Week 1 Lecture 1 Wednesday

1. What is corporate finance? The role of the financial manager?

Financial manager chooses projects to invest in.

Goal: maximize shareholder value. Making a company a cash generating activity.

3 financial statements: - profit and loss account

- Balance sheet

- Cash flow statement

Depreciation is a cost in a profit and loss account

2. Financial markets

Capital market
Primary market: When a corporation issues securities( stocks or bonds), cash flows from investors to
the firm.

Secondary markets  stock market game

● Involve the exchange of already issued securities between investors.

● Securities may be exchange traded or traded over-the-counter in a dealer market.

3. Financial statement analysis

▪ Liquidity ratios

▪ Solvency and leverage ratios

▪ Asset management/turnover ratios

▪ Profitability ratios

▪ Market value ratios

Financial statement analysis looks at measures, which are ratios, indicate economic situations in the
firm. It is to assess the financial health of the firm.

But, financial statement do not express the risk.

Financial ratios generally refer to performance in previous years.

This example is of an investment in a new machinery

Depreciation affect income but not cash flow, depreciation is on the profit and loss account

Balance sheet is snapshot of the company in time.

Income statement ( profit and loss account): changes that happen in the balance sheet, left bottom
corner.

Cash flow statement: Can be computed on the balance sheet through the changes of the cash.

Cash come from operations, investing or financing. Cashflow involved in operations or investment
etc.

Depreciation: You need to add the depreciation because it is not a cash flow. When you buy a
machine, money is going out. If you look at depreciation that is the loss of economic value. You can
lose the economic value of the machine, but money is not going out of the company. It is not a cash
flow. But that does not mean it doesn’t have an economic cost. That’s why you still account for it in
the income statement.
On the income statement you see depreciation is -250, so if ou take that into account, you assume
that it is a cash flow. So to avoid double counting , the depreciation of the operation you should add
the depreciation.

Cash: can be computed easier by using the balance sheet: 120 – 126 = -6

Net working capital ( liquidity)

Net working capital = things that is quickly convertible to cash. You want it to be positive but not too
high, because then you have to much stock.

Net working capital = current assets – current liabilities  If positive, then available cash is larger
than cash to be paid in next 12 months.

Current assets: - inventories, receivables ( nog te ontvangen bedragen) , cash

Current liabilities: - Short term debts, Creditors ( schuldeisers )

Slide 38: investments = cash flow  cash outflow of 100

Balance sheet

Liquidity ratios
Current ratio = current assets / current liabilities  ability to pay all bills in this year.

Quick ratio = ( current assets – inventories) / current liabilities  not easily converted into cash.

Solvency ratios  ability to pay all debts when the firm stops to exist
Equity multiplier = total assets / equity

Debt to equity ratio: liabilities / equity

Debt ratio = liabilities / total assets

Times interest earned ratio = ebit/ interest payable

Asset management or turnover ratios  the ability to use the assets

effectively and efficiently
Asset turnover ratio = sales / total assets  sales per unit of asset, how effectively are you
converting assets into sales

Inventory turnover = cost of sales / average inventories  number of times a year the average
inventory is sold

Days in inventory = 365 / inventory turnover  number of days it takes to sell an average inventory

Profitability ratios
Return on assets = net income / total assets ( Sometimes EBIT / total assets)
Return on equity = net income / equity

(net) Profit margin = net income / sales

Market value ratios

Earnings per share = net income / number of shares

Market to book ratio = market value per share / book value per share

Price earnings ratio = price per share / earnings per share

The dupont identity

Return on equity = net income / total equity

Week 1 Lecture 2 Friday

Chapter 4 & 5
Time value of money

1. One-period case (4.1)

2. Multiple-period case (4.2)

3. Compounding periods (4.3)

4. Simplifications (4.4)

5. Applications:

1. Bond valuation (5.1-5.2)

2. Equity valuation (5.4)

3. Firm valuation (5.9)

One period case certainty

Future or compound value

FV = C * ( 1+r)

Present or discount value

PV = C /( 1+ r)

Net present value ( NPV)

NPV = - cost + PV  Slide 10 : fv / 1+r)

If NPV > 0, then good investment

If NPV < 0, then bad investment

Uncertainty,  gives a bigger discount rate

Multiple period case:

FV = C * ( 1 + r ) ^ T

r = ((FV/ C) ^ 1/T) - 1

5de machts wortel is tot de macht 1/5

Slide 14

Simple interest – Calculate interest for the 1 euro, only interest on the 1 euro

1 + (215* 0,0847) = 18,21

Compound interest – interest on the interest, Compound is when you re-invest the rent you get

1 * ( 1,0847)^215 = 39.045.648

PV = C / ( 1 + r) ^T  how much money needs to be invested today to receive 1 euro in 2 years.

 1/ ( 1 + 0,09 ) ^ 2 = 0,84

Slide 18: r = (( PV/ C) ^ -1/T) – 1

A customer of Chaffkin GmbH wants to buy a tugboat today. Rather than paying immediately, he will
pay €50,000 in three years. It will cost Chaffkin GmbH €38,610 to build the tugboat immediately.

The ratio of construction cost (present value) to sale price (future value) is 38,610/50,000=0.7722.
Thus, he must earn an interest rate that allows €1 received in 3 years to have a present value of
€0.7722. ▪ Algebraically, €38,610  (1 + r) 3 = €50,000. Or, 1/(1+r) 3 =0.7722. ▪ Solving for r, gives the
answer: 9%

Cashflow

NPV = - C + c/ ( 1+ r) + C/ (1+ r) ^ 2 etc

Compounding period – stated annual interest rate

Compounding an investment m times a year provides end-of-year wealth of:

r = the stated annual interest rate

Stated annual interest rate: the annual interest rate without consideration of compounding

Effective annual rate( EAR) a.k.a. effective annual yield

Multi-period compounding frequencies

Continuous compounding

FV = C * e ^ r*T

Continuous compounding and PV

A crossword competition is going to pay you €1,000 at the end of four years. If the annual
continuously compounded rate of interest is 8 percent, what is the present value of this payment?

€1, 000 * (1 / ( e ^ 0.8 * 4)) = = €1, 000 * 1/ 1,13771 = €726.16

Simplifications
Perpetuity: income stream of cash flow without an end.

PV = C/r

Growing perpetuity: a constant stream of increasing cashflow without end

PV = C/(r-g)

r = interest rate

g = cash flow rise

Present value Annuity: A level stream of regular payments that lasts for a fixed number of periods
Annuity factor:

Future value Annuity:

FV =

Growing annuity:

g = increase in income stream

Applications – Bond valuation – slide 36

A consol is a perpetuity

Application – equity valuation

Equity value id determined by PV of future CF

Valuation zero growth, & constant growth

Week 2 lecture 1 Chapter 6 NPV and other investment rules

 Chapter 7: making capital investment decisions

Time value of money

Discount rate is used to compare cash flows across time, it compensates for delayed consumption,
risk and inflation.

Nominal discount rate = 6%

Inflation = 2 %

Real discount rate = 1,06/1,02 = 0,0039 = 3,9 %

Net present value: - initial investment + (cash flow year 1 / discount rate) + (cashflow year 2 /
discount rate)

Strengths NPV = Cash flow are appropriate, other approaches ignore cash flows beyond a certain
date, Fully incorporates the time value of money

Payback period:

Here is the payback period 2 years.

Here the payback period is 3 years, but which

one to choose, you should be indifferent. + Cashflows after payback period not taken into account.

Strengths: Good for analysing very small scale investments, firms with severe capital rationing,
simple to understand

Weaknesses: Timing of cash flows, Not taken into account if you get it in 1 year or 5 years.

- Payments after payback period not used

- Arbitrary benchmark for payback period, What is a good payback

period? It is set random

Discounted payback period:

Calculation

Year 1: 30.000/1,04 = 28.846

Year 2: 20.000/1,04^2 = 18.491

Year 3: 10.000/1,04^3 = 8890

Year 1 + year 2 = 28.846 + 18.491 = 47.337  Accumulated discounted cashflow

50.000 – 47.337 = 2663

2663/8890 = 0,3  So discounted payback period is 2,3 years

Strengths: Simple, Uses time value of money

Weaknesses: Ignores cash flow beyond payback period, Arbitrary benchmark for payback period,
What is a good discounted payback period?

Average accounting return

Step 1. Determine Average net income

Step 2. Determine average investment

Step 3. Determine average accounting return (accounting rate of return)

Question: I don’t get the calculation of the

average investment. The store costs 500.000 and if you divide that over 5 years you should get
100.000 as average investment
 Average investment = (500.000 + 0) /2

Strengths: simple return based measure

Weaknesses: Does not use cash flows but an accounting measure, does not use time value of money,
arbitrary target rate of return

Internal rate of return: The discount rate that returns a zero NPV. You want the IRR to be as
high as possible. In exam they will ask mask 1 period.

 Here the IRR = 0,1, until a discount rate of 10%

project accepted

IRR: investing vs financing

Investing: company invests 200 euro to generate cash flows of 100. Cash goes out before it comes
in.  You want the IRR to be as high as possible

Financing: Airline company sells tickets 6 months before the trip and pays salaries and kerosine bills
after the trip. Cash comes in before it goes out.  You want the IRR to be as low as possible

IRR: problem of mutually exclusive investments

Independent project: Acceptance or rejection is independent of the acceptance or rejection of other

projects.

Mutually exclusive projects: You can accept A or you can accept B of you can reject both of them,
but you cannot accept both of them.

IRR: Scale problem

If you look at the IRR you choose opportunity 1,

but looking at the NPV, you should take opportunity 2.

IRR: timing problem

IRR – solving the problem of mutually exclusive investents

By looking at the incremental cash flow. Terug kijken

A-B  incremental cash flow

Terug kijken
 Project A is preferred if discunt rate is
< 15,38%, after that project B

Profitability index

Profitability index ( PI ) = (PV of cash flows subsequent tinitial investment)/( initial investment)

70/1,12 + 10 / 1,12^2 = 70,5

Profitability index – time and scale problem

 20-10 = initial investment ,

70,5 – 45,3 = p1 – p2. As you are comparing option 1 to option 2, you can say that option 1 is better.

Profitability index – capital rationing

  project 1 to invest in

Incremental cash flows in investment selection

Cash flows, sunk costs, opportunity costs, side effects, allocated costs

. Incremental cash flows in investment selection (2) – cash flows

A company wants to invest in a machine with an initial investment of €120,000 and the following
projected yearly data.

What is the size of the incremental

cash flow?

Depreciation is added, because depreciation Is a cost and not a cash flow

Net profit after taxes + depreciation = 77.000 + 40.000 = 117.000 = incremental cash flow

Depreciation is not a cash flow

. Incremental cash flows in investment selection (3) – sunk costs

Definition • A sunk cost is a cash flow that has already occurred
Rule • Ignore all sunk costs
Examples: ● Marketing research on the market potential of a product ● Production permits that
have already

Incremental cash flows in investment selection (4) – opportunity costs

Definition • Opportunity costs are lost revenues that you forego as a result of making the proposed
investment

Rule • Incorporate opportunity costs into your analysis.

Examples: ● An existing building which is used to produce commodities in a new project could have
been rented out as a storage facility: Rents are opportunity costs.
Incremental cash flows in investment selection (5) – side effects
Definition • A side effect is classified as either erosion or synergy. • Erosion is when a new product
reduces the cash flows of existing products. • Synergy occurs when a new project increases the cash
flows of existing projects.

Rule • Include side effects

Examples: ● Erosion: introduction of a new ice cream reduces the demand for another ice cream
produced by the same company

● Synergy: Introduction of a new ice cream enhances the demand for dietary products  candy +
toothpaste

Incremental cash flows in investment selection (6) – allocated costs

Definition • An allocated cost is an accounting measure to reflect expenditure or an asset’s use
across the whole company.

Rule • Should be viewed as a cash outflow only if it is an incremental cost of the project.

Examples: ● Marketing department does the marketing for several production units ● Financial
department does the administration for several production units

Equivalent annual cost method

▪ Machines A and B have unequal lives.

▪ Costs of machine A and B

Which machine to invest in? Compare npv of 2 machines

Assuming a discount rate of 10%, NPV of machines A and B are:

▪ Problem: Machine A has lower NPV of costs, but NPV of A and B are not comparable.  Unequal
lives

▪ Solution: Convert NPV in a constant annual cost (an annuity payment)

Annuity factor at 10%: Present value at t=0 of a 1 euro constant payment in years 1, 2 and 3.

• Goal: find constant annual cost that exactly yields the inferred NPV

Equivalent annual cost method (3) – annuity factor

EAC machine A = 321.05, EAC machine B = 289,28  choose machine B

ARR  accounting rate of return 6.4

Week 2 lecture 2 chapter 8 & 10 Risk analysis, real options and capital budgeting . Risk
and return CAPM

Value share:
Why are future cashflows ( dividends) uncertain? Because there are a lot of
risk.
Production risks, e.g. machine failure, weather conditions ▪

Market risks

● Prices inputs and outputs ● Currency fluctuations (e.g. euro versus pound) ● Changes in consumer
demand or preferences

▪ Institutional risks ● Government policy ● New product (food safety) requirements

▪ Financial risks (risk of not being able to repay debt)

Sensitivity analysis (1)

Step I. Determine the most likely case and compute the outcome

Step II. Change one parameter and compute the difference with the most likely case

Possible outcomes market size, share and price

 Add 300 because it is
depreciation. 1,15 = assumed, it will be given
Depreciation is not a cash flow, but you put it in cash flow

. Sensitivity analysis (3) – Pessimistic on market size (5,000 instead of 10,000)

 base case scenario

Fixed costs stay the same

because it is fixed

Sensitivity analysis (5) – Pessimistic on market share (20% instead of 30%)

Sensitivity analysis (7) – NPVs

What does it tell us?

Backup In case of negative NPVs: more Backup investigation is needed

Influential variables • Sensitivity analysis identifies influential variables, i.e. variables that must be
estimated with more accuracy  in our case the market size & market share are influential variables

Quality information: •How good is the quality of the information about future conditions?

Isolated treatment: Each variable is analysed in isolation from the others

Scenario analysis
Same concept as sensitivity analysis but: More than one variable is varied at the same time,
Considers different future scenarios that are realistic
Break-even analysis (1)

Profit = revenue – fixed cost – var cost

Slope = price
Real options
NPV and other investment rules ignore adjustments after project is accepted

The option to expand after the initial investment

The option to abandon (quit business) after the initial investment

Real options (2) – the option to expand

Optimistic Scenario (50%): NPV first machine = 3 mln

▪ Pessimistic Scenario (50%): NPV first machine = -7 mln

▪ Expected NPV = 0.5×(-7 mln) + 0.5×3 mln = -2 mln

▪ The project is rejected if you only look at first machine!  Ignoring real optin, the option to
expand

▪ NPV of Expansion is 27 million, so the real NPV is:

▪ 0.5 x (-7 mln) + 0.5 × (3 mln + 27 mln) = 11.5 million

Decision trees
Introduction new DVDR

● If successful: NPV of 20 mln

● If not successful: NPV 5 mln

● Probability of success: 0.50 if it goes directly to the market.

● However testing first (costs of 2 mln) and introduce new DVD one year later can increase the
probability of success to 0.9.

● Discount rate is 15%

▪ Should the company undertake the test?

Decision trees (2) – the option to wait

Option to wait = 14,09 – 12,5 = 1,59  NPV test – npv_notest

Portfolio theory
Central question: what is the optimal mix of securities.
If you combine the shares you will yield a lower std. deviation
Optimal mix of shares: basic concepts
The risk of a portfolio of shares is smaller than the weighted average risk of the shares!

▪ Three basic concepts

● Expected returns

● Variance

● Correlation

Expected returns of shares A and B

Variance and standard deviation share A

Deviation
from expected return = rate of return A – expected return A
Standard deviation ( Ra) measure of risk/ fluctuation
We want Ra to be low
Expected return an variance of shares A and B
Covariance and correlation of shares A and B

The return and risk of portfolios

Now a Portfolio of the assets A and B!

▪ What is the return of a portfolio with 60% in A and 40% in B?

▪ XA , XB are the proportions of asset A and B

▪ Expected Return Portfolio with 60% A and 40% B: 0.6 x 17.5% + 0.4 x 5.5% = 12.7%

General Formula variance of expected return of a portfolio two assets with proportions 𝑋𝐴 and 𝑋𝐵:

▪ 𝑋𝐴 2𝑉𝑎𝑟𝐴 + 𝑋𝐵 2𝑉𝑎𝑟𝐵 + 2𝑋𝐴𝑋𝐵𝐶𝑜𝑣 𝐴, 𝐵 = 0.6 2 × 0.0668 + 0.4 2 × 0.0132 + 2 × 0.6 × 0.4 ×

(−0.0049) = 0.024

▪ Standard deviation of this portfolio: 𝑆𝐷𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 0.024 = 15.44%

Relation between covariance and correlation 𝐶𝑜𝑣 𝐴, 𝐵 = 𝐶𝑜𝑟𝑟 𝐴, 𝐵 𝑆𝐷𝐴𝑆𝐷𝐵

▪ Variance portfolio of A and B can be written as: 𝑋𝐴 2𝑉𝑎𝑟𝐴 + 𝑋𝐵 2𝑉𝑎𝑟𝐵 + 2𝑋𝐴𝑋𝐵𝐶𝑜𝑟𝑟 𝐴, 𝐵
𝑆𝐷a𝑆𝐷b

▪ The larger the correlation between A and B, the higher the variance of the portfolio.

▪ If Corr = 1 (perfect correlation), then the standard deviation of the portfolio with 60% A and 40% B
= 20.11%

0.6^2 x 0.0668 + 0.4^2 x 0.0132 + 2 x [0.6 x 0.4 x 1 x 0.2586 x 0.115] = 0.0404 (so standard deviation
is √(0.0404) x 100 = 20.11%)

▪ Weighted average of standard deviation A and B: 0.6 x 25.86%+ 0.4 x 11.50% = 20.11%!

▪ Hence: in the extreme case of perfect correlation there is no reduction of the variance beyond the
weighted average of the portfolio

You want the std deviation to go down. You buy different shares with a negative correlation

The efficient set of two assets

Portfolio theory (14) – Changing correlations

p = -1, then no risk at all

Portfolio theory (16) – Two vs many assets

Why do people choose different combinations of assets?

All about the risk preferences of people
Managing portfolios
RM  return on market
Separation Principle: the optimal portfolio of risky assets is independent of individual preferences

▪ Investors can reduce (increase) their personal risk by lending (borrowing) money and combine
risky assets with risk-free bank accounts

Measuring risk (1) – Beta

In practice: standard deviation is not used as a measure of risk of a portfolio

▪ Standard Deviation is too complicated for a portfolio

▪ Instead a measure is used called Beta

Requires data on

● Return of a security (e.g. return of stocks ING)

● Average return market (e.g. all stocks in AEX)

 slope = beta = 1,5%  if 10% increase of return on
market, you can expect a 15% increase return on security. But that also holds the other way
around. So it is riskier, higher swings

▪ Beta is a measure of the risk

● Beta > 1 indicates the security is MORE risky than the average of the securities on the market

● Beta < 1 indicates the security is LESS risky than the average of the securities on the market

▪ Beta is unit free and can be compared across securities

Measuring risk (6) – Capital Asset Price Model (CAPM)

▪ Beta helps in making expected return and risk of different securities comparable.

▪ Capital Asset Price Model (CAPM) determines the expected return on a security (Re) for a given risk
(Beta) as: ●

Re = RF +  × (RM − RF )  Re = sometimes Rs Re = expected return on security/ cost of equity

capital

● Where:

● RF = Risk-free rate

● RM = Market return (average of the market such as AEX)

The more risk there is, the higher the rate of return. You need to be compensated for the risky
endeavor. Higher beta = higher rate of return on stocks. If the risk is higher

Market premium = Rm - Rf

Week 3 lecture 1 chapter 12 & 15

Ch. 12: Risk, cost of capital and capital budgeting

Ch. 15: Capital structure: basic concepts

CAPM capital asset pricing model (2) – Beta

Shell is quite save investment. Either good or

bad times, the change is not substantial in the rate of return, indicating we do not have a
risky firm here.

CAPM (5) – expected return and beta

Terminal value: the anticipated value of an asset on a certain date in the future.
The value of a business or project beyond the forecast period when future cash flow can be
estimated

The expected return on a project within the firm should be at least as great as the expected return
on a financial asset outside the firm with comparable beta (risk).  can be compared to discount
rate

Use of the CAPM

● Compare expected return of different securities accounting for risk

● Provides the required return on equity for a firm

● Provides the required return on investment for evaluating new projects of all equity firms

For firms financed without debts, this capm gives appropriate discount rate

CAPM (7) – project evaluation and beta

▪ Kazakhmys plc is a metal producer and is an all-equity firm.

▪ It has a  of 1.57. Assume RM = 14.5% and RF = 5%.

▪ RE = RF +  × (RM − RF ) = 5% + 1.57 × (14.5%-5%) = 19.92%

▪ This is the appropriate discount rate for future projects of Kazakhymys with same Beta.

▪ Kazakhmys is evaluating three projects (each costs £100) in Kazakhstan.

▪ Appropriate discount rate is 19.92% (according to CAPM).

Rf = risk free rate = rate that the bank gives you on your savings account. Money you get as rent on
your bank

You want the IRR as high as

possible, then it can tolerate a higher discount rate

Discount rate will

increase when beta increase… More risk = more required return
When a firm goes into debt, you should use the weighted average cost of capital

CAPM (10) – determinants of beta

▪ Two important factors determining Beta:

● Contribution margin

● Financial leverage

CAPM (11) – contribution margin and beta

▪ Company can choose between technology A and B with low and high contribution margin
 Contribution margin = price – variable
cost
Contribution margin: If you increase sales by 1 euro, how much extra would you have on
contribution. Fixed costs not included in contribution

EBIT of
technology B reacts stronger to a change in sales (so Beta with technology B will be higher).

A small increase in volume = low effect on EBIT

CAPM (13) – financial leverage and beta

bAsset = E D + E ´ bEquity + D D + E ´ bDebt Financial leverage = D/E

b asset  weighted
average
Asssets = equity + debt
Cost of capital and debt (1) – WACC ( discount rate assuming
average risk)
▪ A firm uses debt (D) and equity (E) to finance its investments

▪ The firm pays RD for debt and requires RE for its equity

▪ The weighted average cost of its capital (WACC) is then: Ra

▪ The real cost of debt is a proportion (1-tc ) of the actually paid interest RD

Tc = company tax rate

Lower Rwacc is better. If Tc increases, the WACC gets less, depressed effects. Because cost of debt
can be deducted from profits. You don’t pay taxes on debt tat you occur

Debt ( d) = bonds, equity ( E) = shares

Company beta = Re
Can be computed at multiple
level, industry + company

Rd = cost of debt =
subjective estimate

Equity market value:

20,886 mil
Debt market value: 37,483 mil

Equity Weight Equity/(Equity + Debt) = €20,886/(€20,886+€37,483) = 0.358

Debt Weight: Debt/(Equity + Debt) = €37,483/(€20,886+€37,483) = 0.642

Re = Rf + B * (rm – Rf)
Re = capital asset pricing
model
RWacc can be used to
discount the dividends to
determine the value of the
company  combine info of
Rd & Re

Financial leverage and firm value

Firm Value = Value of Assets = Equity (Share) Value + Debt (Bond) Value

What is the optimal structure? Focus on debt / equity

Firm value = sum of all discounted dividends

Company tax rate usually in NL 25%

• Value of the firm depends on

• Future dividends (Divt )  dividends yielded in the future are discounted by WACC

• WACC  used to determine the value of the firm. Discount rate

• Can managers reduce the WACC and thereby increase the value of the firm?

Financial leverage and firm value (3) – no taxes

 Earnings per share =
800/200 = 4
Earnings = 15% of
8000
Interest = 10% of
4000

• Earnings per share

higher for the levered
firm

• Higher return is compensation for increased risk  because you have debt, so more risk

▪ An individual owns 2000 euro and can invest in:

● Strategy A: 100 shares of levered firm (so a firm with debt)

● Strategy B: 200 shares of all equity firm, after borrowing another 2000 euro (home made
leverage) ▪ In both cases the individual has 50% debt and 50% equity

2000/25 = 80
80 * 4 = 320 earnings
ROE = 320 / 2000 =
16 %

4000/20 = 200
200 * 3 = 600
600 -200 = 400
ROE = 400 / 2000 = 20 %
EPS = earnings per share
You go for the unlevered firm
Because you can buy less shares of strategy A you can now buy 80 shares which results in
320 euros profit on your investments of 2000 euros
Initial costs are the same

Financial leverage and firm value (7) – no taxes, Modigliani and Miller (M&M)

• Proposition I – Firm value is not affected by leverage  when there is no taxes

● VL = VU Firms cannot change total value of their outstanding securities by changing the capital
structure

• Proposition II – Leverage increases the risk and return to stockholders  leverage is going into
debt

● rE = rA + (D / EL ) (rA - rD)

● rD is the interest rate (cost of debt)

● rE is the return on (levered) equity (cost of equity)

● rA is the return on unlevered equity (cost of capital)

● D is the value of debt

● EL is the value of levered equity

RA = higher than Rd because its more risky than Rd, so you require a larger rate of return. That’s why
its larger than Rd

▪ Proposition II

● RE = RA + (D / EL ) (rA - rD)

The required return of equity-holders rises when leverage (D/EL ) increases.

Derived from the general WACC formula: RA = RWACC = E D + E ´ RE + D D + E ´ RD

 Rd remain constant
B = debt, D S= E = equity

▪ Assumptions:

● No taxes

● No transaction costs

● Issuing bonds is costless

● Selling and purchasing equity is costless

● Corporations borrow at same rate as individuals

● If corporations would pay lower interest than individuals, then corporations would become
levered and individuals would buy levered firms.

Financial leverage and firm value (12) – with taxes, M&M

800 = only cash flow to the
share holders
Bondholders get 100.
Earnings after taxes goes
to shareholders
Interest rate = 10 %
Debt results in reduction of corporate taxes. This reduction is the increase in the Cash Flow to bond

holders and share holders:

▪ Assuming Cash Flows are Perpetual, the Present Value of this tax advantage is:

This is called the Tax Shield

▪ Value of Unlevered firm (i.e. without debts):

▪ Value of Levered firm (i.e. with debts):  taking debts is attractive because it makes the firm more
valuable

VL = EBIT ´ (1- t C ) RA + t C RD D RD =VU + t C D

▪ Example

▪ An unlevered firm has the

following data

● EBIT €153.85 in
perpetuity

● Corporate tax rate (tc ) =

35%

▪ The firm is considering a capital restructuring to allow €200 of debt. RD = 10% and current RA =
20%

▪ What is the current and new value of the firm under the proposed capital structure?
 ’=*

Proposition II M&M with taxes compared to Proposition II M&M without taxes

❑ Taxes reduce the required return on equity (i.e. RE )

❑ Weighted average costs of capital will become lower as firms increase debt

Rwacc = discount rate

also decreases
Increase the
debt/equity ratio 
increase value of firm

Week 3 lecture 2
chapter 16 & 18
Chapter 16: capital structure: limits to the use of debt
Chapter 18: dividends and other pay-outs
Countries with higher corp tax rate have companies that are more
indebted
Trade-off theory (1) – factors that determine the costs of debt
▪ Factors that increase the costs of debt
● Bankruptcy costs
● Agency costs of debt
● Incentive to take large risks
● Incentive to underinvest
● Milking the property: Extracting too high dividends

▪ Factors that decrease the costs of debt

● Tax deductibility
● Agency costs of equity

Bankruptcy costs
What happens if the firm is
liquidated? Bondholders
get preference.
The bondholders get $200; the shareholders
get nothing.
There can be difference between book and
market value

There is tension between the shareholders and the bondholders. When firm is bankrupt, the money
first goes to the bondholders. So this create an incentive to not acquire that much debt, so the
WACC decreases.
Agency cost -Incentives to take large risks

Boom 100 shares second, boom

100 bonds first.
Shareholders have incentive to
take high risk

Low risk project = 150 = expected

value firm low risk
High risk project 145 expected
value of firm high risk
Agency cost -Incentives to underinvest

▪ 50% probability of a boom and 50% probability of recession

▪ Firm goes bankrupt without project in case of recession!

▪ The project of 1,000 has a positive NPV for the firm as a whole
▪ Still the manager does not want to invest in the project!

▪ Shareholders gain 900, but also bear the costs of the investment of 1,000.  so incentive to not in-
vest
▪ Therefore, it is not in the interest of the shareholders to pursue the profitable project!  share-
holders pay for the investment
The more power the bondholders get, it is less beneficiary for the shareholders

Agency cost – Milking the property

▪ Firms with debt may be inclined to pay out too high dividends in times of financial distress.  to
show that nothing is going on while something is going on. They hand out high dividends (goes to
the shareholders), this leave less for the bondholders. Incentive for the shareholders to hand out
high dividends when things are going bad.
▪ This leaves less for the bondholders in case the firm goes bankrupt

Trade-off theory (9) – factors that determine the costs of debt

Trade-off theory (11): Agency costs of equity
▪ Debts reduce agency costs of equity
● Firms with debts are less likely making unnecessary expenses (i.e. luxury offices, big cars,
expensive trips)
● Debts increase labour productivity.
● Firms with debt are unlikely to accept loss making projects, just for the sake of firm growth
Pecking order theory
Nothing to do with debt
▪ There is a ‘Pecking Order’ in terms of the firms preference for additional capital.  which source
to use for financing
▪ Which source should be used? Retained earnings, new debt, issue new equity.
▪ Two drivers:
● Asymmetric information: managers/owners know more about the true value of the firm than
external financers
● Transaction costs, i.e. costs of attracting new capital
Pecking order theory (3) – Asymmetric information
▪ Example: World Online
▪ Listed in AEX on 17 March 2000.
▪ The introduction price was 43 euros and soon reached 50 euros.
▪ However, a few days later it appeared that the founder had sold her shares for 6 euros several
months before.
▪ The price of the share dropped by 30% in one week and much more later.

▪ New equity is not preferred by managers.

▪ Why? Because investors think that managers of the firm have better information and suspect that
the firm is overvalued.
▪ Price equity often drops substantially after emission is announced.
▪ Heijmans is a stock exchange listed construction company that needed new equity capital in 2009
to strengthen its balance sheet.
▪ The issue of new equity was announced on 9 June 2009.
Pecking order theory
▪ Pecking Order
1.Retained earnings, since this has the lowest transaction costs
2. Issue new debts
3. Issue new equity; New equity capital bears risk of the firm. Firms that issue new equity are seen as
firms that are likely overvalued (which the management knows)
▪ Pecking Order theory:
● Has no optimal amount of debt
● Predicts that profitable firms will use more internal financing and use less debt
● Predicts that firms will keep more cash to finance future projects
Dividend policy
Dividends in the AEX as a percentage of the current stock price.

Dividend policy (3) – Types

▪ Cash dividend
● Paid in cash once, twice or even four times per year
● Dividend payment reduces corporate cash availability for new investments
▪ Stock dividend
● Dividend payment in stocks (additional shares) to shareholder
● E.g. each share gives an entitlement to 0.1 new share.
● No cash leaves the firm
● Increases the number of shares outstanding  value of the individual share can decrease
Dividend policy (4) – Regular cash dividends
From that moment on
Not possible to claim
dividend for the cur-
rent year, for next
year is ok.
Dividend policy (5)
– Regular cash
dividends, Price
behaviour around
exdividend date:
Microsoft
Price drops on ex-di-
vidend
Date
Dividend policy (6) – Regular cash dividends, Price behaviour around
exdividend date: Microsoft

Shares closed at $29.97 and opened at $27.34 next working day, a drop of $2.63. With a 15 per cent
tax rate on dividends, we would have expected a drop of $2.62, and the actual price drop was almost
exactly that amount.

▪ Dividend policy has no impact on value of the firm!

▪ Example:
● Firm has cash flows of 10,000 in year 0 and year 1.
● The firm will stop after year 1.
● Cash flows in year 1 are discounted using discount rate RE

Policy I: Dividends are equal to Cash Flow

❑Dividends in year 1 and year 2 are equal to the cash flow of £10,000. Value of the firm is:

❑With 1,000 shares are outstanding, the value per share is: V0 = Div0 + Div1 1+ RE = £10,000 +
£10,000 1.1 = £19,090.91 Share Price = £10 + £10 1.1 = £19.09

 because you get 10 % more share,

that means the share value drops
Policy II: Initial Dividend is greater than Cash Flow
❑The firm pays a dividend of £11 per share in year 0 (total £11,000). Therefore, an extra £1,000
must be raised.
❑The extra £1,000 is issued as equity at date 0 to new shareholders which require 10% return
❑The new shareholders will demand £1,100 of the date 1 cash flow (£ 1000 + £ 100), leaving only
£8,900 to the current shareholders.
Policy II: Initial Dividend is greater than Cash Flow
❑The cash flows and payments to the shareholders will be:

▪ Policy II: Initial Dividend is greater than Cash Flow

▪ The dividends to the existing shareholders will be:

▪ The present value of the dividends per share is therefore: Share Price = £11+ £8.90 1.1 = £19.0

Week 4 lecture 1 Wednesday

Types of options

An option gives the owner the right: - to either buy or sell an asset, at a fixed price, on or before the
expiration date

Call vs put

Call option gives the owner the right – to buy an asset, at a fixed price, during a particular period

Put option gives the owner the right – to sell an asset, at a fixed price, during a particular period

American vs Europeam style

American style ( call or put option) – The option can be exercised at any time in the period up to the
expiration date

European style ( call or put option) – The option can be exercised only at the expiration date

Call
- November 2020: Price = € 25 ▪

- March 2021: Price > € 25? ▪

- You decide to buy a call option, giving the right to buy Shell in March 2021 for € 25.

- March 2021: Price = € 27

- If I buy the share in Shell, I pay only € 25 instead of.

- I can sell the call option just before the expiration date at a price of € 2.

The value of the call option upon expiration in March 2021:

Someone who creates and sells a call option is writing an option

The writer of a (European) call option is obliged to sell the share for the exercise price at the date of
expiration

The seller of the call option immediately receives the value of the call option at the moment of
writing.

The buyer of the option pays the seller of the call option a compensation for the possible loss upon
expiration: value of the call

November 2020

The writer of the call option Shell (€25) with expiration March 2020 receives current value of the
call: €1.40

March 2021

Possibility 1: the price of the equity is €27

Writer has to sell for 25 and has net loss: 25-27+1.40 = -0.60 Buyer of the call buys for 25 and has net
gain 27-25-1.40=0.60

Possibility 2: the price of the equity is €23

Writer can keep the share and has net profit : 1.40 - 0= 1.40 Buyer of call will not exercise the option
and has loss of 1.40

- The profit of the writer of the option is the loss of the buyer of the option and vice versa

Putt
The value of the put option upon expiration in March 2021:

November 2020

The writer of a put option Shell (€23) with expiration March 2020 will receive the current value of
the put €1.40

March 2021

Possibility 1: the price of Shell is €25

Writer will not buy the share so net profit is : 1.40 - 0= 1.40

Buyer put option will not exercise the option and loses 1.40

Possibility 2: the price of Shell is €21

Writer has to buy the share for €23 so loss is: 21-23+€1.40 = -0.60 Buyer put option will exercise the
option and sells for 23 instead of 21 so net gain is: 23-21-1.40=0.60

- The profit of the writer of the put option is the loss of the buyer of the put option and vice versa

Option strategy
Put- call parity

The value of the call option is related to the value of the put option in the following way

C+E=P+S

C = Price call option

E = Present value exercise price = exercise price /(1 + risk free interest rate)

S = Price asset ( or) /stock

P = Price put option

Protective put

A protective put consists of: - buying the share

 - Buying a put option at the same exercise price as the price of the share

Consider the example buying a share for 50 and a put with the same exercise price

Same payoff

Covered call

Valuing the option

Factors determining call option price

- Share price ( ‘out of the money’, ‘in the money’ )

- Time to expiration

- Interest rates

- Volatility ( variability of the underlying asset

Share price
Time to expiration

Interest rate

A call option is a delayed payment of a share

Money does not have to be spent yet, instead it can yield interest!

Hence, a higher interest rate increases the value of a call, because you can delay the purchase of
the share and cash in the interest.

Volatility

Assume you own a call on stock A and a call on stock B

▪ Both calls have an exercise price of € 38

▪ Stock B has a higher volatility

Pricing

- Binomial option pricing formula

 - Black- scholes option pricing formula

Binomial pricing

The current market price of a share is €50 and the price will be either € 60 or € 40 in a year from
now.

You buy a call that expires in November 2021 with exercise price 50. What are the payoffs in
November 2021?

Cash flow of buying call option €50. ▪

Assume the interest rate is 10 percent.

What is the value of the call right now, so one year before the date of expiration?

- The binomial option pricing model gives a quick computation of the price of the option

- Value call = Share price (at that moment) x Delta – ‘Amount borrowed’

- Rationale: The value of the call is equivalent to a strategy where you buy a proportion of the
share and borrow an amount to finance the purchase of the share

Step 1. Determine the Delta ▪

The value of the call at expiration will be either €10 or 0 (a potential swing of 10 (= 10 – 0) )

▪ The share price will be either €60 or €40 (potential swing of 20 (= 60 – 40)).

▪ The ratio of the swing of the call and the swing of the equity is called Delta

Delta= 𝑠𝑤𝑖𝑛𝑔 𝑜𝑓 𝐶𝑎𝑙𝑙 / 𝑠𝑤𝑖𝑛𝑔 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = (10−0) /(60−40) = 10/20 = 1/2

To value the call correctly, we define a mixed strategy with the same payoffs as buying the call. The
two components of the mixed strategy are:

I. Buy a proportion of the share. The proportion is equal to Delta, i.e. ½ share in this case.

II. II. Borrow an amount of money, i.e. the share is partly financed with equity and partly
with debt.
● The amount borrowed is paid back together with the interest at the time of expiration.

● The amount is such that the mixed strategy gives the same payoff at the moment of expiration as
buying the call

Step 2. Determine the ‘amount borrowed’

▪ Compute the cash flows from buying the call

▪ Determine amount that has to be borrowed to make cash flow at expiration of the mixed strategy
equivalent to the strategy of buying the call

▪ Use either the high or the low cash flow situation:

delta x price share_low - Cash flow_low = amount borrowed x (1+r)

delta x price share_high- Cash flow_high= amount borrowed x (1+r)

Amount Borrowed = (delta x share price_low – cash flow_low)/(1+r)

= (1/2x40 – 0 )/(1+0.1) = 18.18

Note: the same amount is found when using the high cash flow situation:

= (1/2 x 60 – 10)/(1+0.1) = 18.18

Now we know how to determine both the delta and the borrowing, we can write the value of the
call as follows:

Value of call = Share price  Delta – Amount borrowed

6.82 = 50  0,5 – 18.18

Valuing the option – Black Scholes pricing

On October 4 of year 0, the PEC April 21 call option (exercise price = £49) had a price of £4. ▪

The equity itself was selling at £50. On October 4, the option had 199 days to expiration (maturity
date = April 21, year 1).

▪ The annual risk-free interest rate, continuously compounded, was 7 percent.

▪ The variance of Private Equipment Corporation has been estimated to be 0.09 per year.

What is the value of the call option?

Week 4 lecture 2 Friday

Warrants

Convertible bonds

Forward and futures contracts

SWAPS

Warrants: Are call options that – give the right to buy shares
- Directly from a company

- At a fixed price

- For a given period of time

Difference between warrants and options

- Warrants are issued by firms and call options by individuals  raise money through equity
 - Warrants tend to have longer maturity periods than call options

- When a warrant os exercised, a firm must issue new shares in the future. This can have the
effect of diluting the dividends of existing shareholders

The factors that affect call option value affect the warrant value in the same way

Warrants
Warrant is an option to buy a share at a fixed price in the future

Dividend payment now decreases the potential for paying dividends in the future

So a dividend payment decreases the value of a share

The lower share value decreases the value of a warrant

Convertible bonds:
Definition: A bond with an option to convert into shares

▪ Example

- A convertible bond with 1,000 par value

- The bond can be converted into 50 shares (conversion ratio = 50)

- Each converted bond adds 50 shares to the total number of shares

- Firm has 2 million shares

- 10,000 (1000 par value) convertible bonds (7%)

- Conversion ratio of 50,

Dilution of earnings
There are three value components:

- Straight Bond Value

- Conversion Value

- Option Value

Straight bond value

A zero coupon convertible bond yields no interest for the duration of the period. The bond is paid
back in the final year. ▪

A zero coupon convertible bond ($1000 par value), due in 10 years, has a Straight Bond Value of:

▪ (assuming 10% yield to maturity)

▪ A 4% coupon convertible bond ($1000 par value) yields 40 dollar interest in each year of the
period. In the final year the par value will be paid back. ▪

A 4% coupon convertible bond ($1000 par value), due in 10 years has the following SBV

The straight bond value is a fixed value

Convertible bonds – conversion value
Minimum value: straight bond value or conversion value, whichever is highest
Convertible bonds – option value
Holders of convertibles can convert at any time that is beneficial for them ▪ Holders can wait to get
the highest value of either:

● Straight Bond Value

● Conversion Value.

▪ This option to wait creates an option value. It raises the value over both the straight bond value
and the conversion value.

Convertible bonds, valuation

▪ A company issues a $1000 zero coupon (no interest payments) convertible bond due in 10 years.
The conversion ratio is 25 and the interest rate is 10%. The current stock price is $12 per share.

▪ Each convertible is trading at $400

● What is the straight bond value?

● What is the conversion value?

● What is the option value of the bond?

Straight bond value

▪ Conversion value 25 shares × $12/share = $300

▪ Option value (SBV is highest, so take that one) $400 – 385.54 = $14.46

Convertible bonds vs straight debt

Why are convertible bonds issued?

Convertible bonds have lower interest rates than straight debt and give starting firms low interest
costs in the start up phase.

▪ Convertible bonds require less information about the risk profile of the company, i.e. in case the
risk turns out high then the conversion value will be high; if it is low then the SBV offers a floor.

▪ Convertible bonds reduce agency costs of debt (see trade off theory, chapter 16). Bondholder
benefits from a risky project with high expected returns.

▪ Backdoor Equity: Often the only way of raising capital 24 W

Derivates, hedging, speculation

Derivatives are financial instruments that are derived from an underlying asset like a stock or a
commodity

● Options

● Forward and futures contracts

● SWAPS

▪ Derivatives are meant as instruments to reduce risk in trade and production, i.e. hedging risks

▪ If trade in derivatives is done with the goal of earning money, then this is called speculation

Forward and futures contracts

▪ Agreement to buy or sell an asset at some date in the future at a price agreed today

▪ It is NOT an option: both parties are obliged to perform under the terms of the contract.

▪ If you have ever ordered a textbook that was not in stock, you have entered into a forward
contract.

Forward contracts
You order a book that is not in stock
You order a book that is not in stock

A futures contract is special type of forward contract:

– It specifies that a certain commodity can be delivered at any time within a given period at prices
specified today

– Futures are standardized contracts traded on organized exchanges

– Futures are marked to market: daily losses or gains have to be cleared immediately

▪ Financial assets: Indices (AEX, Dow Jones), stocks, Interest, currencies ▪

Commodities:

● Agricultural (Cereals, Food, Fiber)

● Livestock and meat

● Precious and industrial metals like gold, silver, iron, copper ●

Other minerals and materials (asphalt, cement)

● Environmental commodities (CO2 quota, renewable energy)

Characteristics of Commodities with Futures Markets:

● Prices are determined on well-functioning markets; if not futures contracts can be subject to
manipulation

● Specifications are standardised (e.g. uniform quality, standardised size)

● Can be delivered physically

● Can be stored during a period

● Traded in large quantities (e.g. tonnes of wheat)

Futures contracts: hedging by selling

Two options:

● Sell cocoa beans upon harvest in September directly to the market and receive the price prevailing
at that time.

● Sell the cocoa beans in January through a futures contract, which secures the price in September
at $1,735. This is called a short hedge, i.e. the cocoa farmer sells something he does not have yet (he
is short of).

Futures contracts: hedging by buying

In January, a chocolate producer foresees a large demand for chocolate at the end of the year in the
Netherlands due to Sinterklaas.

▪ The price and quantity of chocolate bars have already been fixed in contracts with retailers. ▪ Two
options:

● Buy cocoa beans in September directly from the market at prevailing market prices

● Buy the cocoa beans in January through a futures contract which fixes delivery and price of cocoa
beans in September at $1,735. This is called a long hedge, i.e. he buys something in the future (to
long for)

Futures contracts: marking to market

Futures contracts: hedging

>Eliminating risk by entering in a contract with opposite cash flows

Two counterparties with opposite risks can eliminate risk.

• The risk for a cocoa bean producer is a low price of beans

• The risk for a chocolate producer is a high price of beans

• Hedgers can also transfer price risk to speculators who absorb price risk from hedgers. This
happens through trade in futures contracts

Swaps
▪ In a SWAP, two counterparties agree on a contractual arrangement wherein they exchange cash
flows at periodic intervals.

▪ Types:

● Interest rate swap

● Currency swap

SWAPS: fixed rate floating SWAP

European banks can borrow at the central bank at Euribor rate

Euribor = Euro Interbank Offered Rate

Firm A prefers a fixed rate, because it does not like interest rate fluctuations. However it will cost the
firm 6% interest

▪ Firm B prefers a loan at a floating rate at EURIBOR ▪ Firm B is cheaper in both But...

❑ Firm B has comparative advantage in the Fixed Rate (Firm B is 2.5% cheaper than A)

❑ Firm A has comparative advantage in the Floating Rate (Firm B is only 0.5% cheaper than A)

SWAP:

Firm A will borrow Euribor +0.5% and pays a fixed rate to Firm B Firm B borrows at 3.5% and pays a
floating rate to firm A

SWAP
● The total advantage in the fixed rate and floating rate of Firm B compared to Firm A: (6% - 3.5%) –
(Euribor+0.5% - Euribor)=2%

● Firm A and B get an equal share of the advantage, so each gets 1%.

● They SWAP cash flows such that each has an advantage of 1% from the SWAP

Firm A will borrow Euribor +0.5% and pays a 4.5% fixed rate to Firm B Firm B borrows at 3.5% and
pays the floating Euribor rate to firm A

Pay 4,5 % = 3,5 + 1 % winst

Week 5 lecture 1 chapter 19, 20  equity and debt financing

Equity financing
Why to issue shares?

Share issue is the process by which companies pass on new shares to shareholders, who may
themselves be new or existing shareholders

▪ A share issue can provide funds to expand or otherwise advance the business

▪ A share transfer involves instead existing shares being passed from an existing shareholder to
someone else - no new money is received by the company

Main reasons

First incorporation of a company

▪ Repay of some or all of the company’s borrowing

▪ Growth targets

▪ Fund for a specific project

▪ Purchase of another company

Issue methods

Public issue:

● shares traded on a stock exchange (SE) market

● the firm must register the issue on the SE on which it is listed

● different per each country

▪ Private issue:

● Issue sold only to a few institutions

● No registration statement involved

Public issue

Public issue: the cash offer

▪ Sold to all interested investors ▪ IPO are cash offers

▪ Banks as financial intermediaries aiding in the issue of securities (broker)

▪ 3 methods to issue securities for cash:

● Firm commitment
● Best effort

● Dutch auction underwriting

Dutch auction cash offer

The Rial Company wants to sell 400 shares to the public and receives the following five bids:

Other factors in cash offers

▪ Investment Banking

▪ The Offer Price

▪ Underpricing

The announcement of new equity and the value of the firm

The market value of existing equity drops on the announcement of a new public issue of equity.
WHY?

▪Managerial information

▪Debt capacity

▪Falling earnings

Cost of new issues

▪ Spread or Underwriting Discount

▪ Other Direct Expenses

▪ Indirect Expenses

▪ Abnormal Returns

▪ Underpricing

▪ Green Shoe Option

Right issues

▪An issue of equity to existing shareholders is called a rights issue or rights offering

▪Each shareholder is issued an option to buy a specified number of new shares from the firm at a
specified price within a specified time, after which the rights expire.

Consider the £12.246 billion rights issue undertaken by the Royal Bank of Scotland in April, 2008. The
firm’s equity was selling at £3.58 on the announcement date and current shareholders were able to
buy a fixed number of shares at £2.00 per share within two months.

Mechanics of the right issues

Questions to issues

What price should the existing shareholders be allowed to pay for a share of new equity?

▪ How many rights will be required to purchase one share of equity?

▪ What effect will the rights offering have on the existing share price of the company?

Subscription price

Price that existing shareholders are allowed to pay for a share of equity

▪ A rational shareholder will subscribe to the rights offering only if the subscription price is below the
market price of the equity on the offer’s expiration date

Number of rights
The Royal Bank of Scotland wanted to raise £12,246,020,924 in new equity. With a subscription price
of £2.00, how many new shares did it need to issue? How many rights were needed to buy one
share?

Effect of right issues on the share price

Suppose a shareholder of The Royal Bank of Scotland owns 18 shares of equity just before the rights
offering.

Initially the price of The Royal Bank of Scotland was £3.58 per share, so the shareholder’s total
holding is worth

18 x £3.58 = £64.44.

The shareholder who has eighteen shares will receive eighteen rights.

The Royal Bank of Scotland rights issue gave shareholders with 18 rights the opportunity to purchase
11 additional shares for £2.00.

▪ The holding of the shareholder who exercises these rights and buys the new shares would increase
to 29 shares.

▪ The value of the new holding would be £64.44 + £22 = £86.44 (the £64.44 initial value plus the £22
paid to the company).

▪ Because the shareholder now holds 29 shares, the price per share would drop to £86.44/29 = £2.98
(rounded to two decimal places).

The value to the individual shareholder

The value to the royal bank

Right issue

Shareholders can exercise their rights or sell them. In either case, the shareholder will neither win
nor lose by the rights offering.

▪ The hypothetical holder of 18 shares of the Royal Bank of Scotland has a portfolio worth £64.44.

▪ On the one hand, if the shareholder exercises the rights, he or she ends up with 11 shares worth a
total of £32.78.

▪ In other words, by spending £32.78, the investor increases the value of the holding by £32.78,
which means that he or she is neither better nor worse off.

On the other hand, a shareholder who sells the 18 rights for £0.60 each obtains £0.60 x 18 = £10.78
in cash. Because the 18 shares are each worth £2.98, the holdings are valued at

▪ Thus, shareholders can neither lose nor gain from exercising or selling rights.

Private equity market

Private Placement

▪ The Private Equity Firm

▪ Suppliers of Venture Capital

▪ Stages of Financing

Stages of financing
Breakdown of private equity funding

Debt financing
Bank loans
▪ Lines of credit: arrangements between a bank and a firm. The bank authorizes the maximum loan
amount but is free to quote the interest rate

▪ Loan commitments: the interest rate and the loan amount are pre-specified. Two types:

● Revolver ● Non revolving

Debt financing

Public issue of bonds

Similar issuing procedure as with equity, but the registration statement must include now an
indenture, a written agreement btw the borrower and a trust company
▪The indenture defines:

● Basic terms of bonds: face value

● Property as security: assets

● Protective covenants: positive or negative

● Sinking funds: account for repaying the bond

● Call provision: to repurchase or call the bonds

Example of a bond

Features of bond
Amount of Issue ▪ Date of Issue ▪ Maturity ▪ Face Value ▪ Annual Coupon ▪ Offer Price ▪ Coupon
Payment Dates ▪ Security ▪ Sinking Fund ▪ Call Provision ▪ Call Price ▪ Rating

Example bond price

Suppose Nero SpA has issued 100 bonds. The amount stated on each bond certificate is €1,000. The
total denomination, face value or principal value of the bonds is €100,000.

▪ Suppose the bonds are currently priced at 100, which means 100 percent of €1,000. This means
that buyers and sellers are holding bonds at a price per bond of €1,000. If interest rates rise, the
price of the bond might fall to, say, 97, which means 97 percent of €1,000, or €970.

Bond rating
Patterns of financing

Week 5 lecture 2  chapter 26 short-term finance and planning

Balance sheet
Current liabilities = short term
assets

Current assets  cash and assets

expected to be converted in cash
within 1 year

How to define cash

Company issue new stock  increase cash

Interest on long term debt is paid  decrease cash

Net working capital + non-current assets = non-current liabilities + equity  balance sheet equation

Net working capital = cash + other current assets – current liabilities

Cash + other current assets – current liabilities = non-current liabilities + equity – non-current assets

Cash = non-current liabilities + equity – net working capital ( excluding cash) – non-current assets

How do the following activities impact cash?

Marketable securities are sold  increase cash

Property is purchased and paid for with short term debt  No impact

Increase in non- current assets; but also short term debt, so the current liabilities will increase  the
2 effects will offset each other.

Sources and uses of cash

Statement of cash flows:

Operating cycle and cash cycle

A typical manufacturing firm’s short term operating activities consist of a sequence of events and
decisions:

These activities create the patterns of cash inflows and cash outflows that are both unsynchronized
and uncertain.

Unsynchronised : purchase to the firm is not the same day as when the purchase of the raw material
happens

Uncertain: company not sure if customer pay on that date or a little later, can have an impact on
firm
 Negative cash cycle: you receive cash for end
product before you pay cash for raw
materials.

Example

We can determine the operating cycle and

the cash cycle for Antofagasta after
calculating the appropriate ratios for
inventory, receivables, and payables.
Consider inventory first. The average
inventory is:

Average inventory =

Inventory turnover ratio = cost of goods sold/ average inventory

Days in inventory = 365 / inventorty turnover ratio

245,896,000 = begin

148,678,000 = end

4,78 times a year inventory get sold

turnover

Average accounts receivable, Average receivable turnover, Days in receivables, Average payables

Accounts payable deferral period , Accounts payable deferral period , Days in payables

Same applies to receivables and payables

average receivable
turnover= credit
sales/ average
receivables

Operating cycle = days in inventory + days in receivables

Cash cycle = operating cycle – days in payables

Every …. Days on average the firm receive cash after it pays its bills

Current Assets and Current Liabilities in Selected Companies

Short-Term Financial Policy

Two Components

●The size of the firm’s investment in current assets

●The financing of current assets

Size of investments in current assets

Flexible Policies  Disadvantage: rather costly, because firm need to invest in cash. Advantage:
customer satisfaction goes up + could stimulate future sales

• Keeping large balances of cash and marketable securities

• Making large investments in inventory

• Granting liberal credit terms, which results in a high level of accounts receivable

Restrictive Policies  less costly, but risk they might run out of inventory

• Keeping low cash balances and no investment in marketable securities

• Making small investments in inventory

• Allowing no credit sales and no accounts receivable

Carrying costs
▪ Costs that rise with the level of investments in current assets ▪ Generally, two kinds of carrying
costs:

● Opportunity costs: The rate of return on current assets is lower compared with that on other
assets ● Costs for maintaining the economic value of inventory: Warehouse storage fees, taxes,
insurance, employee costs

Shortage costs
▪ Costs that fall with the level of investments in current assets

▪ Cash-out and stockout

▪ Generally, two kinds of shortage costs:

● Trading or order costs

Costs of placing an order for more cash (brokerage costs) or more inventory (production set-up
costs)

● Costs related to safety reserves

Costs of lost sales and consumer goodwill, disruption of production schedules

A balanced policy
Sum of carrying + shortage cost =
minimum
A flexible policy

A restrictive policy
Shortage cost are lower

Alternative financing policies

In an ideal world, net working capital is always

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

In an ideal world, net working capital is always

zero, because short-term assets are financed
by short-term debt.
In an ideal world, net working capital is always zero, because short-term assets are financed by
short-term debt.

Different strategies in financing current assets

Long term + short term financing =

total asset requirement

What is the best policy?  long term

since its riskier

▪ Important Considerations

● Cash Reserves  is there a lot of

cash reserve

● Maturity Hedging  Short term asset + short term debt and long term assets + long term debt

● Term Structure

▪ Check short-term and long-term interest rates:

● https://data.oecd.org/interest/long-terminterest-rates.htm

Cash budgeting
Fun Toys has a 90-day collection period, and 100 percent of sales are collected the following quarter.
In other words

Collections = Last quarter’s sales

This relationship implies that Accounts receivable at end of last quarter = Last quarter’s sales

We assume that sales in the fourth quarter of the previous fiscal year were €100 million. From the
previous equation we know that accounts receivable at the end of the fourth quarter of the previous
fiscal year were €100 million, and collections in the first quarter of the current fiscal year are €100
million. The first quarter sales of the current fiscal year of €100 million are added to the accounts
receivable, but €100 million of collections are subtracted. Therefore, Fun Toys ended the first
quarter with accounts receivable of €100 million. The basic relation is

Ending accounts receivables = Starting accounts receivables + Sales - Collections

Cash collection

Cash disbursement Cash Outflows

● Payments of Accounts Payable

● Wages, Taxes and Other Expenses

● Capital Expenditures

● Long Term Financing

Use of cash
Purchases = half of next
quarter sales
Payments of accounts
payable = purchases of
quarter before
Cash balance
(35) not covered,
because of delayed
payments
Short term financial plan
▪ Unsecured Loans: the most common way to finance temporary cash deficits

▪ Secured Loans: usually, for short term loans, they consist of account receivable or inventories

▪ Other Sources: e.g. commercial papers of short maturity

Message to take home

▪ Short-term finance involves short-lived assets and liabilities. We saw how current assets and
current liabilities arise in the shortterm operating activities and the cash cycle of the firm.

▪ Managing short-term cash flows involves the minimization of costs. The two major costs are
carrying costs and shortage costs. The objective is to find the optimal trade-off between these costs.
▪ In an ideal economy, a firm could perfectly predict its short-term uses and sources of cash, and net
working capital could be kept at zero. In the real world, net working capital provides a buffer that
lets the firm meet its ongoing obligations.

▪ The financial manager can use the cash budget to identify shortterm financial needs. The cash
budget tells the manager what borrowing is required or what lending will be possible in the short
term.

Practice exam

Assignment 1
Give the right or best answer.
(1)
If you desire maximum diversification, you should search for stocks with a correlation
coefficient equal to:
a. +1.0
b. 0.0
c. -1.0
d. +0.5

(2) Which statement is correct?

a. The IPO is never a cash offer.
b. Share issue is the process by which companies pass on new shares to new or existing
shareholders
c. Share transfer involves only new stakeholders
d. All the previous statements are false

(3) As to Modigliani and Miller, under perfect market conditions the value of a firm
doesn’t
depend on its financial structure (leverage). The mechanism that leads to the same value
of all
firms with a certain amount of earnings is called:
a. option valuation
b. arbitrage
c. capital asset pricing
d. dividend discount model
(4)
A firm has the possibility to buy European call options Unilever, expiring in august, exer-
cise
price $ 25. There is a 50% chance that the share price at the strike moment will be
$ 45 and a 50% chance that it will be $ 20. The option delta is:
a. 0.6
b. 0.8
c. 1.0
d. none of the above

option delta = Swing call/ swing equity

20/25 = 0,8

(5)
Karen believes the financial markets are efficient. T-bills, which she considers risk-free,
yield
7 percent and she believes the S&P 500 will return 13 percent. A regression of the excess
returns of Patia Labs has a slope of 1.25 against excess returns of the S&P 500. Using
CAPM,
what is her expected return on Patia Labs?
a. 11.5 percent
b. 12.5 percent
c. 13.5 percent
d. 14.5 percent

Expected return using CAPM = Re = Rf + Beta * ( Rm – Rf) = 0,07 + 1,25 * ( 0,13 -0,07) =
0,145
Beta = slope
(6)
Which statement is false?
a. Capital structure theory explains the changes in the various costs of capital when the
degree of leverage changes.
b. According to Modigliani and Miller, the total market value of a firm depends on its
underlying profitability and risk.
c. The greater the costs of bankruptcy, the lower the value of a levered firm to investors.
d. The traditional approach implies that there is not an optimal capital structure for a firm.
(7)
Which condition is required for Modigliani and Miller I to hold?
a. Equal access to all relevant information
b. No transaction costs
c. No taxes
d. All of the above
(8)
Which statement is false ?
In investment analysis…
a. Cash flows matter—not accounting earnings.
b. Sunk costs don’t matter.
c. Inflation doesn’t matter.
d. Time value of money matters.

(9) I Higher volatility of stock means higher option value.

II With the exercise of warrants, no new shares come into circulation, with the
exercise of options, extra shares are brought in circulation.
a. I is true and II is true
b. I is true and II is false
c. I is false and II is true
d. I and II are false
(10) The internal rate of return method of capital budgeting assumes that the cash flows
from a project can be reinvested at the:
a. required rate of return
b. project's internal rate of return
c. risk-free rate
d. beta

(11)
As a company increases its degree of leverage, the
a. solvency will be influenced positively
b. premium for business risk increases
c. premium for financial risk increases
d. the required return on equity doesn’t change
(12)
The security market line relates:
a. expected return to standard deviation
b expected return of securities to expected return of portfolios
c. expected return to beta
d. efficient sets of portfolios to the risk-free rate
(13)
Right issue is ..
a. An issue of shares to new shareholders
b. A form of IPO
c. An issue of equity to existing shareholders
d. None of the above
(14)
A company realizes a return on equity, after 30% taxes, of 14%. The return on total assets
(before taxes) is 15%. The interest rate is on average 8%. What is the company’s debt-to
equity ratio?
a. 3/7
b. 4/7
c. 5/7
d. none of the above
Rwacc = ( E/ D+ E)* Rf + ( D/ D + E) * Rd * ( 1 – Tc)

(15) Avalon Plc has ordinary shares in issue that have a current market price of $ 1.50. The
dividend expected for next year is $ 0.20 per share and future dividends are expected to
grow
at a constant rate of 3% per year.
What is the cost of equity?
a. 13.33%
b. 16.33%
c. 24.50%
d. None of the above
0,2/1,5 +0,03 = 0,163
(16)
According to Modigliani and Miller in a world without taxes, the total market value of a
firmincreases when its (…?…) increases.
a. profitability
b. business risk
c. leverage
d. arbitrage
(17)
The Royal Bank of Canada wants to raise $12.246.020 in new equity from its existing
shareholders. The number of outstanding shares is 10.094.241. With a subscription price
of
$2.00, how many rights are needed to buy one share?
a. 1.648
b. 1.587
c. 2.310
d. 1.696
12.246.020/2 =6.123.010
10.094.241/ 6.123.010 = 0,1648

(18) A firm has bought a call option (100 shares) Unilever, expiring in September, exercise
price $ 25 at a premium of $ 0.50. The current market value of one share is
$ 24. Which statement is true?
I The current market value of the option is zero.
II If the option would expire now, the loss for the firm would be $ 100.
a. I is true and II is true
b. I is true and II is false
c. I is false and II is true
d. I and II are false
(19) Which formula describes the relationship between the value of an unleveraged firm
with a leveraged one?
a. VL = Vu + rD * D
b. VL = Vu + Tc * D
c. VL = Vu + rD * Tc * D
d. None of the above.
(20) In a world with taxes and M&M-propositions:
I The value of the firm decreases with more debt financing.
II The Wacc decreases with more debt financing
a. I is true and II is true
b. I is true and II is false
c. I is false and II is true
d. I and II are false

Assignment 2
A.
Eureka Space Technology Group (an all-equity firm) is announcing a $ 100 million R&D
project, which is expected to drastically improve its satellite launching technology by
reducing its annual launching costs from $ 500 million to $ 475 million. The firm can fin-
ance
the project through either retained earnings or a new bond issue. The firm’s cost of equity
capital is 12.5%. The prevailing market rate of interest for comparable corporate bonds is
8%. Currently, the firm has 15 million shares of stock outstanding at $ 32.5 per share. The
firm has sufficient earnings to fully utilize the corporate tax shield if the project is debt
financed. Assume the marginal corporate tax rate is 35%.
1. Which financing method, retained earnings or external debt financing, would you
recommend to the management and why?

Based on the assumptions made by MMI with corporate taxes, debt would be the optimal source
of financing because the equity holders realize the benefit of the debt interest tax shield.
However, this conclusion wholly ignores the presence of bankruptcy costs and financial distress,
two economic realities that can greatly impact the decision to use debt as a means of financing.

2. What is the resulting PV of the firm from each of these two financing methods?
Project PV using Retained Earnings:
Investment = $100 M After-tax Savings = $25 M*(1-tc)
Unlevered Cost of Capital = 12.5%

The firm value before the project announcement is simply its market capitalization:
Market Capitalization = 15 million shares * $32.50 / share = $487.5 M
Therefore, firm value post announcement is $487.5 M + $30 M = $517.5 M

Project PV using External Debt Financing

The difference in using debt financing arises because of the debt interest tax shield.

Therefore, firm value post announcement is $487.5 M + $65 M = $552.5 M

3. What do you expect will be the stock market stock price response to the different
methods? Explain your statement.
B.
Ryan Home Products Inc. issued $ 430,000 of 8 percent convertible bonds. Each bond is
convertible into 28 shares of common stock anytime before maturity. Suppose the current
price of bonds is $ 1,180 and the current price of Ryan common stock is $ 31.25.
4. What is the conversion ratio?
The conversion ratio is 28
5. What is the conversion value of the convertible bonds?
The conversion value is the conversion ratio times the current stock price.
6. Name one difference and one equality between the possession of warrants and the
possession of convertibles by a portfolio-holder.
You acquire shares on deliverance of warrants and/or bonds. Difference: warrants loose
eventually their value, convertibles are normal bonds + an option to buy shares. Even if the option
is valued 0, the bonds have value.

C.
You bought a 100-share call contract three weeks ago. The expiration date of the calls is
five weeks from today. On that date, the price of the underlying stock will be either $ 120
or $ 95. The two states are equally likely to occur. Currently, the stock sells for $ 96; its
strike price is $ 112. You are able to purchase 32 shares of stock. You are able to borrow
money at 10%/year.
7. What is the value of your call contract?
Value the call by examining the value of the investment combination, which duplicates the payoffs of
the call. The investment strategy, which duplicates the payoffs of the call, is buy stock and borrow
money.

* The net payoffs of the duplicating strategy must be the same as the payoffs of the call. To have the
payoff be $800 when the stock price is $120, the repayment of the loan and its interest must be
$3,040. If the annual interest rate is 10%, then the interest rate applicable for the five week life of
the call is (1.10)^5/52 - 1 = 0.00921. Thus, the amount which you must borrow to be sure you repay
$3,040 is $3,012.26 [= $3,040 / 1.00921].

The cost today of purchasing 32 shares of stock is 32  $96 = $3,072. In addition you will borrow
$3,012.26. The borrowing generates a cash inflow. The cost of establishing this strategy is $3,072 -
$3,012.26 = $59.74. $59.74 is the cost of setting up a strategy, which duplicates the contract. Since
the contract covers 100 shares, each call is worth $0.5974 [= $59.74 / 100].
Assignment 3
A.
Pinnacle Lombo Company is evaluating a new saw with a life of 2 years. The saw costs $
3,000, and future after-tax cash flows depend on demand for the company’s products. The
probability tree of possible future cash flows associated with the new saw is:
The discount rate is 10%.
1. Calculate the NPV, using joint probabilities.

2. Suppose the possibility exists to stop after 1 year. In that case the cash flows of year
two are replaced by a certain cash flow of $ 2000 at the end of year 1.
What is the value of the option to stop?

Value of the option 826.4463 - 595.0413 = €231,41 CF1 is 3500 if the option is exercised namely
$1500 (period 1) + $2000 (salvage value).
B.
Suppose a company has no debt and an equity of $ 300,000. EBIT is $ 60,000, taxes are
40%.
Calculate:
3. rs
rE = (60000 x 0,6)/ $ 300,000 = 12%.
rA = 12% = rE (unleveraged!)
Vu = 36000/0.12 = $ 300000 =equity value
4. Suppose the company is able to sell debt ($ 100,000) carrying 6% interest and
repurchase stock for the same amount. What is then:

a. VL?
a. VL = Vu + Tc x D VL = $ 300,000 + 0,4 x $ 100,000 = $ 340,000
EL = $ 340,000 - $ 100,000 = $ 240,000

b. Wacc?
Wacc = 100/340 x 6% x 0.6 + 240/340 x 13.5% = 10.58823% NB: rE = 12 + (12-6) x 100/240 x 0.6 =
13.5%

c. The relationship between VL, EBIT after tax and Wacc?

c. check: VL = (60 x 0.6)/0.1058823 = $340,000

C. Consider the following cash flows on mutually exclusive projects.

Year Project A Project B
0 -$ 40,000 -$50,000
1 + 20,000 + 10,000
2 + 15,000 + 20,000
3 + 15,000 + 40,000
Cash flows of project A are expressed in real terms while those of project B are expressed
in nominal terms. The appropriate nominal discount rate is 15%, and the inflation is 4%.
5. Which project should you choose?
Real interest rate = (1.15 / 1.04) - 1 = 10.58%
NPVA = -$40,000+ $20,000 / 1.1058 + $15,000 / 1.1058 ^2 + $15,000 / 1.1058^3 = $1,446.76
NPVB = -$50,000+ $10,000 / 1.15 + $20,000 / 1.15^2 + $40,000 / 1.153 = $119.17
Choose project A.
6.
Using the NPV for investment selection, projects should be comparable with respect to
lifetime and amount invested. What supposition(s)/techniques could you use to make pro-
jects
with different lifetimes and amounts invested comparable with respect to their NPV’s?
(answer in words)
Use the equivalent annual profit method.

Assignment 4
A. SLTRSWG plc is a well-established company that has run into difficulty in recent years.
Its management has recently undertaken a review of its activities and has decided to
restructure the business. To restore the company’s financial stability, it has been decided
it will be necessary to raise £160 million through a rights issue. After consulting its invest-
ment bankers the company is planning to make the rights issue at a discount of 20% to the
current market price of £5. The company has 100 million shares outstanding.
1. What is the value of a right?
Number of new shares: £160: £4=40 million
New share price = (£40*4+£100*5)/140 = £4.71
Value of a right = Old price – new price = £0.29
2. Show that a shareholder with 10,000 shares who sells his or her rights is not worse of
than a shareholder who exercises the rights.
(i) Pay 4,000 shares for £4 each = − £16,000
Own 14,000 shares for £4.71 each = £66.000
Net wealth = £66,000 − £16,000 = £50,000

(ii) Sell 10,000 rights for £0.29 each = £2,900

Own 10,000 shares for £4.71 each = £47,100
Net wealth = £2,900 + £47,100 = £50,000

B.
1. Explain what is meant by cash budgeting.

The cash budget shows the cash inflows and outflows in future periods so that a finance manager
can forecast their firm’s short-term financing requirements
2. Name the various ways a firm can finance a short-term cash deficit.
A firm can finance its short-term funding requirements through unsecured loans from banks,
secured loans, banker’s acceptances, or commercial paper.

3. Review the various financing policies to manage current assets.

Financing policies can be flexible or restrictive. Flexible short-term financial policies include
keeping large balances of cash and marketable securities, making large investments in inventory,
and granting liberal credit terms. Restrictive short-term financial policies are keeping low cash
balances and no investment in marketable securities, making small investments in inventory, and
allowing no credit sales and no accounts receivable.
Quizes

Week 2 quiz/assessment 1
Question 1: If you invest €1000 in a savings account that pays 4 per cent
every year, how long would it take you to triple your money (in years)?
(Round your answer to 2 decimal places and use a comma before the decimal
places. (e.g., 32,16)).
Answer 1

PV = €1000; r = 4%; FV = 3 × PV = €3000; t = ?

PV = FV/(1 + r)t
€1000 = €3000/(1,04)t

Solve for t.

1,04t = 3
t In(1,04) = In 3
t = ln 3/In(1,04) = 28,01 years

Question 2: An investor purchasing a Belgian consol is entitled to receive

annual payments from the Belgian government forever.

Required:
What is the price of a consol that pays EUR 5 annually if the next payment
occurs one year from today? The market interest rate is 3,6 per cent
Answer 2

PV of perpetuity = c/r= EUR 5/0,036

PV = EUR 138,89

Question 3
You are planning to save for retirement over the next 30 years. To do this,
you will invest £340 a month in a share account and £340 a month in a bond
account. The return of the share account is expected to be 5,4 per cent, and the
bond account will pay 2,4 per cent. When you retire, you will combine your
money into an account with a 4,4 per cent return.
Required:
How much can you withdraw each month from your account assuming a 25-
year withdrawal period (in £)?
Answer 3

Step 1: Find monthly rate of return on share investment:

r = (1 + 0,054)1/12 − 1 = 0,4392%

Find monthly interest rate on bond investment:

r = (1 + 0,024)1/12 − 1 = 0,1978%

Step 2: Calculate future value in 30 years of share investment

FV=C[(1+r)Tr−1r]=C[(1+r)T−1r]FV=C[(1+r)Tr−1r]=C[(1+r)T−1r]
T = 30 × 12 = 360
C = £340
r = 0,4392%
FV = £297546,35

Calculate future value in 30 years of bond investment

FV=C[(1+r)Tr−1r]=C[(1+r)T−1r]FV=C[(1+r)Tr−1r]=C[(1+r)T−1r]
T = 30 × 12 = 360
C = £340
r = 0,1978%
FV = £178215,24

Total Value of investment in 30 years is £297546,35 + £178215,24 =

£475761,59
Step 3: Calculate monthly rate on retirement investment

r = (1 + 0,044)1/12 − 1 = 0,0036%

Step 4: Calculate monthly payment

T = 25 × 12 = 300 months
PV = £475761,59
r = 0,0036%

PV=C[1r−1r(1+r)T]PV=C[1r−1r(1+r)T]
C = £2594,46
Question 4
Fang plc pays dividends that are expected to grow at 5 per cent each year.
These will stop in year 5, at which point the company will pay out all its earn-
ings as dividends. Next year’s dividend is EUR 0,61 and its earnings per share
at the time will be EUR 1,06.

Required:
If the appropriate discount rate on Fang plc shares is 9 per cent, what is its
share price today?

Answer 4

The retention ratio of Fang plc is (EUR 1,06 − 0,61)/EUR1.06 = 0,4245

The dividends are given below:

Year 1 2 3 4 5
DividendEUR 0,61EUR 0,6405EUR 0,6725EUR 0,7061EUR 0,7414

Earnings at year 5 are EUR 0,7414/(1 − 0,4245) = EUR 1,2883.

To value this company, we discount the dividend stream to present day and
then treat the EUR 1,2883 as a perpetuity since the firm will no longer grow.
The present value of the dividend stream from years 1 to 4 is EUR 2,1182
when discounted at a rate of 9%. = 0,61/1,09 + 0,6405/1,09^2 +
0,6725/1,09^3 + 0,7061/1,09^4 = 2,1182

We use the perpetuity shortcut to value the remaining cash flows.

V4 =EUR 1,2883/0,09
=EUR 14,3144
V4 =EUR 14,3144/(1,094) = EUR 10,1407

So the share price of Fang plc is EUR 2,1182 + EUR 10,1407 = EUR 12,26.

Question 5
Ahold Delhaize has just paid a dividend of €1,08.

Required:
If the annual discount rate on Ahold Delhaize shares is 8 per cent and the div-
idend is expected to grow at 3 per cent per year, what is the current share
price of Ahold Delhaize?

Answer 5

You must first find the Dividend at time 1:

Div1 = €1,08 × 1,03 = €1,1124

P0 = €1,1124/(0,08 − 0,03) = €22,248

Week 3 quiz/assessment 2
Question 1:

A project has annual cash flows of –€45000, €36800, €16800 and €6800.

What is the payback period for this project in years?

Answer 1:
Cumulative cash flows Year 1 = €36800 = €36800
Cumulative cash flows Year 2 = €36800 + €16800 = €53600. (€53600 >
€45000)
The fractional part of year 2 is €8200/€16800 = 0,49. The payback period is
1,49 years.
Question 2: A project has annual cash flows of –€45000, €36800, €16800 and
€6800.

What is the maximum discount rate that would result in a positive NPV?

Answer 2:
The minimum discount rate to have an acceptable NPV is the internal rate of
return of the project. This is calculated by trial and error:

NPV = 0 = −€45000 + €36800/(1 + IRR) + €16800/(1 + IRR) 2 + €6800/(1 +

IRR)3
IRR = 22,38%

Question 3: Your firm is considering purchasing a machine which requires an

annual investment of €19500. Depreciation is calculated using 20 per cent re-
ducing balance (i.e. instead of depreciating the machine by the same amount
each year, we depreciate the residual value of the investment by 20 per cent.)

The machine generates, on average, €5800 per year in additional net income.
Assume that the estimated economic life is 5 years.

Answer 3:
The average accounting return is the average project earnings after taxes,
divided by the average book value, or average net investment, of the machine
during its life. The book value of the machine is the gross investment minus
the accumulated depreciation.

Average book value = (Book value0 + Book value1 + Book value2 + Book
value3 + Book value4 + Book value5) / (Economic life)
Average book value = (€19500 + €15600 + €12480 + €9984 + €7987,2) / (5
years)
Average book value = €13110,24
Average project earnings = €5800

To find the average accounting return, we divide the average project earnings
by the average book value of the machine to calculate the average accounting
return. Doing so, we find:
Average accounting return = Average project earnings / Average book value
Average accounting return = €5800 / €13110,24
Average accounting return = 0,4424 or 44,24%
Question 4: Machine A costs £8206 and costs £2095 per year to maintain. It is
expected to last 10 years. Machine B costs £6580 and costs £2257 per year to
maintain. It is expected to last 8 years.

Answer 4:
Machine A PV of cost = £8206 + £2095 (1/0.10 – 1/(0.10 × 1.10^10)) =
=> £21079
EAC => £21079 = C (1/0.10 – 1/(0.10 × 1.10^10)) => C =
£3430

Machine B PV of cost = £6580 + £2257 (1/0.10 – 1/(0.10 × 1.10^8)) =

=> £18621
EAC => £18621 = C (1/0.10 – 1/(0.10 × 1.10^8)) => C = £3490

Question 5: Ang Electronics has developed a new wearable ring that continu-
ally checks blood pressure during the day. If the ring is successful, the present
value of the pay-off (when the product is brought to market) is £20 million. If
the ring fails, the present value of the pay-off is £5 million. If the product
goes directly to market, there is a 50 per cent chance of success. Alterna-
tively, Ang can delay the launch by one year and spend £2 million to test mar-
ket the ring. Test marketing would allow the firm to improve the product and
increase the probability of success to 75 per cent. The appropriate discount
rate is 15 per cent.

Calculate the NPV when you directly go to the market.

Answer 5: We need to calculate the NPV of the two options, go directly to

market now, or utilize test marketing first. The NPV of going directly to
market now is:

NPV = CSuccess (Prob. of success) + C Failure (Prob. of failure)

NPV = £20000000(0,50) + £5000000(0,50)
NPV = £12500000

Question 6: Ang Electronics has developed a new wearable ring that continu-
ally checks blood pressure during the day. If the ring is successful, the present
value of the pay-off (when the product is brought to market) is £20 million. If
the ring fails, the present value of the pay-off is £5 million. If the product
goes directly to market, there is a 50 per cent chance of success. Alterna-
tively, Ang can delay the launch by one year and spend £2 million to test mar-
ket the ring. Test marketing would allow the firm to improve the product and
increase the probability of success to 75 per cent. The appropriate discount
rate is 15 per cent.

Calculate the NPV if you test the marketing

Answer 6: Now we can calculate the NPV of test marketing first. Test
marketing requires a £2 million cash outlay. Choosing the test marketing
option will also delay the launch of the product by one year. Thus, the
expected payoff is delayed by one year and must be discounted back to year 0.

NPV = C0 + {[CSuccess (Prob. of success)] + [C Failure (Prob. of failure)]} / (1

+ R)t
NPV = −£2000000 + {[£20000000 (0,75)] + [£5000000 (0,25)]} / 1,15
NPV = £12130434,78
Question 7: See previous question. Ang Electronics should conduct test mar-
keting.

Answer 7: False
Question 8: Based on the following information, calculate the expected return
and standard deviation for each of the following equities.

Return Return
State of EconomyProbability of State of Economy
on J on K
Bear 0,25 −0,018 0,037
Normal 0,40 0,065 0,067
Bull 0,35 0,163 0,079

What is the covariance between the returns of the two equities?

Answer 8: The expected return of an asset is the sum of the probability of

each return occurring times the rate of return. So, the expected return of each
equity is:
E(RJ) = 0,25(−0,018) + 0,40(0,065) + 0,35(0,163) = 0,0785 or 7,86%

E(RK) = 0,25(0,037) + 0,40(0,067) + 0,35(0,079) = 0,0637 or 6,37%

To calculate the standard deviation, we first need to calculate the variance. To

find the variance, we find the squared deviations from the expected return.
We then multiply each possible squared deviation by its probability, and then
add all of these up. The result is the variance. So, the variance and standard
deviation of equity J are:

σ2j = 0,25(−0,018 − 0,0785)2 + 0,40(0,065 − 0,0785)2 + 0,35(0,163 −

0,0785)2 = 0,00490

σJ = (0,00490)1/2 = 0,0700 or 7,00%

And the standard deviation of equity K is:

σ2k = 0,25(−0,037 − 0,0637)2 + 0,40(0,067 − 0,0637)2 + 0,35(0,079 −

0,0637)2 = 0,00026

σK = (0,00026)1/2 = 0,0163 or 1,63%

To find the covariance, we multiply probability of each possible state with the
product of each assets’ deviation from the mean in that state. The sum of
these products is the covariance. So, the covariance is:

Cov(J,K) = 0.25(−0,018 − 0,0785) (0,037 − 0,0637) + 0,40(0,065 − 0,0785)

(0,067 − 0,0637) + 0,35(0,163 − 0,0785)(0,079 − 0,0637)

Cov(J,K) = 0,001079
Question 9: Based on the following information, calculate the expected return
and standard deviation for each of the following equities.

Return Return
State of EconomyProbability of State of Economy
on J on K
Bear 0,25 −0,018 0,037
Normal 0,40 0,065 0,067
Bull 0,35 0,163 0,079

What is the correlation between the returns of the two equities?

Answer 9: The correlation is:

ρJ,K = Cov(J,K)/σJσK

ρJ,K = 0,001079/(0,0700)(0,0163)

ρJ,K = 0,9476

Week 4 quiz/assessment 3
Question 1: The Dubya Corporation’s equity has a beta of 1,2. If the risk-free
rate is 5,8 per cent and the expected return on the market is 10 per cent.

Required:
What is Dubya 's cost of equity capital?
Answer 1: With the information given, we can find the cost of equity using
the CAPM. The cost of equity is:

RE = 0,058 + 1,2 (0,10 − 0,058) = 0,1084 or 10,84%

Question 2: XYZ has a market value of equity of £15,01 billion and total debt
of £1,51 billion. The cost of equity capital is 18,24 per cent and the cost of
debt is 5 per cent. The company has a marginal tax rate of 24 per cent.

Required:
What is its WACC?

Answer 2: Total Asset Value is (15,01 + 1,51) = £16,52 billion. This means
that the weight of Debt is 0,09140 and the weight of equity is 0,90860.

WACC = 0,09140(0,05)(1 − 0,24) + 0,90860(0,1824) = 0,1692 or 16,9%

Question 3: Fang plc has 8 million shares of equity outstanding. The current
share price is £60, and the book value per share is £5. Fang plc also has two
bond issues outstanding. The first bond issue has a face value of £70 million
and an 5 per cent coupon, and sells for 91 per cent of par. The second issue
has a face value of £60 million and a 7,5 per cent coupon and sells for 93,5
per cent of par. The first issue matures in 10 years, the second in 6 years. Sup-
pose the company's equity has a beta of 1,2. The risk-free rate is 4.8 per cent,
and the market risk premium is 6 per cent. Assume that the overall cost of
debt is the weighted average implied by the two outstanding debt issues. Both
bonds make semi-annual payments. The tax rate is 35 per cent. Assume face
value of the debt is £1000.

Required:
What is the company's WACC?

Answer 3: First, we will find the cost of equity for the company. The
information provided allows us to solve for the cost of equity using the
CAPM, so:

RE = 0,048 + 1,2(0,06) = 0,12 or 12%

Next, we need to find the YTM on both bond issues. Doing so, we find:

P1 = £910 = £60(PVIFAR%,20) + £1,000(PVIFR%,20)

R = 3,11%

YTM = 3,11% × 2 = 6,22%

P2 = £935 = £37,5(PVIFAR%,12) + £1000(PVIFR%,12)

R = 4,46%

YTM = 4,46% × 2 = 8,92%

To find the weighted average after-tax cost of debt, we need the weight of
each bond as a percentage of the total debt. We find:

wD1 = 0,91(£70M)/£119,8M = 0,5317

wD2 = 0,935(£60M)/£119,8M = 0,4683

Now we can multiply the weighted average cost of debt times one minus the
tax rate to find the weighted average after-tax cost of debt. This gives us:

RD = (1 – 0,35)[(0,5317)(0,0622) + (0,4683)(0,089)] = 0,0487 or 4,87%

The market value of equity is the share price times the number of shares, so:

MVE = 8M(£60) = £480M

Using the relationship that the total market value of debt is the price quote
times the par value of the bond, we find the market value of debt is:

MVD = 0,91(£70M) + 0,935(£60M) = £119,8M

This makes the total market value of the company:

V = £480M + 119,8M = £599,8M

And the market value weights of equity and debt are:

E/V = £480M/£599,8M = 0,8003

D/V = 1 – E/V = 0,1997

Using these costs and the weight of debt we calculated earlier, the WACC is:

WACC = 0,8003(0,1200) + 0,1997(0,0487) = 0,1058 or 10,58%

Question 4: Hoy plc has a profit before interest and taxes of $600000 per
year that is expected to continue in perpetuity. The unlevered cost of equity
for the company is 9 per cent, and the corporate tax rate is 25 per cent. The
company also has a perpetual bond issue outstanding with a market value of
$2 million.

Required:
What is the value of the company?

Answer 4:

5.500.000

Question 5: NoStress will remain in business for one more year. The
probability of a boom year is 60 per cent and the probability of a recession is
40 per cent. It is projected that the company will generate a total cash flow of
£280 million in a boom year and £115 million in a recession. The company’s
required debt payment at the end of the year is £160 million. The market
value of the company’s outstanding debt is £127,25 million. The company
pays no taxes. Assume a discount rate of 8 per cent.
Required:
(a) What pay-off do bondholders expect to receive in the event of a recession?
Answer 5: The expected payoff to bondholders is the face value of debt or
the value of the company, whichever is less. Since the value of the company
in a recession is £115000000 million and the required debt payment in one
year is £160000000, bondholders will receive the lesser amount, or
£115000000.
Question 6: NoStress will remain in business for one more year. The proba-
bility of a boom year is 60 per cent and the probability of a recession is 40 per
cent. It is projected that the company will generate a total cash flow of £280
million in a boom year and £115 million in a recession. The company’s re-
quired debt payment at the end of the year is £160 million. The market value
of the company’s outstanding debt is £127,25 million. The company pays no
taxes. Assume a discount rate of 8 per cent.

(b) What is the promised return on the company’s debt? (Do not include
the per cent sign

Answer 6: The promised return on debt is:

Promised return = (Face value of debt / Market value of debt) − 1

Promised return = (£160000000 / £127250000) − 1

Promised return = 0,2574 or 25,74%

Question 7: NoStress will remain in business for one more year. The proba-
bility of a boom year is 60 per cent and the probability of a recession is 40 per
cent. It is projected that the company will generate a total cash flow of £280
million in a boom year and £115 million in a recession. The company’s re-
quired debt payment at the end of the year is £160 million. The market value
of the company’s outstanding debt is £127,25 million. The company pays no
taxes. Assume a discount rate of 8 per cent.

(c) What is the expected return on the company’s debt?

Answer 7: (c)
In part a, we determined bondholders will receive £115 million in a recession.
In a boom, the bondholders will receive the entire £160 million promised
payment since the market value of the company is greater than the payment.
So, the expected value of debt is:

Expected payment to bondholders = 0,60(£160000000) + 0,40(£115000000)

Expected payment to bondholders = £142000000

So, the expected return on debt is:

Expected return = (Expected value of debt / Market value of debt) − 1

Expected return = (£142000000 / £127250000) − 1

Expected return = 0,1159 or 11,59%

Week 5 quiz/assessment 4:
Question 1: Zodiac call and put options with an exercise price of €15,3 expire
in 4 months and sell for €2,44 and €2,30, respectively.

Required:
If the equity is currently priced at €15,43, what is the annual continuously
compounded rate of interest?
Answer 1: Using put-call parity, we can solve for the risk-free rate as
follows:

€15,43 + €2,3 = €15,3e−R(4/12) + €2,44

€15,29 = €15,3−R(4/12)

0,9993 = e−R(4/12)

ln(0.9993) = ln(e−R(4/12))
-0,000650 = −R(4/12)

Rf = 0,196%
Question 2: Coal mining is becoming more popular because of the demand
for energy in Asia. Assume that you have the rights to a coal mine and the
most recent valuation of the mine was £7,3 million. Because of increasing
demand from Asia, the price of similar mines has grown by 5 per cent per
annum, with an annual standard deviation of 15 per cent. A buyer has recently
approached you and wants an option to buy the mine in the next 12 months
for £7,6 million. The risk-free rate of interest is 3 per cent per year,
compounded continuously.

Required:
How much should you charge for the option?
Answer 2: Using the Black-Scholes option pricing model, with a ‘share’ price
is £7300000 and an exercise price is £7600000, the price you should receive
is:

d1 = 0,0065
d2 = -0,1435
N(d1) = 0,5026
N(d2) = 0,4430

Putting these values into the Black-Scholes model, we find the call price is:

C = £7300000(0,5026) − (£7600000e 0,03(1))(0,4430) = £402020

Question 3: Cedric Hong is the chief executive officer of Chong plc and
owns 272250 shares. The company currently has 3,3 million shares and con-
vertible bonds with a face value of £34 million outstanding. The convertible
bonds have a conversion price of £34, and the equity is currently selling for
£37.

(a) What percentage of the firm’s equity does Mr Hong own?

Answer 3: (a)
The percentage of the company shares currently owned by the CEO is:

Percentage of shares = 272250/3300000

Percentage of shares = 0,0825 or 8,25%
Question 4: Cedric Hong is the chief executive officer of Chong plc and
owns 272250 shares. The company currently has 3,3 million shares and con-
vertible bonds with a face value of £34 million outstanding. The convertible
bonds have a conversion price of £34, and the equity is currently selling for
£37.

(b) If the company decides to call the convertible bonds and force conversion,
what percentage of the firm’s equity will Mr Hong own? He does not own any
convertible bonds.

Answer 4: (b)
The conversion price indicates that for every £34 of face value of convertible
bonds outstanding, the company will be obligated to issue a new share upon
conversion. So, the new number of shares the company must issue will be:

New shares issued = £34000000/£34

New shares issued = 1000000

So, the new number of shares outstanding will be:

New total shares = 3300000 + 1000000

New total shares = 4300000

After the conversion, the percentage of company shares owned by the CEO
will be:

New percentage of shares = 272250/4300000

New percentage of shares = 0,0633 or 6,33%
Question 5: A warrant gives its owner the right to purchase three shares of
equity at an exercise price of 36 Swedish krona per share. The current market
price of the equity is 52 Swedish krona.

What is the minimum value of the warrant?

Answer 5: The total exercise price of each warrant is shares each warrant can
purchase times the exercise price, which in this case will be:

Exercise price = 3(SKr36)

Exercise price = SKr108
Since the shares are selling at SKr52, the value of three shares is:

Value of shares = 3(SKr52)

Value of shares = SKr156

Therefore, the warrant effectively gives its owner the right to buy SKr156
worth of shares for SKr108. It follows that the minimum value of the warrant
is the difference between these numbers, or:

Minimum warrant value = SKr156 − SKr108

Minimum warrant value = SKr48

If the warrant were selling for less than SKr48, an investor could earn an
arbitrage profit by purchasing the warrant, exercising it immediately, and
selling the shares. Here, the warrant holder pays less than SKr48 while
receiving the SKr48 difference between the price of three shares and the
exercise price.
Question 6: Suppose today is 16 April 2020, and your firm produces choco-
late and needs 69500 tonnes of cocoa in July 2020 for an upcoming promo-
tion. You would like to lock in your costs today because you are concerned
that cocoa prices might go up between now and June. The closing price for
July 2020 futures is £1468 per ton of cocoa.

(a) What price would you effectively be locking in based on the closing price
of the day (total price for 69500 tonnes)?

Answer 6: a)
You’re concerned about a rise in cocoa prices, so you would buy July
contracts.

Since each contract is for 10 tonnes, the number of contracts you would need
to buy is:

Number of contracts to buy = 69500/10 = 6950

By doing so, you’re effectively locking in the settle price in July, 2020 of
£1468 per tonne of cocoa, or:

Total price for 69500 tonnes = 6950(£1468) (10) = £102026000.

Question 7: Suppose today is 16 April 2020, and your firm produces choco-
late and needs 69500 tonnes of cocoa in July 2020 for an upcoming promo-
tion. You would like to lock in your costs today because you are concerned
that cocoa prices might go up between now and June. The closing price for
July 2020 futures is £1468 per ton of cocoa.

(b) Suppose cocoa prices are £1499 per contract in July. What is the profit
(indicate as a positive number) or loss (indicate as a negative number) on your
futures position?

Answer 7: (b)
If the price of cocoa at expiration is £1499 per tonne, the value of your futures
position is:

Value of future position = (£1499 per tonne) (10 tonnes per contract) (6950
contracts) = £104180500.

Ignoring any transaction costs, your gain on the futures position will be:

Gain = £104180500 − £102026000 = £2154500

While the price of the cocoa your firm needs has become £2154500 more
expensive since April, your gain from the futures position has netted out this
higher cost.
Week 6 quiz/assessment 5:

Toets 2.

MC

A ) Current ratio is measure for liquidity

B) Option value of zero coupon convertible bond

E ) How many rights needed to buy a share

F ) Accounts payable defferal period

Cash cyle = … What is the operating cycle for Jaded given a 365 day year

G ) Profitability index of project

H ) CAPM cost of equity  beta 1,2 , risk free rate is 2%

I ) Indebted company

Debt value At percentage EBIT

A 100 6% 80.000

B 110 5% 80.000

C 150 7% 80.000

M & M proposition hold a corp tax rate of 30%. Which company has the highest value?

Antwoord: Company C

J ) key assumptions of M&M prop w/out taxes

K ) Call option has a lower value if

L) Firm A & B fixed rate floating SWAP … Euribor  SWAP

M ) Mpress VaLet has investment cost expected to be 72 mil and will return 13,5 mil for 5 years in
net cash flows. The ratio of debt to equity is 1:1. The cost of equity is 13%, the cost of debt is 9 %, tax
rate = 34%. The discount rate assuming average risk is 9,47%

72 mil invest cost 13,5 mil in 5 year return  Disocunt rate assuming average risk =

N ) Profitability index = closely related to  The NPV

P) Cost of goods sold 3210

Interest 215

Dividends 160

Depreciation 375

Change in retained earnings 360

Tas rate 35%

What is the operating cash flow?

1110

Q ) A project produces annual income of 9.500, 12.500, 15.500 over 3 years. Initial cost is 260.400.
This cost, is depreciated straight line to a zero bookvalue over 3 years. What is the average
accounting rate of return if the required discount rate = 7 %?

9,6%

R ) Asymmetric info increase the cost of debt. The trade off theory predicts that firms prefer retained
earnings as a source of income

T) 1) One can not obtain a higher expected return than the upper bound of opportunity set.

2) If the covariance is negative, then the correlation must be negative

 1 & 2 are correct

Assignment 2 A

Turnover 200.000

Operating var cost 80.000

Depreciation 20.000

Interest expenses 7,5 % of par value 24.000

Net profit before taxes 76.000

Taxes 30% 22.800

Net profit after taxes 53.200

C) Calculate the ( after tax) weighted average cost of capital ( WACC) in 4 dec

D) What would be the value of a firm if it were fully equity financed?

C& D  right formula, wrong answer

4 ) Annuity factor berekening Machine A or B

5 ) Expect to sell 7000 units a year at 60,-. Net cash flow for next 10 years. In other words, the
annual operating cash flow is projected to be 60 * 7000 = 420.000. The relevant discount rate is
16%, and the initial investment is 1.800.000.

A) What is the base case NPV?

-1.800.000 + 420.000 / 1,16 + … 420.000 /1,16^10

B) After the first year the project is abandoned and sold for1.400.000. If expected sales are revised
based on the first year performance, when would it make sense to abandon the investment. In
other words, at what level of expected sales would it make sense to abandon the project?

 expected sales to abandon the investment

C  Explain how the 1.400.000 abandonment value can be viewed as the opportunity cost of
keeping the project in one year.

abandonment = opportunity cost

Suppose you think it is likely that expected sales will be revised upward to 9000 units if the first
year is a success and revised downward to 4000 units if the first year is not a success.

D ) If success and failure are equally likely, what is the NPV of the project ?

 NPV project if 50% chance of both.. 0,5 * 420/1,16 + 0,5 * 420/1,16 + 0,5 * 9000/1,16^2 + 0,5
4000 / 1,16^2

E ) Consider the opportunity of abandonment in answering. What is the value of the option to
abandon?
6 ) A share of company beta has either a value of 60 or a value of 20 after 1 year. A call option exist
with an exercise price of 35. The market price of a share is now 45 and interest rate is 10%.

A) What is the option delta?

B) What is the value of the call option with exercise price at 35?

What is the value of a put option with the same exercise price?

7) A company equity currently sells for 30 per share. Last week the firm issued rights to raise new
equity. To purchase a new share, a shareholder must … 10 and 4 rights

a) What is the ex-rights share price?

B) What is the price of 1 right ?

8) Financial statement

Item Beginning Ending

Inventory 4211 6042

Account receivable 2051 2143

Account payable 3103 3612

Net sales 31302

Costs of goods sold 26321

A  Calculate the operating cycle?

Average inventory

Inventory turnover ratio

Days in inventory

Average receivables turnover

Average receivables turnover

 Mijn antwoord fout.

B  Calculate he cash cyle?