two business days.
Spot exchange rate the exchange rate on a spot
deal.
Forward deal an agreement to exchange
currency at some time in the future.
Forward exchange rate the agreed-upon
exchange rate to be used in a forward deal.

23-
686
Purchasing Power Parity

The idea that the exchange rate adjusts to keep


purchasing power constant among currencies.
Absolute purchasing power parity (PPP)a
commodity costs the same regardless of what
currency is used to purchase it or where it is
selling.
For absolute PPP to hold:
transaction costs must be zero
there must be no barriers to trade
the items purchased must be identical in all locations.

23-
687
Relative Purchasing Power
Parity

The idea that the change in the exchange rate


between two currencies is determined by the
difference in inflation rates between the two
countries.

Relative PPP, therefore, explains the changes in


exchange rates over time rather than the absolute
levels of exchange rates.

23-
688
Relative PPP Equation

E St S 0 1 hFC hA
t

where
E St expected exchange rate at time t
S 0 current (time 0) spot exchange rate
hA inflation rate in Australia
hFC foreign country inflation rate

23-
689
ExampleRelative PPP

The German exchange rate is currently 1.3 DM per


dollar. The inflation rate in Germany over the next
five years is estimated to be 5 per cent per year,
while the Australian inflation rate is estimated to be
3 per cent per year. What will be the estimated
exchange rate in five years?

23-
690
SolutionRelative PPP

The DM will become less valuable; $A will become


more valuable.
The exchange rate change will be 5% 3% = 2%
per year.

E S5 1.3 1 0.02
5

1.4353

23-
691
ExampleCovered Interest Arbitrage
(CIA)
Assume: S0 = $A1/66.42 F1 = $A1/64.80
RA = 7% RJ = 5%

$A1 000 000 @ 7% $A1 070 000


Profit
$A1 076 250

@ 66.42 1 year @ 64.80

66 420 000 @ 5% 69 741 000


23-
692
Interest Rate Parity (IRP)

The interest rate differential between two countries is


equal to the percentage difference between the
forward exchange rate and the spot exchange rate.
Ft S 0 1 RFC RA
t

where
Ft forward exchange rate for settlement at time t
S 0 current spot exchange rate
RFC nominal risk - free rate in foreign country
RA nominal risk - free rate in Australia
23-
693
Unbiased Forward Rates (UFR)

The current forward rate is an unbiased predictor of


the future spot exchange rate.

Ft ESt

On average, the forward exchange rate is equal to


the future spot exchange rate.

23-
694
Uncovered Interest Parity (UIP)

The expected percentage change in the exchange


rate is equal to the difference in interest rates.

ESt S0 1 RFC RA
t

Combines IRP and UFR.

23-
695
International Fisher Effect (IFE)

Real interest rates are equal across countries.

RA hA RFC hFC

Combines PPP and UFR.

Ignores risk and barriers to capital movements.

23-
696
ExampleInternational Capital
Budgeting

Pizza Shack is considering opening a store in Mexico. The store


would cost $A500 000 or 3 million pesos (at an exchange rate of
$A1/6.000 pesos). They hope to operate the store for two years
and then sell it to a local franchisee. Assume that the expected
cash flows are 250 000 pesos in the first year and 5 million
pesos in year 2 (including the selling price of the store and
fixtures). The Australian risk-free rate is 7 per cent and the
Mexican risk-free rate is 10 per cent. The required return in
Australia is 12 per cent. Ignore taxes.

23-
697
ExampleMethod 1: Home Currency
Approach
Using the interest rate parity relationship:

Year Cash Flow Expected Cash Flow


(Pesos) Exchange Rate (Dollars)
0 3 000 000 6.0000 500 000
1 250 000 6.1800 40 453
2 5 000 000 6.3654 785 497

40 453 785 497


NPV 500 000
1.12 1.122
$162 312

23-
698
ExampleMethod 2: Foreign
Currency Approach

Using a 3 per cent inflation premium: (1.12 1.03) 1 =


15.36%
250 000 5 000 000
NPVPesos - 3 000 000
1.1536 1.15362
973 871 pesos

973 871
NPVDollars
6.0000
$162 312

23-
699
Exchange Rate Risk

The risk related to having international operations


in a world where currency values vary.

Short-run exposureuncertainty arising from day-


to-day fluctuations in exchange rates.

Long-run exposurepotential losses due to long-


run, unanticipated changes in the relative
economic conditions in two or more countries.

23-
700
Translation Exposure

Uncertainty arising from the need to translate the


results from foreign operations (in foreign currency)
to home currency for accounting purposes.

What is the appropriate exchange rate to use for


transferring each balance sheet account?

How should balance sheet accounting gains and


losses from foreign currency translation be
handled?
23-
701
Political Risk
Changes in value due to political actions in the
foreign country.
Investment in countries that have unstable
governments should require higher returns.
The extent of political risk depends on the nature of
the business:
The more dependent the business is on other operations
within the firm, the less valuable it is to others.
Natural resource development can be very valuable to
others, especially if much of the ground work in
developing the resource has already been done.
Local financing can often reduce political risk.
23-
702
Types of Political Risk

Risk Nature of Loss

Currency devaluation Loss in value of cash flows in


terms of home currency
Increased taxation Reduction in total cash flows
repatriated
Funds blockage Reduction or elimination of
cash flows repatriated
Expropriation of assets Loss of firm property and future
cash flows
Terrorism/sabotage Danger to employees and/or
loss of future cash flows

23-
703
Chapter Twenty-four
Leasing

24-
704
Chapter Organisation

24.1 The Nature of Leases


24.2 Types of Leases
24.3 A Brief Look at Accounting for Leases
24.4 Taxation and Leases
24.5 An Evaluation of Leasing
24.6 The Role of the Residual Value
24.7 Setting Lease Premiums
24.8 Alleged Advantages and Disadvantages of
Leasing
24.9 Summary and Conclusions

24-
705
Chapter Objectives

Understand the characteristics of the different


types of leases.
Explain how leases are recorded in a firms
accounting records.
Identify the tax implications of leases.
Evaluate a lease by calculating the net advantage
of leasing (NAL).
Explain the calculation of lease premiums.
Discuss the advantages and disadvantages of
leases.

24-
706
Leasing versus Buying
Buy Lease
Sass buys asset and uses asset; Sass leases asset from lessor; the
financing raised by debt lessor owns the asset

Manufacturer Manufacturer
of asset of asset

Sass arranges
financing and buys
asset from Sass leases asset
manufacturer from lessor

Lessee (Sass)
Sass Lessor 1. Uses asset
1. Uses asset 1. Owns asset 2. Does not own
2. Owns asset 2. Does not use asset asset

24-
707
Leasing

What is a lease?
A lessee (user) enters an agreement in which they make
lease payments to the lessor (owner) in return for the use
of the leased property/asset.
Who are the major providers of lease finance in
Australia?
Finance companies and banks.
What assets are leased?
Any asset including photocopiers, cars, construction
equipment, computers, shop/office fittings and equipment.

24-
708
Types of Leases

Operating lease

Financial lease
Sale and leaseback agreement
Leveraged lease

24-
709
Operating Leases

Short-term lease.
Cancellable prior to the expiry date at little or no
cost.
Lessor is responsible for maintenance and upkeep
of asset.
The sum of the lease payments does not provide
for full recovery of the assets costs.
Includes telephones, televisions, computers,
photocopiers, cars.

24-
710
Financial Leases

Long-term lease.
Non-cancellable (without penalty) prior to expiry
date.
Lessee is responsible for the maintenance and
upkeep of the asset.
Lease period approximates assets economic life.
The sum of the lease payments exceeds the
assets purchase price.
Includes specialist equipment, heavy industrial
equipment.

24-
711
Residual Value Clause

Lease continues for its full term


Lessee can purchase the asset for its residual
value, return the asset to the lessor (paying any
shortfall from residual value) or renew the lease.

Lease is cancelled during its initial term


Lessee must pay outstanding premiums (less
interest component) plus residual value of asset.

24-
712
Types of Financial Leases

Sale and leaseback agreements


Companies sell an asset to another firm and
immediately lease it back. Enables the company to
receive cash and yet maintain use of the asset.

Leveraged leases
The lessor arranges for funds to be contributed by
one or more partiesform of risk-sharing and
transferring tax benefits. Often used to finance
large-scale projects.
24-
713
Leasing and the Statement of
Financial Position
A. Statement of Financial Position with Purchase (company finances $100 000 truck with debt)

Truck $100 000 Debt $100 000


Other assets 100 000 Equity 100 000
Total assets $200 000 Debt plus equity $200 000

B. Statement of Financial Position with Operating Lease (co. finances truck with an operating
lease)
Truck $ 0 Debt $ 0
Other assets 100 000 Equity 100 000
Total assets $100 000 Debt plus equity $100 000

C. Statement of Financial Position with Financial Lease (co. finances truck with a financial lease)
Assets under financial Obligations under
lease $100 000 financial lease $100 000
Other assets 100 000 Equity 100 000
Total assets $200 000 Debt plus equity $200 000

24-
714
Criteria for a Financial Lease

AAS17 Accounting for Leases states that a


financial lease occurs where substantially all risks
and benefits pass to the lessee.
A financial lease must be disclosed on the
Statement of Financial Position if at least one of
the following criteria is met:
the lease term is 75 per cent or more of the estimated
economic life of the asset
the present value of the lease payments is at least 90 per
cent of the fair market value of the asset at the start of the
lease.

24-
715
Leasing and Taxation
Lease premiums paid under a lease contract are
tax deductible.

Any payment relating to the ultimate purchase of


the asset is not deductible.

The residual payment does not qualify as a tax


deduction.

Any profit made on the asset previously leased is


subject to capital gains tax.
24-
716
ExampleLease versus Buy

Macca Co. has to decide whether to borrow the


$15 000 needed to purchase a new gadget
machine (with a borrowing cost of 10 per cent) or
to lease the machine for $4000 per annum. If
purchased, the asset could be depreciated using
the straight-line method over the three-year life.
The company tax rate is 30 per cent.

Under the lease agreement, Macca Co. would be


responsible for maintaining the machine.

24-
717
ExampleLease versus Buy:
Repayment Schedule


Repayment 15 000 / 1 - 1 / 1.10 / 0.10
3

$6032

Year Principal Interest Total amount Repayment Principal


Outstanding @ 10% owing carried
forward
1 15 000 1 500 16 500 6 032 10 468
2 10 468 1 047 11 515 6 032 5 483
3 5 483 548 6 031 6 032 nil

24-
718
ExampleLease versus Buy:
Tax Subsidises Borrowing

Year Depreciation Interest Total PV of


Deduction Deduction deductions Deductions
1 5 000 1 500 6 500 5 909
2 5 000 1 047 6 047 4 997
3 5 000 548 5 548 4 168
Total $15 074
PV of tax subsidies (30%) $ 4 522

24-
719
ExampleLease versus Buy:
Tax Subsidises Leasing

Year Lease Premium Present Value


1 4 000 3 636
2 4 000 3 306
3 4 000 3 005
Total $9 947
PV of tax subsidies (30%) $2 984

24-
720
ExampleLease versus Buy:
Net Advantage of Leasing

Opportunity cost PV of lease payments- Borrowing cost


$4 000 2.4869 - $15 000
($5 052)

NAL Net tax savings - Opportunity cost


$2 984 - $4 522 - $5 052
- $1 538 $5052
$3 514

The advantage is greater than zero so Macca Co.


should lease.
24-
721
Residual Value

The residual value is the amount for which the


asset may be purchased by the lessee from the
lessor at the end of the lease term.

The salvage value is the amount the asset can be


sold for in the market place by the lessee (once
they have acquired the asset).

In the previous example, assume a residual value


of $2000 and a salvage value of $1500.
24-
722
ExampleLease the Asset with
Residual Value

Salvage value $1 500


Residual value $2 000
Loss on leasing ($500)
Tax savings in year 3 $150
PV of tax savings $113
Add tax subsidies $2 984
Total tax subsidies (A) $3 097

24-
723
ExampleBorrow to Purchase the
Asset with Residual Value

Salvage value $2 000


Depreciated value Nil
Gain on salvage $2 000
Tax payable in year 3 ($600)
PV of tax payable ($451)
Add tax subsidies $4 522
Total tax subsidies (B) $4 071
Net tax savings (A-B) ($974)

24-
724
Net Advantage of Leasing

Opp cost PV lease pay. PV residual value - Borrowing cost


$4 000 2.4869 $2 000 / 1.10 - $15 000
3

($3 550)

NAL Net tax savings - Opportunity cost


$974 - $3 550
$2 576

24-
725
Setting Lease Premiums

Lease premiums are paid in advance in Australia.

Lease premium in advance


Asset value - PV residual value
1 PV annuity factor for t - 1 payments

24-
726
ExampleLease Premiums

KAZ Co. has started a four-year lease of a photocopier which


has a $70 000 purchase price. Had the company purchased
the copier, the interest rate quoted on borrowings was 1.5 per
cent per month. KAZ has agreed with the lessor to a residual
value of $10 000 at the end of four years.

What will be the amount of the lease premiums?

24-
727
SolutionLease Premiums

Lease premium
Asset value - PV residual value
1 PV annuity factor for t - 1 payments


70 000 - 10 000 1.015 48

1 1 - 1 / 1.015 / 0.015
47

65 106 / 1 33.5532

$1884.22

24-
728
Advantages of Financial Leases
No restrictions on future borrowing.
Can be tailored to suit firms needs.
Eliminates the need to raise extra capital.
No unnecessary financial outlay.
May be excluded from the Statement of Financial
Position.
Facilitates financing capital additions on a
piecemeal basis.
Is an allowable cost under government contracting.
Offers tax advantages.
24-
729
Advantages of Operating Leases

Frees up capital for alternative uses.


Increases the companys working capital.
Provides greater control due to greater certainty in
future outlays.
Assures more competent upkeep of asset.
Avoids the risk of obsolescence.
Avoids the equipment disposal problem.
Future outlays cost less in real terms due to
inflation.

24-
730
Disadvantages of Leasing

Interest cost often higher.


May not offer the right to the residual value of the
asset.
Allows the acquisition of assets without submitting
formal capital expenditure procedures.
May cause distortions in the evaluation of interfirm
and interdivision performance.
Lacks the prestige associated with ownership.

24-
731
Good Reasons for Leasing

Taxes may be reduced by leasing.


The lease contract may reduce certain types of
uncertainty that might otherwise decrease the
value of the firm.
Leasing reduces the impact of obsolescence of an
asset on a firm.
Transaction costs may be lower for a lease
contract than for buying the asset.
Leasing may require fewer (if any) restrictive
covenants than secured borrowing.
24-
732
Bad Reasons for Leasing

The perception of 100 per cent financing.

The apparent low cost.

Using leasing to artificially enhance accounting


income.

24-
733