BUSINESS FINANCE FINS1613 SUMMARY Business finance control of companys money and monetary affairs Financial decisions: o Investment

ment amount and type of investments to make determine size, profits, risk, liquidity o Financing how the firm will raise money affect financing costs and financial risk o Dividend how much of profits are given out as dividends vs retained Influences of business finance: o Globalisation extension of markets and company interests around the world due to transportation and communication, demand for quality goods, costs of new products, can operate in several countries and risk o New and improved technology improves the flow of information between companies and improves the processing of data accuracy and speed Responsibilities in business finance: o Financial staff employed to acquire and operate resources in the most effective manner: Forecasting and planning Investment and funding decisions Coordinating and controlling operations Dealing with financial markets Managing risk Types of companies: o Sole proprietorships: Owned and run by one owner Simple to establish, few regulations, avoid corporate income tax Difficult to raise sums, unlimited liability, only lasts as long as owner o Partnerships: Owned and run by two or more people informal or legally binding Cheap and easy to establish Difficult to raise sums, unlimited liability, only lasts as long as owner, difficult to transfer ownership o Corporations: Legally registered company, distinct group of owners and managers Unlimited life, easily transfer ownership, limited liability Liable for corporate tax, legal formalities are lengthy and costly o Hybrid organisations: Formed using combination of above 3 picked to maximize advantages to the firm Capital budgeting long term investment decisions, whether long term investments are profitable or not Capital structure how capital is sourced within firm (equity vs debt) Working Capital short term assets and liabilities Objectives of the firm: o Primary maximize shareholder value o Social and ethical responsibilities safety and welfare of employees, customers, environment Agency issues: o Whenever one group (principles) hire and other (the agent) to perform a service, there is a potential conflict of interest agency problem 1

o For management and shareholders: Separation of ownership and control managers are different to owners may not have same objectives Managers may act in own interests need to be observed (monitoring costs) Can set up contracts to control the managers costly Solutions: compensation packages re incentives, exert influence, fire managers, threaten hostile takeover (as usually fired after acquisition) o For creditors: Creditors have claim on assets if firm goes bankrupt Rate of interest charged depends on riskiness of firms current and future project and expected capital structure But creditors do not control company, shareholders through managers do conflict of interests between creditors and shareholder/managers Once creditors have lent money, they do not get any higher returns if the firm invests in risky projects can refuse to fund in the future, interest rates, or use restrictive covenants Maximizing firm value: o Managers want to maximize share price not always the same as maximizing value of shareholders investment agency issues o Determination of share price: Expected cash flows generated by assets Timing of these cash flows earlier preferable Riskiness of cash flows o Determination of cash flows: Investment decisions The way investments are funded debt vs equity Dividend policy o Share price, EPS, cash flows are correlated all when sales o Take care when using EPS or cash flows as an indicator of share price as also depends on expected future earnings and cash flows Times lines: o Cash flows are written immediately bellows tick marks o Unknown cash flows are denoted with a question mark o Interest rates are written above the line and between tick marks if alter, the rate new rate will be shown between the next tick marks o If rate left blank after, assume same rate as before Time value of money: o Dollar today is worth more than a dollar tomorrow o Present value amount you have today o Interest rate amount bank pays on money invested each year o Interest received amount received during the year o Future value amount you will have in the future o Number of periods in the analysis o FV = PV (1+r) simple interest o FV = PV (1+r)^n compound interest o To discount: FV = PV (1+r)^-n Annuities: o Sequence of equal payments made at fixed times for a specified number of periods 2

o Ordinary annuity payments are made at the end of each time period PV = R [1 (1+r)^-n] /r FV = R [(1+r)^n -1] / r o Annuity due payments are made at the beginning of each time period PV = (1+r) R [1 (1+r)^-n] / r FV = (1+r) R [(1+r)^n -1] / r o FV of annuity due > FV of ordinary annuity b/c payments made earlier and therefore earn more interest Perpetuity annuity that goes on making payments forever A = R / r Uneven cash flows: It is more likely that investments will generate uneven cash flows Calculate PV by adding together all PVs of future cash flows Make changes if time periods change change r (periodic rate) and n The compounding period, the payout Interest rates: o Nominal rate quoted by institutions need to know compounding period to be meaningful o Effective rate of interest actually being earned i = (1 + r/m)^m 1,where m compounding period o Periodic rate charged by lender in each period eg) semi-annual, monthly o Periodic = nominal / compounding periods Bonds: o Form of debt financing contract in which the borrower agrees to pay a specified amount of interest and principle, on designated rates, to the holder o Eg) Treasury bill / Government bonds issues by govt, default risk o Eg) Corporate bonds issues by companies, different levels of default risk depending on characteristics of the firm o Characteristics of bonds: Par value stated face value, value paid at maturity Maturity date specified date when par value is repaid Coupon payment interest paid at each payment date Zero coupon bond no coupon payments sold at substantial discount to allow for capital gains Coupon interest rate interest / face value Floating rate bonds interest rate adjusted periodically to take into account changes in interest rates (some have limits caps and floors) Call provision provision which allows the issuing company to call the bonds for redemption usually pay more than par value to compensate Sinking fund company pays amount into fund periodically which is used to retire a proportion of the firms bonds eg) call provision o Valuing bonds: Present value of all future cash flows ie. par value and coupon payments C [1 (1+r)^-n] / r + FV / (1+r)^n Where: C is interest payment par value x coupon rate r is bonds market rate of interest n is the number of periods until maturity FV is the face or par value paid at maturity 3

If all values are not expressed annually, then change C, r, n to reflect this o Issues in bonds valuation: Changes in market rates inverse relationship between interest rates and bonds values r = b or r = b (due to discounting factor) Interest rate risk r can alter in the future and can alter the value of b: Price effects valuation of future cash flows is calculates using a new market rate of interest Reinvestment effects coupons can be reinvested at the new market rate rather than the old one Causes of interest rate risk: o Term to maturity longer term to maturity, the greater the effect of the change in r will be prices of longer bonds are more sensitive to changes in r o Default risk chance that issuer will fail to make a payment risk, value o Term structure of interest rates: Relationship between the term to maturity and the interest rate for securities of the same risk Suggested determinants: (all theories about how r is set) Market expectation hypothesis says r is set so that investors all receive the same return (av) regardless of security risk? Liquidity premium hypothesis says investors must be given reward (premium) for longer investments (due to risk) Market segmentation hypothesis r in each market is determined independently due to preferred habits of investors in that market Influence of inflation inflation alters the term structure of r as lenders require nominal r to compensate expected inflation, nominal r o Default structure of interest rates relationship between default risk and r probability of default, yield o Other factors affecting interest rate structure: The marketability of securities: Yield differentials = different marketability Only buy marketability if yield than that of marketability Bond have return than shares due to risk Shares: o A share is a stake in a company an owner who has the right to pick the manages and receive any profits o Types of companies: Privately held companies (Closely held) usually small firm owned by a few who are closely involved with the running of the company Publicly owned companies listed on stock exchange number of owners who employ managers to run the firm o Types of shares: Ordinary shares own the firm, voting rights, residual claim on earnings, no guarantees Preference shares usually do not have voting rights, preferred right to dividends (usually a stated percentage of face value) hybrid o Characteristics of shares: Market price value at which traded on the exchange Intrinsic (theoretical) value share value based on the companies fundamentals estimates by each investor using their expectations 4

Dividends payments made to shareholders reflecting performance over the previous year in cash or stock form Growth rate expected rate of dividend growth in the future Required rate of return minimum rate of return on the stock for an investor to buy the share based on alternative investments and risk o Valuation of shares: Capital gains (loss) difference between price bought and sold for Dividends decision made by management no guarantees To value a share, work out PV of all future cash flows to infinity, we may ignore the final sell price and just future dividends to infinity With constant dividend growth rate: P0 = D1 / (ks g) must be div in 1 period from now Dt = D0 (1+g)^t to work out the future dividend Non-constant growth rate value determined by splitting up into different periods constant and non-constant periods Using price-earning ration: Pt = (P / E) x EPS Dt = (1-r)Et , where r is the proportion of earning retained and Et is earnings About the 2 models: Combing the 2 models P0 = (1-r)Et(1+g) / (ksg) Same uncertainty with both models, just use different indicators Capital Budgeting: o The decision whether or not to invest in a project that will generate cash flows o If just one project to consider accept or reject? o Capital budgeting with multiple projects: Independent projects have no impact on each other, decides whether to accept or reject each project independent one or more, or none Mutually exclusive projects company can only accept one investment and must accept all the others due to financial constraints or limitations of financial assets o Types of investments: Replacement of assets: Maintenance of existing business replace equipment: should we continue operation, using same process? usually yes Cost reduction replace inefficient equipment to costs Expansion: Expansion of existing markets or products investment almost always necessary for expansion complex estimations Expansion into new markets or products can be expensive as cash flows are often delayed for some time can involve a change of structure Safety and environmental projects must comply with govt legislation mandatory investments so firm has no choice but to invest no matter no cash flow return still analyse best way and effect Other investments use best analysis approach suited to investment if not one of the above categories o Summary of process: estimate all future cash flows, determine discount rate via riskiness, estimate PV, compare PV with initial outlay, if PV > initial outlay than accept o Techniques for capital budgeting: 5

Payback period: Payback period is the number of years to repay original investment After this is profit, hence the shorter the better Payback period = initial outlay / cash flow ie. CF0 / CFt, if constant cash flow If non-constant cash flow use cumulative: Payback period = year before recovery + unrecovered at beg of Y / flow next year ie. Y + UCF / CF If mutually exclusive, then pick with shorted period Disadvantages merely a break-even analysis ie. no discounting, doesnt take into account any flows after re-paid (even if outlay) Discounted payback period: Extension of payback period deals with second problem Future cash flows are discounted before they are cumulated this means that how we fund the project is taken into account Same decision rule as above Disadvantages doesnt take into account payments after the initial investment is repaid Net present value (NPV): NPV is the value of an investment taking into account the discounted value of all future cash flows Calculate sum of PV of all cash flows including initial outlay If NPV > 0 then accept as will generate more cash than it costs If NPV = 0 then the project will break even If NPV < 0 then reject If mutually exclusive, choose project with highest NPV Internal rate of return (IRR): IRR is the discount rate that results in the project generating returns that exactly equal the costs of the project ie. the discount rate that gives a NPV of 0 If IRR > discount rate, then invest Hurdle rate minimum acceptable IRR for a project CF0 + CF1 / (1+IRR)^1 + + CFn / (1+IRR)^n = 0 If mutually exclusive, choose project with highest IRR Disadvantages assumes cash flows can be reinvested at the IRR rate (most likely at discount rate), possible to get more than one answer if non-normal cash flows Comparing NPV and IRR: o Set up axis with IRR on horizontal, NPV on vertical for 2 projects o Crossover rate IRR that gives equal NPVs o For 2 independent projects, NPV and IRR approach give same answer o For mutually exclusive projects: Using IRR, will pick project with IRR Using NPV, depends on discount rate depends on discount rate in relation to crossover rate Different methods may disagree on which project to select use other factors eg) distribution of cash flows o Where large cash outflow at beginning, and large cash outflow later on, IRR can give 2 answers o IRR also assumes that cash flows from the investments are reinvested at IRR, whilst NPV assumes reinvested at discount more realistic o Therefore NPV seems more preferable Modified IRR: 6

o Finds the discount rate at which PV of the projects costs = PV of terminal value o MIRR = (TV / PV costs)^1/n 1 o When comparing projects: Independent if exceeds hurdle rate Mutually exclusive highest MIRR o IRR vs MIRR MIRR superior because: MIRR assumes cash flows are reinvested at discount rate MIRR will not generate multiple answers o NPV vs MIRR re mutually exclusive If equal size and life span same result If same size but different life span same result if use terminal year of longer project as terminal year of both give shorter project $0 flows If same life span but different sizes may not agree NPV seems easier to use and better Uncertainty and cash flows: o In reality it is difficult to know cash flows exactly estimate free cash flows o Estimating Free cash flows = after tax income + depreciation capital expenditure change in net working capital o Identifying cash flows: Factors that alter project free cash flows: Project requires fixed assets negative cash flow Depreciation dollar value of assets used up tax liability so is added to projects net income NOWC CA - CL If interest charges are removed before discounting, do not remove again when estimating cash flows o Incremental cash flows: The only cash flows that are relevant are those which will be created if the project goes ahead incremental cash flows Factors: Sunk costs not incremental cash flows as do not affect project Existing assets of the firm could be used for other projects opportunity costs so is included in project cost The project may impact on other part of the firm (+ or -) must be considered in deciding whether to accept or reject o Timing of cash flows: Important cash flows should be analysed exactly when they take place not so simple: costly and difficult to gather info Different types of capital budgeting projects: o Incremental cash flows also affected by nature of project: Expansion project uses new assets to sales incremental cash flows are in/out flows the project creates Replacement project replacement of existing assets with new ones incremental cash flows are only the extra in/out flows from new asset Evaluating capital budgeting projects: o Initial investment = upfront costs + necessary in NOWC 7

o Operating cash flows incremental cash flows over the life-span of the project (includes any terminal cash flows) o Net cash flows each year sum of cash flows in each area above use these net cash flows in NPV calculation o Example in lecture notes Ending a project early: o If project not performing as expected, or more profitable project arises, firm can elect to abandon / retire the existing project o Abandonment / retirement company stops a project before it reaches the end o Should be abandoned at the point when NPV of future cash flows < 0 (unprofitable) o There may be some costs in abandoning project loss of establishment costs, opportunity costs eg) lost revenue Project risk analysis: o Corporate risk: Level of risk that a project represents for the firm as a whole Important because: undiversified shareholders exposed, influences share price, impacts firm stability Very difficult to measure as firms involved with many projects, difficult to assess true risk of only one o Stand-alone risk: Risk involved in the project alone Important because: easy to measure, highly correlated with other types of risk eg) corporate and market Techniques for measuring stand-alone risk: Sensitivity analysis measures impact on NPV of a change in one factor Scenario analysis measures impact on NPV when several aspects are changes base (most likely), best, worst case Monte Carlo simulations mathematical simulations that are repeated numerous times to determine how NPV changes under certain conditions o Market risk: Level of risk that the project represents to a well-diversified shareholder who realises that the project is just one investment Important because this type of risk cannot be eliminated by diversification spreading investments of portfolio across different areas and markets to risk o Using project risk in capital budgeting: Risk is reflected in capital budgeting by adjusting discount rate to evaluate risk cash flows risky project has discount rate o Timing investments: Sometimes a company will be able to choose when to invest ie. wait Decision tree diagram that is used to show different possible outcomes each branch represents possible outcome for comparison Shows probability of each outcome so can estimate NPV for each outcome add together for expected NPV But, if the option would lose money (ie. negative NPV), then the firm would not invest so branch becomes 0, not negative The result shows the NPV for investment in year 1 so discount back 1 year for NPV now Select option with highest NPV ie. wait a year or now Only wait if there is no downside to waiting ie. first move advantage 8

Optimal capital budgeting: o Optimal capital budget all profitable independent project + any selected mutually exclusive projects essential for company to decide on funding requirements so it can raise funds in most effective way o Steps: Determine firms discount rate Scale rate to represent the risk of each division in the firm Calculate cash flows and NPV for the firms accepted projects = Optimal capital budget o Capital rationing: Situation in which company has limit to how much it can spend on projects ie. cant raise large amounts of capital, especially small poor performing firms Such a firm must select projects with NPVs with funding requirements it can meet Taxation and capital budgeting: o Classical approach company pays corporate tax on earnings, shareholders pay income tax on any dividends paid double taxing o Dividend imputation system: Treats investors as if they are partners in the system Company pays corporate tax, issues remainder as dividends to shareholders Fully-franked dividends dividends whereby tax has already been paid in full (vs unfranked dividends) Shareholders are informed about their franking credits (ie. proportion of income tax that has already been paid) these are offset against shareholders personal income tax, avoiding double taxing This can impact on firms cash flows and therefore on capital budgeting o Different types of companies: Fully integrated with tax system and issue fully franked shares Not integrated with tax system eg) sole trader, partnership do not issue franking credits Partially integrated with tax system shareholders cannot take full advantage of franking system o Re capital budgeting: Capital budgeting should be treated in different ways depending on whether company issues fully franked or unfranked dividends If using imputation system in tax liability will franking credits issued to shareholders. Shareholder wealth is maximized by pre-tax profits and cash flows but tax deductions ie. need to consider capital budgeting using pre-tax cash flows If not issuing franking credits eg) sole trader, partnership. Owners wealth is usually directly linked to after-tax profits evaluate projects using after-tax cash flows If partially integrated firm company needs to estimate its effective corporate tax rate, reflecting proportion of franking credits that can be effectively used by shareholders use this effective rate in capital budgeting decisions

Week 7: Dollar return: o Amount received amount invested o Better if receive off a outlay, or quicker than longer Rate of return: o Scale the dollar return by the amount invested 9

o Rate of return = dollar return / amount invested o Allows comparison Risk: o Uncertainty regarding the outcome --> anticipated loss is not risk, only unexpected loss o Also seen as variation from the most likely (expected) outcome o Usually two sided in finance ie. someone loses, someone wins Measuring uncertainty probability o Sum of all probabilities = 1 o Discrete vs continuous probability --> in practice continuous Statistics: o Average outcome: Expected rate of return = k(^) = (pi x ki) o Uncertainty of outcome: Deviation = ki k(^) Variance (average squared deviation) = = Pi(ki k(^)) Standard deviation = (square root of variance) Standard deviation measure stand alone risk (risk for only one stock) Standardise risk by scaling by expected return: Chance/Prob of loss Coefficient of variation: CV = / k(^) Ex-ante expectation vs Ex-post realisation: Ex-ante expectations assume we know future probability distribution But in reality, we need to estimate from past data ie. ex-post realisations --> to do this, assume the outcomes are independent they had the same ex-ante probability From a time series of past return: o Estimated k(^) = [ ki ] / n o Estimated = S = (ki k(^)) / n 1 (root all) Risk aversion and risk premium: o We assume investors are risk averse o Risk averse investor prefers certain prospect to an uncertain one with the same expected return o Such an extra return = risk premium Portfolio risk: o Real investors invest in a bundle of stocks --> a portfolio o Investors are concerned with portfolio risk --> by how much will an asset the risk of the total portfolio? o Weight of a security is proportion by value: Weight ws = value of security / value of portfolio Sum of all weights = 1 Return of portfolio is the weighted average of returns: kp = wiki Correlation: o Correlation is measured by the correlation coefficient (r): -1 < r < 1 (or equal to) Perfectly positively correlated (r = 1) stock returns move in step Perfectly negatively correlated (r = -1) stock returns move proportionally in opposite directions Low or zero correlation returns change independently Real correlations: 10

Averages in stock market is 0.65, average = 0.35 Diversification: o Since stocks have correlation < 1, combining them will risk of portfolio vs the stand alone risk of the stock o But because all stocks significantly positively correlated, there is a limit to the amount of risk reduction Risk reduction from diversification Standard Deviation Firm unique diversifiable risk Market risk No of stocks o Market (systematic) risk eg) r changes, growth shocks o Firm specific (diversifiable) risk eg) new CEO, new project

Weeks 10 and 11: Slide 9 as guide for test Risk premium for market risk: o Rational diversified shareholder will only expect a risk premium to compensate for market risk o Market (portfolio) risk < standalone risk diversified shareholder will accept return (pay price therefore setter of market price and return) than undiversified shareholder No risk premium for diversifiable risk: o Only can be one expected return which will be set by diversified shareholders in regard to market risk cannot obtain full return for standalone risk The measure of market risk beta: o Standalone risk = market risk + diversifiable risk o Beta is market risk contribution of a stock to the market risk of a portfolio o This depends on total volatility (standalone risk) and the correlation with market changes o Mathematically: tot = mkt + div o Beta is also the slope of the regression line (line of best fit) of return of asset vs return of market o Beta = correlation coefficient x standalone risk risk of market o Values for beta: Market return has = 1 Average stock has = 1 > 1 stock more risky than average < 1 stock less risky than average Most real stock 0.5 < < 1.5 negative if stock had negative correlation with market very rare Market risk premium: o Risk premium expect extra return required to hold a risky asset (vs risk-free) 11

o Market risk premium expected extra return on the average risky asset also the expected extra return on a value weighted index of the whole market o Depends on investors risk aversion and expectation of variability of market return o Risk premium = expected extra market return expected risk free return o RPm = km krf expected k Capital Asset Pricing Model (CAPM): o Formal theory for relationship between and k (expected return of an asset) o Useful part of CAPM is the Security Market Line relationship o Postulates: Risk premium for an asset = x Market risk premium o ie. SML equation: k = krf + (km krf) or k = krf + (RPm) o Return calculated from SML The Required Return Terms: o Expected return return market expects from the asset in the future calculated from price and expected cash flows IRR o Realised return past return received by investors in the asset mean of actual previous returns o Required return return calculated from theory based on assets market risk o Rational expectations market is in equilibrium when expect returns = required returns rational because: if expected > required, can risk/reward or portfolio by buying more of that asset Undervalued if k(^) > k expected return > required return Overvalued if k(^) < k Fairly valued if k(^) = k

SML Graph k (%) [required return] undervalued km krf Risk () =1 Beta for a portfolio: o Portfolio = weighted average of asset s o ie. p = wi i o kp = weighted average k or kp = krf + p(km krf) Effect of macro factors: o If some macro factor caused r to risk free rate whole SML by Changing risk aversion: o Slope of SML is mark risk premium o If investors become risk averse market risk premium SML slope check graphs for these changes CAPM and SML in practice: 12 overvalued

o Formidable obstacles to testing: Theory is about expected returns can only measure realised returns, and estimate using real returns Theory requires that market portfolio used to calculate s include all risky assets, including intangibles eg) human capital Impossible to get data on such a portfolio o Empirical results: Using stock market to test conformance of stocks to SML Results depend on methods used Some researchers pursed more complex models, adding more factors lack theoretical justification Others argue CAPM correct, and that results of testing are due to use of stock market indexes instead of correct index using all assets o CAPM to estimate costs of capital: CAPM is better than no risk adjustment Should ignore diversifiable risk if aim to max shareholder value Can usefully distinguish between and market risk projects Must recognise that CAPM estimates of cost of capital are imprecise o Examples: and market risk if outcome is sensitive to economic conditions eg) capital goods manufacture, property development and market risk if outcome is insensitive to economic conditions eg) food retailing, water and power utilities o Conclusion: Distinction between standalone and portfolio risk leads to theory of required return for a given level of market risk Can still yield imprecise estimates of cost of capital Still useful to estimate appropriate discount rates for DCF techniques Motivations for estimating cost of capital: o To provide required rate of return (hurdle rate) to use in DCF evaluation o To provide cost of capital for accounting calculations of Economic Value Added (EVA) o Regulators setting prices for monopoly --> aim for zero EVA Components of capital: o Debt: Money raised from investors in return for contractual payments Long term (bonds or debentures), Short term (bank bills, overdraft) Debt may be secured --> default therefore cost of secured debt --> hence risk and cost of other unsecured debt Cost of debt = kd o Preferred shares: Receive fixed dividends Preferred because no dividend can be paid on ordinary shares until preferred shareholders have been fully paid Equity because no legal right to dividend, can only be paid from profit Companies will pay preferred dividends of they can Cost of preferred stock = kp o Ordinary equity: Owners of company 13

Entitled to all remaining funds after other have all been paid Vote at general meetings, appoint/remove directors All limited companies must have shareholders Cost of ordinary equity = ks o Watchpoints: Balance sheets prepared using accrual accounting --> finance techniques such as DFC uses cash accounting therefore components of capital balance sheet headings Equity shares, retained profits, reserves only distinguished for tax purposes --> in finance all are ordinary equity Trade creditors, accruals are all cash flow timing issues --> in finance, cash flow is explicit only interested in point where it becomes cash flows and hence not part of cost of capital Tax considerations rationale: o Usually calculate costs of capital after allowing for company tax because: Maximizing shareholder value is maximizing after tax value To capture investment decisions on tax related cash flows o Tax allowable debt: Market return is after tax cost of capital for equity Interest is tax deductible for the company If company is paying tax, after tax cost of debt = (1-t) x (Market cost of debt) Historic vs current market costs: o Should we use market cost of capital, or cost of the capital to us eg) from retained profits? o Opportunity costs issue --> must use current market costs o Rationale could also use this money to repurchase securities --> this would save the company the market cost of capital = opportunity cost. Alternatively, the investors could reinvest their capital at market rate must use as hurdle Estimating component costs of capital: o Debt: Pretax cost of debt = market yield to maturity of issued debt After tax cost of debt = pretax cost of debt x (1-t) ie. kdAT = kdBT(1-t) To calculate yield when not given: Set up in bond (or other) calculation formula If x% coupon and x% market rate will trade at FVso if P > FV, yield < x% Estimate yieldif value > P, yield must be etc o Preferred shares: Assume companies will always pay preferred dividend when calculating cost of capital --> as failure to pay often results in vote entitlement which dilutes ordinary shareholder control Perpetual preferred shares are a perpetuity Cost = dividend / price Pp = Dp / kp --> kp = Dp / Pp Dividends of preferred stock not tax deductible Do not adjust for tax or floatation cost o Equity: CAPM: Uses SML relationship ks = krf + s(km krf) 14

For: o Backed by theory o Consistent uses market data to estimate market cost of equity Against: o Only useful for listed companies o Estimation problems for o Assumes shareholder diversified Discounted cash flow from dividend growth model: Current price = discounted PV of future dividend cash flows ks = k(^)s = (D1 / Po) + g(^) Estimating growth rate: o From analysts estimates o Expected growth = retention rate x ROE, where: ROE is the expected future return on equity Retention rate is the % of equity earning retained ie. (1 payout ratio) For: o Only requires single current share price and dividend o May be used for unlisted company (price derived from private transactions) o No assumption that shareholders are diversified Against: o Very hard to estimate growth rate o Using retention ratio x ROE is using accounting data to estimate market cost of equity Own bond yield plus risk premium: Assumes relative bond yields reflect relative equity risk ks = bond yield + risk premium Risk premium judgement --> 3-5% For: o Simple to implement --> used by those who dont understand other methods Against: o No theoretical basis o Bond yields are assumed to reflect difference in equity risk between companies: Bond determinants maturity, coupon, r, default risk Equity risk determinants earning variability, market correlation, leverage Only leverage and default risk are somewhat related Should you average? averaging does not imply better answer --> judgement call Floatation costs (of equity): o Cost of raising new capital eg) brokers, underwriters o Negative signal that raising new equity may send o Approaches: Add to initial investment cost Allow for in calculation via DCF model: ks = D1 / Po(1-F) + g(^) o Depends on type of capital and markets perception (re company riskiness and negative signal) 15

o Mainly issue with equity, but equity raising infrequent --> cost per project small o Often ignored or treated outside the evaluation of other decisions Notes: Can use any one of above, or combination --> judgement needed No correct answer --> estimates are imprecise WACC (Weighted average cost of capital): o Cost to company of securities sold to raise funds = return to investor of holder that portfolio o WACC = k = wdkd(1-t) + wpkp + wsks o Factors influencing WACC: Investment policy of firm --> riskiness of its assets - risk = WACC Market conditions eg) r, average risk premium Firms capital structure and dividend policy o Tax imputation and WACC: Effective company tax rate and tax subsidy for debt will be depending on amount of company tax which is claimed as personal tax Dividends must be grossed up by the attached franking credits eg) for cost of equity with DFC, market/company return for CAPM regression o WACC as hurdle rate: Projects should be evaluated with cost of capital appropriate to the risk WACC is average cost for all companies activities --> need some adjustment for individual projects Results of not adjusting for risk: (graph) risk but positive NPV projects will be rejected risk but negative NPV project will be accepted average company risk will returns to shareholder will be than they should be o Types of project risk: Standalone risk cash flow variability Corporate risk effect of project on total firm cash flow Market risk effect on firms market / beta risk Market risk is theoretically correct for maximizing wealth of diversified shareholder Corporate risk relevant to undiversified shareholder, creditors and employees Balance these considerations using judgements o Project risk adjustment procedures: Subjective adjustment of WACC for projects of different risk Evaluate project as if standalone company and estimate for market risk adjustment Use one of above to establish cost of capital for each division and use that for the divisions projects: Pure play find companies that operate only in the same areas as the division, estimate and average s --> difficult Accounting beta regress divisions ROA against ROA of companies in similar markets --> these s are somewhat correlates, but difficult to get ROAs for projects that dont exist Week 11 onwards Capital Structure: o Financial leverage use of debt and preferred stock o Financial risk additional risk resulting from financial leverage 16

o Example re financial leverage Ratios: BEP Basic Earning Power = EBIT / assets ROE Return on Equity = NI after tax / OE TIE times Interest Earned = EBIT / interest Conclusions: To expected ROE, must have BEP > kd because if not, then interest expense > operating income produced by debt-financed assets; therefore leverage income As debt , TIE because EBIT is unaffected by debt and interest expense (Int Exp = kdD) BEP is unaffected by financial leverage The effects of taxes on capital structure: o Classical tax system: Company income is taxed, then shareholders pay tax on dividends o Imputation taxation systems: Company tax is paid, shareholders get a franking credit on dividends Capital gains tax tax paid on real capital profits (1/2 personal rate) o Effect on value of the firm: VL = VU + [ tcI / kd ] VL = VU + PV of annual tax savings Effectively get govt paying some of your interest repayment as it is tax deductible why not borrow everything Costs of financial distress: firm borrows, probability it will default Direct costs liquidation costs (legal, accounting fees) Indirect costs lost sales, value for assets in illiquid markets, managerial time, firm specific human capital etc Thus, Value = Value if all equity financed + PV of tax savings PV of expected bankruptcy costs Company taxes and personal taxes: o VL = VU + [ 1 (1 tc)(1 ts)] D (1 td) where tc corporate tax rate , ts shareholder tax rate (average div + cap gains rates), td debt tax rate o Provide [ ] > 0, VL > VU o But with imputation, no advantage for un/levered firm o Imputation removes any tax advantage for debt, other reasons for debt if return > cost Business risk: o Uncertainty about future operating income (EBIT) how well can we predict operating income? o Business risk does not include financing effects o Determinants of business risk: Uncertainty about demand (sales) variability, risk Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage: 17

Use of fixed costs rather than variable costs If more costs are fixed (ie. do not when demand falls) operating leverage Effect of operating leverage: o operating leverage business risk (because small sales causes big profit break even point area to make a loss, but past break even point profit region ie. region of profit and losses Profits can by by FC mechanise production process variable costs may work, may not Operating leverage can E(EBIT), but also risk in mean but at cost of dispersion ie risk Business risk vs financial risk: o Business risk depends on business factors competition, product liability, operating leverage shared between shareholders and debt holders o Financial risk depends only on the types of securities issued debt = financial risk shareholders only Operating leverage and financial leverage combined: o Degree of operating leverage: DOL = 1 + (FC / NI) o Degree of financial leverage: DFL = 1 + [ I / (FC + NI) ] o Degree of total leverage: DTL = DOL x DFL o Questions Optimal capital structure: o Capital structure (mix of debt, preferred and common equity) at which P0 is maximised o Trades off E(ROE) and EPS against risk the tax benefits of leverage are exactly offset by the debts risk costs o Target capital structure is mix with which firm intends to raise capital o If debt levels , riskiness of firm o This riskiness = cost of debt, but also equity (ks) o The Hamada Equation: Quantifies the cost of equity due to financial leverage ie. if D , tell us the new cost of equity Uses the unlevered beta business risk of a firm if it had no debt L = U [ 1 + (1 T)( D/E ) ] Note: in CAPM is L o Other factors re target capital structure: Industry average debt ratio TIE ratios under different scenarios TIE, rate lender will charge Lender / rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure intangible assets able to borrow Expected tax rate Modigliani-Miller Irrelevance Theory: o Capital structure of a firm is irrelevant to firms value o Uses many assumptions eg) shareholders have same info as managers, no bankruptcy costs, no taxes (MM vs reality graph) o Incorporating signaling effects: 18

Signaling theory suggests firms should use debt than MM suggests This unused debt capacity helps avoid stock sales, which stock price because of signaling effects If we assume: Managers have better info than outsiders and that managers cat in best interest of stockholders, then management would: Issue stock if they think it is overvalued Issue debt if they think stock is undervalued Hence, investors view stock offering as a negative signal empirically cause share price to Conclusions on capital structure: o Need to make calculations but only estimates o judgmental component o capital structures therefore differ widely, even within industries Welsh: (level of detail?) o Empirically found that external stock market influences capital structure mostly (specifically, lagged stock returns) o Concluded that managers are essentially inert ie. capital structure is imposed by external forces and not management intervention Dividend policy: o Decision to pay out earning vs retain and reinvest o Theories: Dividend irrelevance: Investors dont care about payout any OK Investors are indifferent between dividends and capital gains create their own dividend policy ie. want cash sell stock; no cash use div to buy more stock Proposed by MM but on unrealistic assumptions eg) no taxes, brokerage costs difficult to test empirically Bird-in-the-hand: Investors prefer a high payout Investors think dividends are risky than potential capital gains like dividends payout = price Tax preference: Investors prefer a low payout Retained earnings lead to long-term capital gains, which are taxed at rate to dividends capital gains also deferred (therefore still preferred even if taxed equally) payout = price Note: reverse implication for cost of equity eg) tax preference > irrelevance > bird-in-thehand Dont know which theory is correct manager use judgment (must apply analysis with judgment) o Information content or signaling hypothesis: Managers wont dividends unless they think it is sustainable so investors view dividend as managements view of the future Therefore price could reflect E(EPS) not desire for dividends o Clientele effect: 19

Different groups of investors prefer different dividend policies Firms past dividend policy determines its current clientele Therefore clientele effect impedes changing dividend policy (tax, brokerage costs) change unfavourable to existing clientele Residual dividend model: Payout as dividends residual of earnings after taking out retained earnings needed for the capital budget This minimises floatation and equity signaling costs, hence minimises WACC Dividends = Net Income (Target equity ratio x Total capital budget) Then divide this by Net Income for ratio Implies that dividend will change every year empirically wrong Change in investment opportunities: good investment = capital budget = dividend payout good investment = payout Advantage minimises frequency of new stock issues and floatation costs Disadvantages results in variable dividends, sends conflicting signals, risk, doesnt appeal to any clientele Conclusion consider residual model when setting target payout, but dont follow rigidly adjust slowly only if circumstances allow Dividend reinvestment plan (DRIP): Shareholders can reinvest dividends in shares of the companys common stock get more stock instead of cash Types of plans: Open market: o Dollars to be invested are turned over to a trustee, who buys shares on the open market o brokerage costs due to volume, convenient o Equity capital ie. no of shares, doesnt change New stock: o Firms issue new stock (usually at a discount), keeps money and uses it to buy assets o Convenient way for company to expand capital base Firms that need new equity use new stock plans Firms with no need for new equity use open market plans Setting dividend policy: Forecast capital needs over a planning horizons eg) 5 years Set a target capital structure Estimate annual equity needs Set target payout based on residual model Generally, some dividend growth rate emerges try to maintain this growth rate, varying capital structure somewhat if necessary Stock repurchases: Buying own stock back from shareholders Reasons: Alternative to distributing cash as dividends allows investors to realise capital gains as opposed to dividends To dispose of one-time cash from an asset sale To make a large capital structure change 20

Advantages: Stockholder can tender or not Helps avoid setting dividends that cant be maintained Repurchased stock can be used in takeovers or resold to raise cash as needed greenmail reacquisition of shares from hostile bidder at a premium Income received is capital gains rather than taxed dividends Stockholders may take as positive signal management thinks stock is undervalued Disadvantages: May be viewed as a negative signal poor investment opportunities. Repurchase is a zero NPV project (div = price) can signal that this is the best option available to firm (assumes however that market is efficient) Penalties if purpose was to avoid taxes on dividends Selling stockholders may be ill-informed, hence treated harshly Firm may have to bid up prices to complete purchase, thus paying too much for its own stock Reasons for undertaking share buybacks (Lamba and Ramsay 2001): Leverage D/E ratio Information signaling might signal undervaluation Anti-takeover mechanism buyout hostile shareholders Wealth transfer more wealth to shareholders if undervalued Free cash flow cash left after all + NPV projects. Managers reluctant to give up FCF b/c of possible wage may invest in NPV projects instead therefore buy back positive Earnings per share (magic?) false: assets would therefore expect earning to , PE ratio would likely change more risky as D/E (cant work, otherwise would do it to max) Conclusions (of the article): o Share buy backs are good news o Share markets are efficient at pricing with buybacks o Buybacks signal stock is undervalued wealth transfer to those who stay with the company o Stock dividends and stock splits: Stock dividend firm issues new shares instead of cash dividend price as + signal Stock split firm increases the number of shares outstanding no change in price Both number of shares All things remaining constant, both will cause price to to keep each investors wealth unchanged Both may get stock to an optimal price range Stock splits generally occur when management is confident, so are interpreted as positive signals Note cum-dividend (declared but not paid) vs ex-dividend (after paid) o Australian Tax System: Before imputation capital gains taxed at full income rates after indexation for CPI Now (since 1999) no indexation but tax rate is half that of income

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