DOVE CONSULT

FIN 810 KEY POINTS AND FORMULA

OLOWE PART –

Introduction to Finance

Objectives of a Firm

Mathematics of finance

Capital budgeting – Certainty and Uncertainty

FORMULA

LUMP SUM OR A SINGLE AMOUNT

𝐹𝑉 = 𝑃(1 + 𝑟)𝑛 - Future Value

𝑃𝑉 = 𝐹𝑉(1 + 𝑟)−𝑛 - Present Value

* When you have the concept of multi-period such as semi-annually (2), quarterly (4), monthly
(12). Divide r by m and multiply n by m.

𝐹𝑉 = 𝑃(1 + 𝑟/𝑚)𝑛𝑚

𝑃𝑉 = 𝐹𝑉(1 + 𝑟/𝑚)−𝑛𝑚

ANNUITY OR REPEATED AMOUNT

FUTURE VALUE OF ANNUITY

(1+𝑟)𝑛 −1
𝐹𝑉𝐴 = 𝐴 ( ) REGULAR OR ORDINARY ANNUITY usually at the end of the year
𝑟

(1+𝑟)𝑛 −1
𝐹𝑉𝐴 𝐷𝑢𝑒 = 𝐴 ( ) (1 + 𝑟) ANNUITY DUE usually at the beginning of the year.
𝑟

PRESENT VALUE OF ANNUITY

1−(1+𝑟)−𝑛
𝑃𝑉𝐴 = 𝐴 ⌊ ⌋ REGULAR OR ORDINARY ANNUITY usually at the end of the year
𝑟

1−(1+𝑟)−𝑛
𝑃𝑉𝐴 𝐷𝑢𝑒 = 𝐴 ⌊ ⌋ (1 + 𝑟) ANNUITY DUE usually at the beginning of the year.
𝑟

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SINKING FUND SOLVING FOR (A) MAKE ANNUITY THE SUBJECT OF FORMULA.
𝐹𝑉𝐴
A = (1+𝑟)𝑛 −1 when you hear things like targeted amount or savings plan to achieve
⌊ ⌋
𝑟

future amount

LOAN AMORTIZATION SOLVING FOR A MAKE ANNUITY THE SUBJECT OF

FORMULA.
𝑃𝑉𝐴
𝐴= 1−(1+𝑟)−𝑛 When you hear things like installment repayment amount
⌊ ⌋
𝑟

Finding Number of years (n)

fv
log( )
pv
⌊log(1+r)⌋

Finding rate of return or interest rate or discount rate (r)

𝑛 𝐹𝑉
r = √ -1
𝑃𝑉

CAPITAL BUDGETING UNDER CERTAINTY

Net Cash flows (NCF) = (Revenue - Cost) – Depreciation) x (1-tax) + Depreciation

Profit after depreciation and tax = (Revenue - Cost) – Depreciation) x (1-tax)

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
Depreciation = =
𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒

Traditional Methods: Payback periods and Accounting Rate of Return (ARR)

PAYBACK PERIOD WITH EVEN CASH FLOWS

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡
Payback period of Even Cash flows = ⌊ ⌋
𝑁𝐶𝐹

PAYBACK OF UNEVEN CASHFLOWS

Payback period you add up PV till it accumulates to the initial cost.

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 𝐴𝑣 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝐷𝑒𝑝 & 𝑇𝑎𝑥
Finding ARR = Average or Accounting Rate of Return = ∗ 100
𝐴𝑣 . 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡

Modern Methods: NPV, IRR AND PI

Xt = Net cash flows, Sv - Salvage value, Co - Initial cost or Capital outlay

𝑋𝑡 𝑆𝑣
(NPV) Net Present Value = ∑ (1+𝑟)𝑡 + (1+𝑟)𝑛 – Co

𝑁𝑃𝑉 +
Finding 𝐼𝑅𝑅 = (𝑅+ ) + ⌊𝑁𝑃𝑉 +−𝑁𝑃𝑉 −⌋ (𝑅− − 𝑅 + )

𝑋𝑡
Profitability Index = ∑ (1+𝑟)𝑡 / Co

OWUALAH TOPIC: CAPITAL BUDGETING UNDER UNCERTAINTY

Concept of risk and uncertainty

Multiply the risk probability to the Cash flows (Xi.Pi) where Pi is the probability attached
𝑋𝑖.𝑃𝑖 𝑆𝑣
(NPV) Net Present Value = ∑ (1+𝑟)𝑡 + (1+𝑟)𝑛 – Co

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ABASS SHIRO PART

LEVERAGE, COST OF CAPITAL AND CAPITAL STRUCTURE

Leverage is the result of using borrowed capital as a source of funding when investing to expand
the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of
using borrowed money: specifically, the use of various financial instruments or borrowed capital
to increase the potential return of an investment. Leverage can also refer to the amount of debt
used to finance assets. When one refers to something (a company, a property or an investment) as
"highly leveraged," it means that item has more debt than equity.

MAJOR COMPONENTS OF LEVERAGE

1) Breakeven point

In simple words, the break-even point can be defined as a point where total costs (expenses) and
total sales (revenue) are equal. Break-even point can be described as a point where there is no net
profit or loss.

Break-even point is the number of units (N) produced which make zero profit. N is units sold

Revenue – Total costs = 0

Total costs = (Variable costs * N) + Fixed costs

2) Operating leverage / degree of operating leverage

The Degree of Operating Leverage (DOL) is the leverage ratio that sums up the effect of an amount
of operating leverage on the company’s earnings before interests and taxes (EBIT). Operating
Leverage takes into account the proportion of fixed costs to variable costs in the operations of a
business. It measures the riskiness or risk exposure of a business operation relating to sales and
earnings before interest and tax, If the degree of operating leverage is high, it means that the
earnings before interest and taxes would be unpredictable for the company, even if all the other
factors remain the same.

The Degree of Operating Leverage Ratio helps a company in understanding the effects of operating
leverage on the company’s probable earnings. It is also important in determining a suitable level
of operating leverage which can be used in order to get the most out of the company’s Earnings
before interest and taxes or EBIT.

If the operating leverage is high, then a smallest percentage change in sales can increase the net
operating income. The net operating income is the amount of income that is left after payments of
fixed cost are made, regardless of how much sales has been made. Since the Degree of Operating
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Leverage or DOL helps in determining how the change in sales volume would affect the profits of
the company, it is important to ascertain the value of degree of operating leverage in order to
minimize the losses to the company.

A business would benefit if the can estimate the Degree of Operating Leverage or DOL. The
impact of the leverage on the percentage of sales can be quite striking if not taken seriously;
therefore it is really important to minimize these risks of the business. If you get a higher degree
of operating leverage or DOL then you should try and balance the operating leverage to balance
with the financial leverage in order to provide with profits to the company. A company’s balance
Degree of Operating Leverage can provide the financial leverage is an important factor
contributing to business profits. Even a small percentage of increase in sales can help in having a
greater proportion of profits in the company, so it is really important to maintain a balance between
both financial leverage and operating leverage to yield maximum benefits.

3) Financial Leverage /degree of financial leverage

The degree of financial leverage (DFL) is the leverage ratio that sums up the effect of an amount
of financial leverage on the earning per share of a company. The degree of financial leverage or
DFL makes use of fixed cost to provide finance to the firm and also includes the expenses before
interest and taxes. If the Degree of Financial Leverage is high, the Earnings Per Share or EPS
would be more unpredictable while all other factors would remain the same.

The degree of financial leverage or DFL helps in calculating the comparative change in net income
caused by a change in the capital structure of business. This ratio would help in determining the
fate of net income of the business. This ratio also helps in determining the suitable financial
leverage which is to be used to achieve the business goal. The higher the leverage of the company,
the more risk it has, and a business should try and balance it as leverage is similar to having a debt.

The degree of financial leverage is useful for figuring out the fate of net income in the future,
which is based on the changes that take place in the interest rates, taxes, operating expenses and
other financial factors. Debts added to a business would provide an interest expense to the company
which is a fixed cost, and this is when the company’s business begins to turn to provide profit. It
is important to balance the financial leverage according to the operating costs of the company as
it would minimize the level of risks involve

4) Combined leverage / Degree of combined leverage

The Degree of Combined Leverage (DCL) is the leverage ratio that sums up the combined effect
of the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL) has on
the Earning per share or EPS given a particular change in shares. This ratio helps in ascertaining
the best possible financial and operational leverage that is to be used in any firm or business.
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This ratio has been known to be very useful to a company or firm as it helps a firm understand the
effects of combining financial and operating leverage on the total earnings of the company. A high
level of combined leverage shows the risk involved in the company as there are more fixed costs
in the company, while a low combined leverage would mean better for the company.

Since the degree of combined leverage is calculated by combining both the operational leverage
and the financial leverage, it helps us in ascertaining the total risk involved in the business.
Operating Leverage measures the operating risk or business risk of the company while Financial
Leverage measures the financial risk of the company. Together when combined, both the financial
leverage ratio and the operating leverage ratio can provide you with an idea of how much risk per
share are involved. Operating leverage is determined by the percentage change in earning before
tax or interest is due and similarly financial leverage is determined by the percentage change in
the gross before the tax and interest per share is due.

It is up to the company to maintain the degree of combined leverage so as to minimize the risks
involved in the business. Maintaining the risk and not increasing it from where it is, the business
should try to lower or minimize the financial leverage in order to balance the operating leverage
and by minimizing the operating leverage when the financial leverage is to be balances. The
balanced degree of combined leverage (DCL) provides with an increase in the earnings per share
of the equity holders which is why it is important to calculate the Degree of Combined Leverage
(DCL) for better understanding of the position of the company and minimizing the risks of the
company.

5) EPS

Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share
of common stock. Earnings per share serves as an indicator of a company's profitability.

FORMULA

BREAK EVEN POINT IN NAIRA =

𝐹𝑐
𝑆 − 𝑉𝑐
( )
𝑆
BREAK EVEN POINT IN UNITS =

𝐹𝑐
(𝑆 − 𝑉𝑐)

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DOL
𝑄(𝑆−𝑉𝑐)
Simply put 𝑄(𝑆−𝑉𝑐)−𝐹𝑐

DFL = % Change in EPS / % Change in EBIT =

𝑄(𝑆−𝑉𝑐)−𝐹𝑐
Simply put 𝐷𝑝
𝑄(𝑆−𝑉𝑐)−𝐹𝑐−𝐼−( )
1−𝑡𝑎𝑥

DCL = %Change in EPS / %Change in Sales = DOL * DFL

S= SALES it can be in per naira then you need to multiply by the volume of units

Vc = Variable cost it can be in per naira then you need to multiply by the volume of units

Fc = Fixed cost

EPS is calculated as:

EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares

NOTE

ABASS HAS A QUESTION AND ANSWER TEXTBOOK

PRACTICE SECTION FOR LEVERAGE: CHAPTER 9, 1-10

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COST OF CAPITAL

Cost of capital is the required return necessary to make a capital budgeting project/investment,
such as building a new factory, worthwhile. Cost of capital includes the cost of long-term sources
of funds such as the cost of deb, cost of preference share and the cost of equity. Another way to
describe cost of capital is the cost of funds used for financing a business. Cost of capital depends
on the mode of financing used — it refers to the cost of equity if the business is financed solely
through equity, or to the cost of debt if it is financed solely through debt. Many companies use a
combination of debt and equity to finance their businesses and, for such companies, the overall
cost of capital is derived from a weighted average of all capital sources, widely known as the
weighted average cost of capital (WACC).

TYPES OF LONG-TERM SOURCES OF CAPITAL

Equity capital is money invested in a business and is not repaid to the investors in the normal
course of business but are given dividend as returns. It represents the risk capital staked by the
owners through purchase of a company's common stock (ordinary shares).

Preference capital. A special class of a company's shares, on which dividends are paid before the
dividends on ordinary shares, and whose holders are repaid before others if the company goes
bankrupt

Debt capital is the capital that a business raises by taking out a loan, debenture or bond. It is a loan
made to a company that is normally repaid at some future date. This means that legally, the interest
on debt capital must be repaid in full before any dividends are paid to any suppliers of equity.

FORMULA

Cost of debt …redeemable that has maturity where R is interest on the debt Pn is maturity value
and Po is current market value or price
𝟏
𝑹(𝟏−𝒕𝒂𝒙)+ 𝒏(𝑷𝒏−𝑷𝒐)
Kd = 𝟏
𝟐
(𝑷𝒏+𝑷𝒐)

Cost of debt…irredeemable that has maturity where R is interest on the debt and Po is current
value or price

𝑹(𝟏−𝒕𝒂𝒙)
Kd =
𝑷𝒐

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Cost of Preference share – Irredeemable where Dp is dividend on the preference share or stock
and Po is the current market selling price

𝑫𝒑
Kp =
𝑷𝒐

Cost of equity is the return that stockholders require for their investment in a company. The
traditional formula for cost of equity (COE) is the dividend capitalization model:

𝑫𝟏
Ke = +g =
𝑷𝒐

𝐸 𝑃 𝐷
WACC = ∗ 𝐾𝑒 + ∗ 𝐾𝑝 + ∗ 𝐾
𝑉 𝑉 𝑉

To calculate WACC, multiply the cost of each capital component by its proportional weight and
take the sum of the results. The method for calculating WACC can be expressed in the following
formula for Weighted Average Cost of Capital (WACC)

Ke = cost of equity

Kd = cost of debt

Kp = cost of preference share

E = market value of the firm's equity

P = market value of the firm's preference share

D = market value of the firm's debt

V = E + P+D = total market value of the firm’s financing (equity and debt)

E/V = percentage of financing that is equity

P/V = percentage of financing that is preference

D/V = percentage of financing that is debt

NOTE- ABASS HAS A QUESTION AND ANSWER TEXTBOOK COST OF CAPITAL

(chapter 8) QUESTIONS 5,6,7,9 AND 10

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CAPITAL STRUCTURE DECISIONS

This is a key aspect of corporate finance where by the decisions as how the capital structure of an
organization must be made. The goal is to achieve the optimal mix of capital structure where
overall value of the firm is maximum and overall cost of capital is minimum. A firm's capital
structure is the composition or 'structure' of its equity and debt liabilities. For example, a firm that
has $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-
financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's
leverage.In reality, capital structure may be highly complex and include dozens of sources of
capital

The Modigliani–Miller theorem, proposed by Franco Modigliani and Merton Miller in 1958, forms
the basis for modern thinking on capital structure, though it is generally viewed as a purely
theoretical result since it disregards many important factors in the capital structure process factors
like fluctuations and uncertain situations that may occur in the course of financing a firm. The
theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result
provides the base with which to examine real world reasons why capital structure is relevant, that
is, a company's value is affected by the capital structure it employs. Some other reasons include
bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be
extended to look at whether there is in fact an optimal capital structure: the one which maximizes
the value of the firm. The optimal capital structure is identified by the Ko that is minimum and V
that is maximum

FORMULA

Cost of Capital (Ko) =

𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠
=
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑓𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑓𝑖𝑟𝑚

Value of a Firm (V) = Value of Equity + Value of Debt

𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟 𝑖𝑛𝑡𝑒𝑟𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠 𝑙𝑒𝑠𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑠ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠
Value of Equity = =
𝐶𝑜𝑠𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 (𝐾𝑒) 𝐶𝑜𝑠𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 (𝐾𝑒)

NOTE- ABASS HAS A QUESTION AND ANSWER TEXTBOOK CAPITAL

STRUCTURE Chapter 14, questions 1,2,3, and 7

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AMAH TOPIC: DIVIDEND POLICY AND MERGERS AND ACQUISISTION

DIVIDEND POLICY

Dividend policy is a company’s guideline with respect to its dividend decisions such as how much
to pay, when to pay, what type to pay and who to pay. A dividend is a return on investment given
to shareholders for their investment in a company.

Types of dividend

Cash Dividend

Stock Dividend

Share repurchase

Factors influencing dividend policy

- Availability of investment opportunity in the market

- Clientel Consideration
- Legal Consideration
- Signaling effect
- Tax consideration.

Theories of dividend policy

(1) Relevant Theories or Relevant school of thought; Dividend decision is relevant to the valuation
of firm.

(2) Irrelevant Theories or Irrelevant school of thought; Dividend decision is irrelevant to the
valuation of firm. (M&M)- According to Modigliani and Miller (M-M), dividend policy of a firm
is irrelevant as it does not affect the wealth of the shareholders. They argue that the value of the
firm depends on the firm’s earnings which result from its investment policy.

The most critical is Relevant school of thought it has two aspects

Traditional Right – Pay more Dividend, retain less, it will increase the value of the firm

Radical Left – Pay less Dividend, retain more for reinvestment into the firm it will increase the
value of the firm

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TWO MODELS OF RADICAL LEFT

Gordons model

Firstly the popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.

Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

𝑫𝒐(𝟏+𝒈)
Po = where Po is Value of the firm, Do is present Dividend, Ke cost of capital
𝑲𝒆−𝒈
and g is growth rate (rate of return * retention rate).

Walters Model

Professor James E. Walter argues that the choice of dividend policies almost always affects the
value of the firm. His model shows clearly the importance of the relationship between the firm’s
internal rate of return (K) and its cost of capital (Ke) in determining the dividend policy that will
maximize the wealth of shareholders. The choice of an appropriate dividend policy affects the
overall value of the firm. The efficiency of dividend policy can be shown through a relationship
between returns and the cost.

If K>Ke, the firm should pay less dividend, retain more earnings because it possesses better
investment opportunities and can gain more than what the shareholder can by re-investing. The
firms with more returns than a cost are called the “Growth firms.

If K<Ke, the firm should pay more dividend, retain less of its earnings, because the shareholders
have better investment opportunities than a firm.

If K=Ke, the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent
towards how much is to be retained and how much is to be distributed among the shareholders.
The payout ratio can vary from zero to 100%.
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 𝑲
𝑫𝒕+𝑲𝒆 (𝑬𝒕−𝑫𝒕)
Po = where Po is Value of the firm, Dt is Dividend at time t, Et is
𝑲𝒆
Earnings (Net operating earnings) Ke is cost of capital and K is rate of return.

MERGERS AND ACQUISISTION

Mergers and acquisitions (M&A) are transactions in which the ownership of companies, other
business organizations, or their operating units are transferred or consolidated with other entities.
From a legal point of view, a merger is a legal consolidation of two entities into one entity, whereas
an acquisition occurs when one entity takes ownership of another entity's stock, equity interests or
assets. From a commercial and economic point of view, both types of transactions generally result
in the consolidation of assets and liabilities under one entity, and the distinction between a
"merger" and an "acquisition" is less clear

Mergers and acquisitions are a global business strategy that enables firms to enter into new
potential markets or to a new business area. Merger and acquisition are not the same terminologies
but often it is used interchangeably. M&A can include a number of different transactions, such as
mergers, acquisitions, consolidations, tender offers, purchase of assets and management
acquisitions.

Merger is the combining of two business entity that may either result in a totally new entity or one
of the existing original one.

Acquisition or takeover is the purchase of one business or company by another company or other
business entity.

Horizontal merger - Two companies that are in direct competition and share the same product lines
and markets.

Vertical merger - A customer and company or a supplier and company. Think of a cone supplier
merging with an ice cream maker.

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Congeneric mergers - Two businesses that serve the same consumer base in different ways, such
as a TV manufacturer and a cable company.

Conglomeration - Two companies that have no common business areas.

In corporate finance the decision to be involved in merger and acquisition can be as a result of
many factors and justifications, some of these include:

- Theory of Differential efficiency

- Theory of Market Power
- Theory of Synergy
- Agency Theory
- Tax Theory

Economic justification: This is the most important motive or theory supporting mergers and
acquisitions. Irrespective of the other motives, merger and acquisition must be economically
justifiable hence yielding to positive net present value for the maximization of shareholders wealth.

FORMULA

(EVA) to validate the merger and acquisition.

Benefits= Vxy - (Vx+Vy)

Net economic gains =Vxy - (Vx+Vy) - (Consideration - Vy) Where:

x is Acquiring firm

y is Target firm –

Vxy is Post merger value – Vx+ Vy +PV of Cost Savings

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