corporate finance - slides

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Corporate Finance

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CHAPTER 1

Introduction to Corporate Finance

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Chapter Outline

1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm Value

1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Markets

1.6 Outline of the Text

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What is Corporate Finance?

Corporate Finance addresses the following three questions:

1. What long-term investments should the firm engage in?

2. How can the firm raise the money for the required investments?

3. How much short-term cash flow does a company need to pay its bills?

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The Balance-Sheet Modelof the Firm

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm engage in?

The Capital Budgeting Decision

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How can the firm raise the money for the required investments?

The Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

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How much short-term cash flow does a company need to pay its bills?

The Net Working Capital Investment Decision

Net Working Capital

Shareholders’ Equity

Current Liabilities

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Long-Term Debt

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Capital StructureThe value of the firm can be thought of as a pie.

The goal of the manager is to increase the size of the pie.

The Capital Structure decision can be viewed as how best to slice up a the pie.

If how you slice the pie affects the size of the pie, then the capital structure decision matters.

50% Debt

50% Equity

25% Debt

75% Equity

70% Debt

30% Equity

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Hypothetical Organization Chart

Chairman of the Board and Chief Executive Officer (CEO)

Board of Directors

President and Chief Operating Officer (COO)

Vice President and Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

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The Financial Manager

To create value, the financial manager should:

1. Try to make smart investment decisions.

2. Try to make smart financing decisions.

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Cash flowfrom firm (C)

The Firm and the Financial Markets

Taxe

s (D

)

Firm

Government

Firm issues securities (A)

Retained cash flows (F)

Investsin assets

(B)

Dividends anddebt payments (E)

Current assetsFixed assets

Financialmarkets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm must be a cash generating activity.

The cash flows from the firm must exceed the cash flows from the financial markets.

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1.2 Corporate Securities as Contingent Claims on Total Firm Value

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date.

The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.

If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

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Debt and Equity as Contingent Claims

$F

$F

Payoff to debt holders

Value of the firm (X)

Debt holders are promised $F.

If the value of the firm is less than $F, they get the whatever the firm if worth.

If the value of the firm is more than $F, debt holders get a maximum of $F.

$F

Payoff to shareholders


If the value of the firm is less than $F, share holders get nothing.

If the value of the firm is more than $F, share holders get everything above $F.

Algebraically, the bondholder’s claim is: Min[$F,$X]

Algebraically, the shareholder’s claim is: Max[0,$X –$F]

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$F

$F

Combined Payoffs to debt holders and shareholders


Debt holders are promised $F.

Payoff to debt holders

Payoff to shareholders

If the value of the firm is lessthan $F, the shareholder’s claim is: Max[0,$X –$F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X

If the value of the firm is morethan $F, the shareholder’s claim is: Max[0,$X –$F] = $X –$F and the debt holder’s claim is:

Min[$F,$X] = $F.

The sum of these is = $X

Combined Payoffs to Debt and Equity

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1.3 The Corporate Firm

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.

However, businesses can take other forms.

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Forms of Business Organization

The Sole ProprietorshipThe Partnership

General PartnershipLimited Partnership

The CorporationAdvantages and Disadvantages

Liquidity and Marketability of OwnershipControlLiabilityContinuity of ExistenceTax Considerations

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A Comparison of Partnershipand Corporations

Corporation Partnership

Liquidity Shares can easily be exchanged.

Subject to substantial restrictions.

Voting Rights Usually each share gets one vote

General Partner is in charge; limited partners may have some voting rights.

Taxation Double Partners pay taxes on distributions.

Reinvestment and dividend payout

Broad latitude All net cash flow is distributed to partners.

Liability Limited liability General partners may have unlimited liability. Limited partners enjoy limited liability.

Continuity Perpetual life Limited life

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1.4 Goals of the Corporate Firm

The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

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The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts.

One of these contracts is between shareholders and managers.

The managers will usuallyact in the shareholders’ interests.

The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders.

The shareholders can monitor the managers behavior.

This contracting and monitoring is costly.

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Managerial Goals

Managerial goals may be different from shareholder goals

Expensive perquisites

Survival

Independence

Increased growth and size are not necessarily the same thing as increased shareholder wealth.

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Separation of Ownership and Control

Board of Directors

Management

AssetsDebt

Equity

Shareholders

Debtholders

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Do Shareholders ControlManagerial Behavior?

Shareholders vote for the board of directors, who in turn hire the management team.

Contracts can be carefully constructed to be incentive compatible.

There is a market for managerial talent—this may provide market disciplineto the managers—they can be replaced.

If the managers fail to maximize share price, they may be replaced in a hostile takeover.

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1.5 Financial Markets

Primary MarketWhen a corporation issues securities, cash flows from investors to the firm.

Usually an underwriter is involved

Secondary MarketsInvolve the sale of “used” securities from one investor to another.

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

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Financial Markets

FirmsInvestors

Secondary Market

money

securitiesSueBob

Stocks and Bonds

Money

Primary Market

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Exchange Trading of Listed Stocks

Auction markets are different from dealer markets in two ways:

Trading in a given auction exchange takes place at a single site on the floor of the exchange.

Transaction prices of shares are communicated almost immediately to the public.

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Corporate Finance

Part 1Firm Financial Statements

and Cash Flow

Financial Statements and Firm Valuation

Chapter 2

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Chapter Outline – Part 1

2.1.1 The Balance Sheet

2.1.2 The Income Statement

2.1.3 Net Working Capital

2.1.4 Financial Cash Flow

2.1.5 The Statement of Cash Flows

2.1.6 Summary and Conclusions

Corporate Finance

Sources of Information

Annual reports

Wall Street Journal

InternetNYSE (www.nyse.com)

Nasdaq (www.nasdaq.com)

Text (www.mhhe.com)

SECEDGAR

10K & 10Q reports

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2.1.1 The Balance Sheet

An accountant’s snapshot of the firm’s accounting value as of a particular date.The Balance Sheet Identity is:Assets ≡ Liabilities + Stockholder’s EquityWhen analyzing a balance sheet, the financial manager should be aware of three concerns: accounting liquidity, debt versus equity, and value versus cost.

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The Balance Sheet of the U.S. Composite Corporation

(in $ millions)20X2 and 20X1Balance Sheet

U.S. COMPOSITE CORPORATION

Liabilities (Debt)Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1

Current assets: Current Liabilities:Cash and equivalents $140 $107 Accounts payable $213 $197Accounts receivable 294 270 Notes payable 50 53Inventories 269 280 Accrued expenses 223 205Other 58 50 Total current liabilities $486 $455

Total current assets $761 $707 Long-term liabilities:

Fixed assets:Deferred taxes $117 $104

Property, plant, and equipment $1,423 $1,274Long-term debt 471 458

Less accumulated depreciation -550 -460Total long-term liabilities $588 $562

Net property, plant, and equipment 873 814Intangible assets and other 245 221

Stockholder's equity:

Total fixed assets $1,118 $1,035Preferred stock $39 $39Common stock ($1 per value) 55 32Capital surplus 347 327Accumulated retained earnings 390 347

Less treasury stock -26 -20Total equity $805 $725

Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

The assets are listed in order by the length of time it normally would take a firm with ongoing operations to convert them into cash.

Clearly, cash is much more liquid than property, plant and equipment.

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Balance Sheet Analysis

When analyzing a balance sheet, the financial manager should be aware of three concerns:

1. Accounting liquidity

2. Debt versus equity

3. Value versus cost

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Accounting Liquidity

Refers to the ease and quickness with which assets can be converted to cash.Current assets are the most liquid.Some fixed assets are intangible.The more liquid a firm’s assets, the less likely the firm is to experience problems meetingshort-term obligations.Liquid assets frequently have lower rates of return than fixed assets.

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Debt versus Equity

Generally, when a firm borrows it gives the bondholders first claim on the firm’s cash flow.

Thus shareholder’s equity is the residual difference between assets and liabilities.

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Value versus Cost

Under GAAP audited financial statements of firms in the U.S. carry assets at cost.

Market value is a completely different concept.

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2.1.2 The Income Statement

The income statement measures performance over a specific period of time.

The accounting definition of income is

Revenue – Expenses ≡ Income

Corporate Finance

2-10 U.S.C.C. Income Statement

(in $ millions)20X2

Income StatementU.S. COMPOSITE CORPORATION

Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes

Current: $71Deferred: $13

Net incomeRetained earnings: $43Dividends: $43

The operations section of the incomestatement reports the firm’s revenues and expenses from principal operations

$2,262- 1,655

- 327- 90

$19029

$219- 49

$170- 84

$86

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(in $ millions)20X2


Total operating revenues $2,262Cost of goods sold - 1,655Selling, general, and administrative expenses - 327Depreciation - 90Operating income $190Other income 29Earnings before interest and taxes $219Interest expense - 49Pretax income $170Taxes - 84


Net income $86Retained earnings: $43Dividends: $43

The non-operating section of the income statement includes all financing costs, such as interest expense.

U.S.C.C. Income Statement

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(in $ millions)20X2





Usually a separate section reports as a separate item the amount of taxes levied on income.

$2,262- 1,655

- 327- 90

$19029

$219- 49

$170- 84

$86


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(in $ millions)20x2





Net income is the “bottom line”.

$2,262- 1,655

- 327- 90

$19029

$219- 49

$170- 84

$86


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Income Statement Analysis

There are three things to keep in mind when analyzing an income statement:

1. GAAP

2. Non Cash Items

3. Time and Costs

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Generally Accepted Accounting Principles

1. GAAP

The matching principal of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred

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2. Non Cash Items

Depreciation is the most apparent. No firm ever writes a check for “depreciation”.

Another noncash item is deferred taxes, which does not represent a cash flow.

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3. Time and CostsIn the short run, certain equipment, resources, and

commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials.

In the long run, all inputs of production (and hence costs) are variable.

Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.

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2.1.3 Net Working Capital

Net Working Capital ≡ Current Assets – Current Liabilities

NWC is usually growing with the firm.

Corporate Finance

2-19 The Balance Sheet of the U.S.C.C.

(in $ millions)20X2 and 20X1Balance Sheet

U.S. COMPOSITE CORPORATION

Liabilities (Debt)Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1

Current assets: Current Liabilities:Cash and equivalents $140 $107 Accounts payable $213 $197Accounts receivable 294 270 Notes payable 50 53Inventories 269 280 Accrued expenses 223 205Other 58 50 Total current liabilities $486 $455

Total current assets $761 $707Long-term liabilities:

Fixed assets: Deferred taxes $117 $104Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562

Net property, plant, and equipment 873 814Intangible assets and other 245 221 Stockholder's equity:

Total fixed assets $1,118 $1,035 Preferred stock $39 $39Common stock ($1 par value) 55 32Capital surplus 347 327Accumulated retained earnings 390 347

Less treasury stock -26 -20Total equity $805 $725

Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

Here we see NWC grow to $275 million in 20X2 from $252 million in 20X1.

This increase of $23 million is an investment of the firm.

$23 million

$275m = $761m- $486m

$252m = $707- $455

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2.1.4 Financial Cash Flow

In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.

Since there is no magic in finance, it must be the case that the cash from received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.

CF(A)≡ CF(B) + CF(S)

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2-21 Financial Cash Flow of the U.S.C.C.

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $238

(Earnings before interest and taxesplus depreciation minus taxes)

Capital spending (173)(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capital (23)Total $42

Cash Flow of Investors in the FirmDebt $36

(Interest plus retirement of debtminus long-term debt financing)

Equity 6(Dividends plus repurchase ofequity minus new equity financing)

Total $42

Operating Cash Flow:

EBIT $219

Depreciation $90

Current Taxes ($71)

OCF $238

Corporate Finance


(in $ millions)20X2




Capital spending(Acquisitions of fixed assetsminus sales of fixed assets)

Additions to net working capitalTotal

Cash Flow of Investors in the FirmDebt


Equity(Dividends plus repurchase ofequity minus new equity financing)

Total

Capital Spending

Purchase of fixed assets $198

Sales of fixed assets (25)

Capital Spending $173

(173)

(23)$42

$36

6

$42

Corporate Finance


(in $ millions)20X2









Total

NWC grew from $275 million in 20X2 from $252 millionin 20X1.

This increase of $23 million is the addition to NWC.

(173)

(23)$42

$36

6

$42

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(in $ millions)20X2









Total

(173)

(23)$42

$36

6

$42

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(in $ millions)20X2









Total

Cash Flow to Creditors

Interest $49

Retirementof debt 73

Debt service 122

Proceeds from new debt sales (86)

Total 36

(173)

(23)$42

$36

6

$42

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(in $ millions)20X2









Total

Cash Flow to Stockholders

Dividends $43

Repurchase of stock 6

Cash to Stockholders 49

Proceeds from newstock issue (43)

Total $6

(173)

(23)$42

$36

6

$42

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(in $ millions)20X2









Total

)()(

)(

SCFBCF

ACF

+≡

The cash from received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

(173)

(23)$42

$36

6

$42

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2.1.5 The Statement of Cash Flows

There is an official accounting statement called the statement of cash flows.

This helps explain the change in accounting cash, which for U.S. Composite is $33 million in 20X2.

The three components of the statement of cash flows areCash flow from operating activities

Cash flow from investing activities

Cash flow from financing activities

Corporate Finance

2-29 U.S.C.C. Cash Flow

from Operating Activities

(in $ millions)20X2

Cash Flow from Operating ActivitiesU.S. COMPOSITE CORPORATION

To calculate cash flow from operations, start with net income, add back noncash items like depreciation and adjust for changes in current assets and liabilities (other than cash).

OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities

Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther

Total Cash Flow from Operations

$869013

(24)111618(3)

$199

(8)

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from Investing Activities

(in $ millions)20X2

Cash Flow from Investing ActivitiesU.S. COMPOSITE CORPORATION

Cash flow from investing activities involves changesin capital assets: acquisition of fixed assets and sales of fixed assets(i.e. net capital expenditures).

Acquisition of fixed assetsSales of fixed assets

Total Cash Flow from Investing Activities

$(198)25

$(173)

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from Financing Activities

(in $ millions)20X2

Cash Flow from Financing ActivitiesU.S. COMPOSITE CORPORATION

Cash flows to and from creditors and owners include changes inequity and debt.

Retirement of debt (includes notes)Proceeds from long-term debt salesDividendsRepurchase of stockProceeds from new stock issue

Total Cash Flow from Financing

$(73)86(43)

43

$7

(6)

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2-32 U.S.C.C. Statement of Cash Flows

The statement of cash flows is the addition of cash flows from operations,cash flowsfrom investing activities, and cash flows from financing activities.

OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities

Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther

Total Cash Flow from Operations

$869013

(24)111618(3)

$199(8)

Acquisition of fixed assetsSales of fixed assets

Total Cash Flow from Investing Activities

$(198)25

$(173)

Investing Activities

Financing ActivitiesRetirement of debt (includes notes)Proceeds from long-term debt salesDividendsRepurchase of stockProceeds from new stock issue

Total Cash Flow from Financing

$(73)86(43)

43$7

(6)

Change in Cash (on the balance sheet) $33

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2-33 Statement of Cash Flows versus Cash Flow

from the Firm

Since interest paid is deducted as an expense when net income is calculated (and not deducted under financing activities) there is a difference between cash flow from operations and total cash flow to the firm—the difference is interest expense.

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2.1.6 Summary and Conclusions

Financial statements provide important information regarding the value of the firm.

You should keep in mind:Measures of profitability do not take risk or timing of cash flows into account.

Financial ratios are linked to one another.

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Part 2Financial Statement Analysis

and Firm Valuation

Financial Statements and Firm Valuation

Chapter 2

Corporate Finance

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FSA: Ratio Analysis

Liquidity

Long-term Solvency

Asset Management

Profitability

Market Value

Dupont Analysis

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Liquidity Ratios

Current ratio (Rc)

Case of ABT (2006)

Rc = 1.94

sLiabilitieCurrent

AssetsCurrent =Rc

2

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Liquidity Ratios

Quick ratio (Rq)

Case of ABT (2006)

Rq = 1.47

sLiabilitieCurrent

Inventory-AssetsCurrent =Rq

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Liquidity Ratios

Cash ratio (Rq)

Case of ABT (2006)

CR = 0.11

sLiabilitieCurrent

Securities Marketable Cash +=CR

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Long-term Solvency Ratios

Total Debt Ratio

Case of ABT (2006)

TDR = 0.39

Assets Total

Debt Total=TDR

MeanVN: 0.54

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Long-term Debt Ratio

Case of ABT (2006)

LDR = 0.008

Assets Total

Debt term-Long=LDR

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Long-term Debt/Equity Ratio

Case of ABT (2006)

LD/E R = 0.013

Equity

Debt term-Long/ =RELD

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Asset Management Ratios

Total Asset Turnover

Case of ABT (2006)

TAT = 2.81

Assets Total

Sales=TAT

MeanVN: 1.77

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Fixed Asset Turnover

Case of ABT (2006)

FAT = 14.37

Assets FixedNet

Sales=FAT

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Average Collection Period

Case of ABT (2006)

ACP = 40 (days)

dayper Sales Average

Receivable Accounts=ACP

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Inventory Turnover

Case of ABT (2006)

IT = 12.86

Inventory

Sold Goods ofCost =IT

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Profitability Ratios

Profit Margin

Case of ABT (2006)

PM = 0.09

Sales

Interest IncomeNet +=PM

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Return on Assets (ROA)

Case of ABT (2006)

PM = 0.25

Assets Total

Interest IncomeNet +=ROA

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Return on Equity (ROE)

Case of ABT (2006)

PM = 0.35

Equity

IncomeNet =ROE

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Market Value Ratios

Price-Earnings Ratio (P/E)

Case of ABT (2006)

P/E = 18

shareper Earnings

shareper Price/ =EP

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Market Value Ratios

Market-to-Book Ratio (P/B)

Case of ABT (2006)

P/B = 6.4

shareper Book value

shareper Price/ =BP

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Ratio Analysis – Case of ABT

2004 2005 2006 AGF SJ1 TS4 Mean

Current Ratio 1,16 1,07 1,94 1,65 3,15 2,07 2,20

Quick Ratio 0,49 0,71 1,47 1,07 0,95 1,58 1,27

Cash Ratio 0,06 0,10 0,11 0,08 0,11 0,03 0,08

Total Debt Ratio 0,70 0,70 0,39 0,36 0,28 0,43 0,36

Long-term Debt Ratio 0,05 0,06 0,01 0,00 0,00 0,09 0,03

Long-term Debt/Equity Ratio 0,16 0,18 0,01 0,00 0,00 0,16 0,04

Benchmark 2006

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Ratio Analysis – Case of ABT

2004 2005 2006 AGF SJ1 TS4 Mean

Total Asset Turnover 2,38 3,03 2,81 2,54 3,61 1,62 2,65

Fixed Asset Turnover 9,97 13,84 14,37 6,37 27,49 5,92 13,54

Average Collection Period 42,78 47,10 40,10 41,63 18,49 111,37 52,90

Inventory Turnover 5,03 11,49 12,86 10,84 5,44 8,46 9,40

Profit Margin 0,03 0,04 0,09 0,04 0,04 0,04 0,05

Return on Assets (ROA) 0,08 0,12 0,25 0,11 0,14 0,06 0,14

Return on Equity (ROE) 0,20 0,28 0,35 0,16 0,20 0,11 0,20

Benchmark 2006

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Du Pont Analysis

LeverageLeverageAsset Asset

TurnoverTurnoverProfit Profit

MarginMargin

EquityEquity

Net IncomeNet IncomeROE =ROE =

Net Income + InterestNet Income + Interest

Net Income + InterestNet Income + Interestxx

EquityEquity

Net IncomeNet Income

SalesSalesTotal AssetsTotal Assets

SalesSalesxx

Total AssetsTotal AssetsxxROE =ROE =

xxEquityEquity

Total AssetsTotal Assets

SalesSalesTotal AssetsTotal Assets

Net Income + InterestNet Income + Interestxx

SalesSalesxxROEROE==

Net Income + InterestNet Income + Interest

Net IncomeNet Income

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Du Pont Analysis – Case of ABT

Year 2004 2005 2006 Benchmark 2006Return on Equity (ROE) 0,20 0,28 0,35

1/ Total Assets / Equity (Leverage ) 3,34 3,30 1,63 1,582/ Sales / Total Assets (Asset Turnover ) 2,38 3,03 2,81 2,653/ (Net Income + Interest)/ Sales (Profit Margin ) 0,03 0,04 0,09 0,054/ Net Income / (Net Income + Interest) 0,74 0,69 0,87 0,945/ (1)*(4) 2,46 2,29 1,42 1,49P/E 16,41 17,34

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Basic earnings per share

Weighted average number of ordinary shares outstanding (WANOSO)

Share repurchase or treasury shares sellingPrivate placementBonus issue, stock dividend, share split or reverse share splitRights issue

Weighted average number of ordinary shares outstandingWeighted average number of ordinary shares outstanding

Profit or loss attributable to ordinary equity holdersProfit or loss attributable to ordinary equity holdersBasic EPS =Basic EPS =

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Share repurchase, treasury shares selling or private placement

Share repurchase or treasury shares selling: the event date is the day when it finishesPrivate placement: the event date is the day when issued shares are officially traded

Number of days in the periodNumber of days in the period

Number of days from Number of days from the event date to the the event date to the

end of the periodend of the period××

Number of Number of OSO after the OSO after the

event dateevent date++

Number of days from Number of days from the beginning of the the beginning of the

periodperiod to the event dateto the event date××

Number of OSO Number of OSO at the beginning at the beginning

of the periodof the period==WANOSO for WANOSO for

the periodthe period

Corporate Finance

16-23


Example

Date Event Number of shares

WANOSO

01/01 Beginning of period 1000 1000 x 3/12 = 250.00

31/03 Private placement 600 1600 x 5/12 = 666.67

Total 1450 1400

30/08 Share repurchase (150) 1450 x 4/12 = 483.33

9

Corporate Finance

16-24


Bonus issue or stock dividend

The number of ordinary shares outstanding before the event is adjusted for the proportionate change in the number of ordinary shares outstanding as if the event had occurred at the beginning of the earliest period presented (Retrospective Adjustment)

The event date is the day where issued shares are officially traded

Corporate Finance

16-25

Basic EPS – Case of Hoa An JSC.

Weight(C)

01-01 Beginning of the period 3,428,124 1.1 256 965,359,718

54(14/9 - 6/11)

06-10

Ex-bonus date. 1 for 10 bonusissue => The number of ordinaryshares outstanding before this dateis adjusted. Adjustment factor =11/10 = 1.1

07-11Day on which 350,000 bonusshares were traded

3,850,000 55 211,750,000

31-12 End of the period 3,850,000

Total 365 1,385,009,718

Weighted average number ofordinary shares outstanding

3,794,547

Profit or loss attributable to ordinary shares for 2005: 36,515,586,209 VND

Weighted average number of ordinary shares outstanding: 3,794,547

EPS = 36,515,586,209 / 3,794,547 = 9,623 VND

Number of shares (A)

Adjustment factor (B)

14-09Finishing date of selling of 71,876 treasury shares

3,500,000 1.1

D = A x B x C

207,900,000

Date Event

Corporate Finance

16-26

Adjusted earnings per share

Share split, reverse share split, bonus issue or stock dividend:At the ex-date, basic EPS is adjusted for the proportionate change in the number of ordinary shares outstanding

Rights issue:Diluted EPS = Basic EPS × Adjustment factor

Fair value per share immediately before exFair value per share immediately before ex--datedate

Theroretical exTheroretical ex--rights fair value per sharerights fair value per shareAdjustment factor =Adjustment factor =

10

Corporate Finance

16-27

Adjusted EPS – Example (Rights Issue)

Issuing firm: An Giang Import Export Fishery Joint Stock Company Stock symbol: AGFType of stock: Common stockPar value: VND 10,000Issuing purpose: mobilize capital for investment plans

Frozen Warehouse with the capacity 3000 tons and Frozen Fishery FactoryNo.1Supplement the working capital for business purposes

Additional volume: 1,278,000 sharesIssuing method: 05 old shares can buy one additional shareIssue price: VND 10.000/shareEx-right date: August 2nd 2006Record date: August 4th 2006

Corporate Finance

16-28


Rights compensate existing shareholders for dilution

Maintain ownership proportion if exercisedMaintain value if sold

V + R = PV + R = PNew shareholders

PPII + N+ N××R = VR = V

⇒⇒⇒⇒⇒⇒⇒⇒ ⇒⇒⇒⇒⇒⇒⇒⇒N + 1N + 1

PPI I + N+ N××PPV =V = Adjustment FactorAdjustment Factor

(N + 1)(N + 1)××PP

PPI I + N+ N××PP==

Corporate Finance

16-29


Stock symbol AGF

Ex-rights date August 2nd 2006

Old shares / New shares (N) 5

Issue price (PI ) 10,000

Stock price immediately before ex-date (P) 66,500

Basic EPS 6,360

Adjustment factor 0.8584

Diluted EPS 5,459

11

Corporate Finance

16-30

Analysis of Price-Earning Ratio (P/E)

No growth assumptionStock AStock A Stock BStock B

EPSEPS 5 $5 $ 5 $5 $

Payout ratioPayout ratio 100 %100 % 100 %100 %

rr 12.5 %12.5 % 12.5 %12.5 %

Number of outstanding sharesNumber of outstanding shares 3 M3 M 3 M3 M

($) 40125.0

51 ====r

DPP BA

Corporate Finance

16-31

Analysis of Price-Earning Ratio (P/E)

Growth assumptionFirm A engages in projects generating ROE of 15%Firm A engages in projects generating ROE of 15%Plowback ratio: 60%; Payout ratio: 40% (DPlowback ratio: 60%; Payout ratio: 40% (D00 = 2 $ per share)= 2 $ per share)Added earnings: 1.35 M (growth rate: 9%)Added earnings: 1.35 M (growth rate: 9%)

Present value of growth opportunities = 62.29 Present value of growth opportunities = 62.29 –– 40 = 22.29 ($)40 = 22.29 ($)

( )($) 29.62

09.0125.0

09.1210 =−

×=−

+=gr

gDPA

+=⇒+=rE

PVGO

rE

PPVGO

r

EP

/1

1 0

0

Corporate Finance

16-32

Analysis of Market-to-Book Ratio (P/B)

( )

( ) ( )

( )gr

dgROE

B

P

gr

dgBROE

gr

dgBB

E

gr

dgE

gr

dE

gr

DP

−×+×=⇒

−×+××=

−

×+××=

−×+×=

−×=

−=

1

11

1

0

0

00

0

0

0110

12

Corporate Finance

16-33

Introduction to Valuation: a simple example

You plan to buy an asset at 316 M VND. This is a riskless investment as if you buy this asset, somebody is willing to take it at 400 M VND after 3 years. Your close friend advices you not to buy it, recommending more risky investments with higher return (15 % per year, including a risk premium of 5 %)

Will you buy this asset?

Corporate Finance

16-34

Equity Valuation – Dividend Discount Model (DDM)

General Model

No growth assumption

Stable growth assumption

1 + r1 + r

DD11==PP00 (1 + r)(1 + r)22

DD22++

(1 + r)(1 + r)33

DD33++

(1 + r)(1 + r)44

DD44++

(1 + r)(1 + r)55

DD55++ ……………………++

rr

DD==PP00

r r -- gg

DD11==PP00

Corporate Finance

16-35

DDM – A simple example

Stock A: D = 10 $

Stock B: Forecasted D1: 5 $Forecasted stable growth rate: 3 %

Stock C:Forecasted D1: 5 $Forecasted growth rate for 5 following years: 20 %Stable dividends after this fast growth period

Required return for all 3 stocks: 12 %

13

Corporate Finance

16-36

Equity Valuation - Residual Income Model

DDM

Clean surplus relation

Abnormal earnings

⇒⇒⇒⇒ Residual Income Model

( )( )∑

∞

=

+

+=

1 1ˆ

τ

τt

ttt

r

dEP

tttt dxbb −+= −1

1−+++ ×−= τττ ttat brxx

( )( )∑

∞

=

+

++=

1 1ˆ

τττ

r

xEbP

att

tt

Corporate Finance

16-37

Economic Value Added (EVA)

Economic Value Added

Abnormal earnings: Shareholder Value Added

( ) Capital Invested×−= WACCROAEVA

1−+++ ×−= τττ ttat brxx

( ) 1−++ ×−= ττ tat brROEx

Corporate Finance

16-38

Relative Valuation

×= ∈tj

tjjtiti VD

PMVDP

i

,

,,,

ˆψ

PPi,ti,t: Relative value of the stock : Relative value of the stock ii at time at time tt

VDVDi,ti,t: Value driver of the stock : Value driver of the stock ii at time at time tt

PPj,tj,t: Price of stock j comparable to : Price of stock j comparable to ii at time at time tt

VDVDj,tj,t: Value driver of stock : Value driver of stock jj comparable to i at time comparable to i at time t t

MM: Mean or median estimated from the set : Mean or median estimated from the set ψψ of stocks comparable of stocks comparable to to ii

PPi,ti,t: Relative value of the stock : Relative value of the stock ii at time at time tt

VDVDi,ti,t: Value driver of the stock : Value driver of the stock ii at time at time tt

PPj,tj,t: Price of stock j comparable to : Price of stock j comparable to ii at time at time tt

VDVDj,tj,t: Value driver of stock : Value driver of stock jj comparable to i at time comparable to i at time t t

MM: Mean or median estimated from the set : Mean or median estimated from the set ψψ of stocks comparable of stocks comparable to to ii

14

Corporate Finance

16-39

Starting with an exercise

Corporate Finance

16-40

Residual Income Model – Case of Chiron Corporation (USA)

Forecast horizon: n

Case of Chiron: n = 3

( )( )∑

∞

=

+

++=

1 1ˆ

τττ

r

xEbP

att

tt

( )( )

( )( ) 1

1

1 11ˆ

−+

−

=

+

+×+

++= ∑ n

antt

n

ii

aitt

ttrr

xE

r

xEbP

( ) ( )( )

( )( )2

3221

111ˆ

rr

xE

r

xE

r

xEbP

att

att

att

tt +×+

++

++= +++

Corporate Finance

16-41

Dividend Discount Model – Case of Bibica (Vietnam)

( )( )

+++

−

++−

=−

n

n

n

rr

g

grr

g

DP1

111

1ˆ

1

10

15

Corporate Finance

16-42


2003 2004 2005 2006 AverageReturn on Equity (ROE) 0,1350 0,1139 0,1342 0,1140 0,1243Earnings per share (EPS) 1893 1642 2194 2713Dividend per share (DPS) 1200 1200 1200 1200Plowback ratio (b) 0,3661 0,2692 0,4531 0,5577 0,4115Long-term growth rate (g) 0,0511Forecast DPS 1 1261,37

Corporate Finance

16-43


Price = 54 (Comparable price = 54×1.12 = 61)n r Po n r Po n r Po

10 0,08 22396,30 20 0,08 27452,54 50 0,08 36493,960,09 19630,05 0,09 23535,56 0,09 29455,920,1 17434,27 0,1 20494,67 0,1 24454,14

0,11 15652,07 0,11 18079,11 0,11 20776,250,12 14178,96 0,12 16123,42 0,12 17990,690,13 12942,70 0,13 14514,32 0,13 15825,900,14 11891,79 0,14 13171,92 0,14 14105,260,15 10988,50 0,15 12038,39 0,15 12710,460,16 10204,61 0,16 11070,99 0,16 11560,160,17 9518,57 0,17 10237,53 0,17 10597,100,18 8913,66 0,18 9513,34 0,18 9780,05

Corporate Finance

16-44



70 0,08 39510,26 100 0,08 41844,07 VC 0,08 43705,550,09 31005,97 0,09 31969,88 0,09 32458,79

0,1 25266,90 0,1 25675,24 0,1 25815,650,11 21209,97 0,11 21386,88 0,11 21429,750,12 18225,78 0,12 18304,00 0,12 18317,700,13 15955,14 0,13 15990,36 0,13 15994,900,14 14177,22 0,14 14193,35 0,14 14194,900,15 12751,00 0,15 12758,51 0,15 12759,050,16 11583,26 0,16 11586,80 0,16 11587,000,17 10610,39 0,17 10612,09 0,17 10612,160,18 9787,77 0,18 9788,59 0,18 9788,62

16

Corporate Finance

16-45

Dividend Discount Model – Case of SACOM (Vietnam)

2002 2003 2004 2005 2006 AverageReturn on Equity (ROE) 0,2923 0,2750 0,2842 0,1867 0,2930 0,2662Earnings per share (EPS) 4835 3562 4061 5593 5531

Dividend per share (DPS) 1600 1600 1600 1600 1600

Plowback ratio (b) 0,6691 0,5508 0,6060 0,7139 0,7107 0,6501Long-term growth rate (g) 0,1731Forecast DPS1 1876,94

Corporate Finance

16-46

Dividend Discount Model – Case of SACOM (Vietnam)


19 0,08 189706,21 20 0,08 207794,92 25 0,08 324491,850,09 152838,87 0,09 166211,00 0,09 250006,460,1 125215,80 0,1 135241,60 0,1 196292,97

0,11 104065,75 0,11 111671,13 0,11 156694,350,12 87577,68 0,12 93404,49 0,12 126952,50,13 74525,71 0,13 79028,28 0,13 104251,010,14 64055,87 0,14 67561,35 0,14 86675,170,15 55558,72 0,15 58306,13 0,15 72892,990,16 48590,37 0,16 50756,55 0,16 61959,500,17 42821,82 0,17 44538,97 0,17 53192,850,18 38005,41 0,18 39373,33 0,18 46093,620,19 33952,22 0,19 35046,89 0,19 40291,18

Corporate Finance

16-47

Relative Valuation based on P/E – Case of the Transport Sector (Vietnam)

GMD 169 3990 42,36 92,7

HAX 51 2540 20,08 59,0

HTV 40,7 3090 13,17 71,8

MHC 39,1 1640 23,84 38,1

SHC 33,5 1740 19,25 40,4

TMS 68 3900 17,44 90,6

VFC 41,8 1580 26,46 36,7

VIP 95,5 1980 48,23 46,0

Sector Mean 23,23

Stock Price EPS P/E

Relative

Value

8/18/2013

1

Corporate Finance

6-0

Capital Budgeting

Chapter 3

Corporate Finance

6-1

Why Use Net Present Value?

Accepting positive NPV projects benefits shareholders.

ExampleRiskless project:

Initial cost: 100; unique cash flow in one year: 107; discount rate: 6 % ⇒NPV = 0.94

If the project is forgone: bank deposit 100 → 106 in one year → the project benefits shareholders (absolute opportunity cost: 6)

Firm value without project: V + 100; with project: V + 107/1.06

Risky project:About as risky as the stock market: expected return (=required return) = 10 % ⇒ NPV < 0

Opportunity cost = expected return on stock market = 10 %

Corporate Finance

6-2

The Net Present Value (NPV) Rule

Net Present Value (NPV) = Total PV of future CF’s - Initial Investment

Estimating NPV:1. Estimate future cash flows: how much? and when?2. Estimate discount rate3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0Ranking Criteria: Choose the highest NPV

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2

Corporate Finance

6-3

Good Attributes of the NPV Rule

1. Uses cash flows

2. Uses ALL cash flows of the project

3. Discounts ALL cash flows properly

Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.

Corporate Finance

6-4

The Payback Period Rule

How long does it take the project to “pay back” its initial investment?

Payback Period = number of years to recover initial costs

Minimum Acceptance Criteria: set by management

Ranking Criteria: set by management

Corporate Finance

6-5

The Payback Period Rule (continued)

Disadvantages:Ignores the time value of moneyIgnores cash flows after the payback periodBiased against long-term projectsRequires an arbitrary acceptance criteriaA project accepted based on the payback criteria may not have a positive NPV

Advantages:Easy to understandBiased toward liquidity

8/18/2013

3

Corporate Finance


Year A B C

0 -100 -100 -100

1 20 50 50

2 30 30 30

3 50 20 20

4 60 60 60,000

Payback period (years) 3 3 3

6-6

Corporate Finance


Managerial perspectiveUsed by large, sophisticated companies when making relatively small decisions

Desirable features for managerial control: shorter time to evaluate the manager’s decision-making ability

Also used by firms with good investment opportunities but no or little cash available

Practitioners: academic criticisms of payback overstate real-world problems (e.g., project C)

Bigger projects: NPV becomes the order of the day

6-7

Corporate Finance

6-8

The Discounted Payback Period Rule

How long does it take the project to “pay back” its initial investment taking the time value of money into account?

By the time you have discounted the cash flows, you might as well calculate the NPV.

8/18/2013

4

Corporate Finance

6-9

The Average Accounting Return Rule

Investment of ValueBook Average

IncomeNet AverageAAR =

Corporate Finance

The Average Accounting Return Rule

Another attractive but fatally flawed approach.Ranking Criteria and Minimum Acceptance Criteria set by managementDisadvantages:

Ignores the time value of moneyUses an arbitrary benchmark cutoff rateBased on book values, not cash flows and market values

Advantages:The accounting information is usually availableEasy to calculate

6-10

Corporate Finance

6-11

The Internal Rate of Return (IRR) RuleIRR: the discount that sets NPV to zero Minimum Acceptance Criteria:

Accept if the IRR exceeds the required return.Ranking Criteria:

Select alternative with the highest IRRReinvestment assumption:

All future cash flows assumed reinvested at the IRR.Disadvantages:

Does not distinguish between investing and borrowing.IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments

Advantages:Easy to understand and communicate

8/18/2013

5

Corporate Finance

6-12

The Internal Rate of Return: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

32 )1(

150$

)1(

100$

)1(

50$0

IRRIRRIRRNPV

++

++

+==

Corporate Finance

6-13

The NPV Payoff Profile for This Example

Discount Rate NPV0% $100.004% $71.048% $47.3212% $27.7916% $11.6520% ($1.74)24% ($12.88)28% ($22.17)32% ($29.93)36% ($36.43)40% ($41.86)

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.

IRR = 19.44%

($60.00)

($40.00)

($20.00)

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

-1% 9% 19% 29% 39%

Discount rate

NP

V

Corporate Finance

6-14

Problems with the IRR Approach

Multiple IRRs.

Are We Borrowing or Lending?

The Scale Problem

The Timing Problem

8/18/2013

6

Corporate Finance

Problems with the IRR Approach6-15

Corporate Finance

6-16

Multiple IRRsThere are two IRRs for this project:

0 1 2 3

$200 $800

-$200 - $800

($150.00)

($100.00)

($50.00)

$0.00

$50.00

$100.00

-50% 0% 50% 100% 150% 200%

Discount rate

NP

V

100% = IRR2

0% = IRR1

Which one should we use?

Corporate Finance

Summarizing rules

6-17

8/18/2013

7

Corporate Finance

6-18

The Scale Problem

Would you rather make 100% or 50% on your investments?

What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?

Corporate Finance

6-19

The Timing Problem

0 1 2 3

$10,000 $1,000 $1,000

-$10,000

Project A

0 1 2 3

$1,000 $1,000 $12,000

-$10,000

Project B

The preferred project in this case depends on the discount rate, not the IRR.

Corporate Finance

6-20

The Timing Problem

($4,000.00)

($3,000.00)

($2,000.00)

($1,000.00)

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

0% 10% 20% 30% 40%

Discount rate

NP

V

Project A

Project B10.55% = crossover rate

16.04% = IRRA12.94% = IRRB

8/18/2013

8

Corporate Finance

6-21

Calculating the Crossover RateCompute the IRR for either project “A-B” or “B-A”

Year Project A Project B Project A-B Project B-A 0 ($10,000) ($10,000) $0 $01 $10,000 $1,000 $9,000 ($9,000)2 $1,000 $1,000 $0 $03 $1,000 $12,000 ($11,000) $11,000

($3,000.00)

($2,000.00)

($1,000.00)

$0.00

$1,000.00

$2,000.00

$3,000.00

0% 5% 10% 15% 20%

Discount rate

NP

V A-B

B-A

10.55% = IRR

Corporate Finance

6-22

Mutually Exclusive vs.Independent Project

Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.

RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.

Must exceed a MINIMUM acceptance criteria.

Corporate Finance

6-23

The Profitability Index (PI) Rule

Minimum Acceptance Criteria: Accept if PI > 1

Ranking Criteria: Select alternative with highest PI

Disadvantages:Problems with mutually exclusive investments

Advantages:May be useful when available investment funds are limited

Easy to understand and communicate

Correct decision when evaluating independent projects

Investment Initial

FlowsCash Future of PV TotalPI =

8/18/2013

9

Corporate Finance


Independent projectsAccept if PI > 1

Reject if PI < 1

6-24

Corporate Finance


Mutually exclusive projectsPI may lead to wrong selection

This flaw can be corrected using incremental analysis

In case of capital rationing: PI may be useful3 independent projects, limited funds: $20 million

Project 3:

6-25

Corporate Finance

6-26

The Practice of Capital Budgeting

Varies by industry:Some firms use payback, others use accounting rate of return.

The most frequently used technique for large corporations is IRR or NPV.

8/18/2013

10

Corporate Finance

6-27

Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.

Year Project A Project B

0 -$200 -$150

1 $200 $50

2 $800 $100

3 -$800 $150

Corporate Finance

6-28


Project A Project B

CF0 -$200.00 -$150.00

PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%

PI = 1.2096 1.6053

Corporate Finance

6-29


Payback Period:Project A Project B

Time CF Cum. CF CF Cum. CF0 -200 -200 -150 -1501 200 0 50 -1002 800 800 100 03 -800 0 150 150

Payback period for project B = 2 years.Payback period for project A = 1 or 3 years?

8/18/2013

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Corporate Finance

6-30

Relationship Between NPV and IRR

Discount rate NPV for A NPV for B-10% -87.52 234.77

0% 0.00 150.0020% 59.26 47.9240% 59.48 -8.6060% 42.19 -43.0780% 20.85 -65.64

100% 0.00 -81.25120% -18.93 -92.52

Corporate Finance

6-31

Project AProject B

($200)

($100)

$0

$100

$200

$300

$400

-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%

Discount rates

NP

V

IRR 1(A) IRR (B)

NPV Profiles

Cross-over Rate

IRR 2(A)

Corporate Finance

7-32

Incremental Cash Flows

Cash flows matter—not accounting earnings.Incremental cash flows matter.

Cash flows with project – cash flows without project

Sunk costs don’t matter.Sunk costs: cost already occurred, cannot be changed by the decision to accept or reject the project.

Opportunity costs matter.e.g., by taking a project, a firm forgoes other opportunities for using an asset.

8/18/2013

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Corporate Finance

Incremental Cash Flows (cont.)

Side effectsErosion: e.g., a new product reduces the cash flows of existing productsSynergy: e.g., a new product increases the cash flows of existing products

Allocated costsAn expenditure may benefit a number of projectsViewed as cash outflow only if it is an incremental cost of the project

7-33

Corporate Finance

7-34

Cash Flows—Not Accounting Earnings

Consider depreciation expense.

You never write a check made out to “depreciation”.

Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.

Corporate Finance

7-35


Sunk costs are not relevantJust because “we have come this far” does not mean that we should continue to throw good money after bad.

Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.

8/18/2013

13

Corporate Finance

7-36


Side effects matter.Erosion and cannibalism are both bad things. If our new product causes existing customers to demand less of current products, we need to recognize that.

Corporate Finance

7-37

Estimating Cash Flows

Cash Flows from OperationsRecall that:

Operating Cash Flow = EBIT – Taxes + Depreciation

Net Capital SpendingDon’t forget salvage value (after tax, of course).

Changes in Net Working CapitalRecall that when the project winds down, we enjoy a return of net working capital.

Corporate Finance

7-38

Interest Expense

Later chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value.

For now, it’s enough to assume that the firm’s level of debt (hence interest expense) is independent of the project at hand.

8/18/2013

1

Corporate Finance

9-0

Part 1Capital Market Theory:

An Overview

Risk, Return and Firm Cost of Capital

Chapter 4

Corporate Finance

Chapter Outline – Part 1

Returns

Holding-Period Returns

Return Statistics

Average Stock Returns and Risk-Free Returns

Risk Statistics

Summary and Conclusions

Corporate Finance

9-2

Returns

Dollar Returnsthe sum of the cash received and the change in value of the asset, in dollars.

Time 0 1

Initial investment

Ending market value

Dividends

•Percentage Returns

–the sum of the cash received and the change in value of the asset divided by the original investment.

8/18/2013

2

Corporate Finance

Dollar Return = Dividend + Change in Market ValueDollar Return = Dividend + Change in Market Value

Returns

yieldgainscapitalyielddividend +=

uemarket valbeginning

uemarket valin changedividend+=

uemarket valbeginning

returndollar returnpercentage =

Corporate Finance

9-4

Returns: Example

Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $25. Over the last year, you received $20 in dividends (= 20 cents per share × 100 shares). At the end of the year, the stock sells for $30. How did you do?

Quite well. You invested $25 × 100 = $2,500. At the end of the year, you have stock worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000 – $2,500).

Your percentage gain for the year is20.8% = $2,500$520

Corporate Finance

9-5

Returns: Example

Dollar Return:$520 gain

Time 0 1

-$2,500

$3,000

$20

Percentage Return:

20.8% = $2,500$520

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Corporate Finance

9-6

Holding-Period Returns

The holding period return is the return that an investor would get when holding an investment over a period of n years, when the return during year i is given as ri:

1)1()1()1(

return period holding

21 −+××+×+==

nrrr L

Corporate Finance

9-7

Holding Period Return: Example

Suppose your investment provides the following returns over a four-year period:

Year Return1 10%2 -5%3 20%4 15% %21.444421.

1)15.1()20.1()95(.)10.1(

1)1()1()1()1(

return period holdingYour

4321

==−×××=

−+×+×+×+==

rrrr

Corporate Finance

9-8

So, our investor made 9.58% on his money for four years, realizing a holding period return of 44.21%


actually realized an annual return of 9.58%:An investor who held this investment would have actually realized an annual return of 9.58%:

Year Return1 10%2 -5%3 20%4 15% %58.9095844.

1)15.1()20.1()95(.)10.1(

)1()1()1()1()1(

return average Geometric

4

43214

==

−×××=

+×+×+×+=+=

g

g

r

rrrrr

4)095844.1(4421.1 =

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Corporate Finance

9-9


Note that the geometric average is not the same thing as the arithmetic average:

Year Return1 10%2 -5%3 20%4 15%

%104

%15%20%5%104

return average Arithmetic 4321

=++−=

+++= rrrr

Corporate Finance

9-10

Holding Period Returns

A famous set of studies dealing with the rates of returns on common stocks, bonds, and Treasury bills was conducted by Roger Ibbotson and Rex Sinquefield.They present year-by-year historical rates of return starting in 1926 for the following five important types of financial instruments in the United States:

Large-Company Common StocksSmall-company Common StocksLong-Term Corporate BondsLong-Term U.S. Government BondsU.S. Treasury Bills

Corporate Finance

9-11

The Future Value of an Investmentof $1 in 1925

0.1

10

1000

1930 1940 1950 1960 1970 1980 1990 2000

Common StocksLong T-BondsT-Bills

$59.70

$17.48

Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™ , Ibbotson Associates, Inc., Chicago (annually upda tes work by Roger G. Ibbotson and Rex A. Sinquefield). All righ ts reserved.

$1,775.34

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Corporate Finance

9-12

Return Statistics

The history of capital market returns can be summarized by describing the

average return

the standard deviation of those returns

the frequency distribution of the returns.

T

RRR T )( 1 ++= L

1

)()()( 222

21

−−+−+−==

T

RRRRRRVARSD TL

Corporate Finance

9-13

Historical Returns, 1926-2002

Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™ , Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

– 90% + 90%0%

Average StandardSeries Annual Return Devia tion Distribution

Large Company Stocks 12.2% 20.5%

Small Company Stocks 16.9 33.2

Long-Term Corporate Bonds 6.2 8.7

Long-Term Government Bonds 5.8 9.4

U.S. Treasury Bills 3.8 3.2

Inflation 3.1 4.4

Corporate Finance

9-14

Average Stock Returnsand Risk-Free Returns

The Risk Premium is the additional return (over and above the risk-free rate) resulting from bearing risk.One of the most significant observations of stock market data is this long-run excess of stock return over the risk-free return.

The average excess return from large company common stocks for the period 1926 through 1999 was 8.4% = 12.2% – 3.8%The average excess return from small company common stocks for the period 1926 through 1999 was 13.2% = 16.9% – 3.8%The average excess return from long-term corporate bonds for the period 1926 through 1999 was 2.4% = 6.2% – 3.8%

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Corporate Finance

9-15

Risk Premia

Suppose that The Wall Street Journal announced that the current rate for on-year Treasury bills is 5%. What is the expected return on the market of small-company stocks?Recall that the average excess return from small company common stocks for the period 1926 through 1999 was 13.2%Given a risk-free rate of 5%, we have an expected return on the market of small-company stocks of 18.2% = 13.2% + 5%

Corporate Finance

9-16

The Risk-Return Tradeoff

2%

4%

6%

8%

10%

12%

14%

16%

18%

0% 5% 10% 15% 20% 25% 30% 35%

Annual Return Standard Deviation

Ann

ual R

etur

n A

vera

ge

T-Bonds

T-Bills

Large-Company Stocks

Small-Company Stocks

Corporate Finance

9-17

Rates of Return 1926-2002

-60

-40

-20

0

20

40

60

26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000

Common Stocks

Long T-Bonds

T-Bills


8/18/2013

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Corporate Finance

9-18

Risk Premiums

Rate of return on T-bills is essentially risk-free.

Investing in stocks is risky, but there are compensations.

The difference between the return on T-bills and stocks is the risk premium for investing in stocks.

An old saying on Wall Street is “You can either sleep well or eat well.”

Corporate Finance

9-19

Stock Market Volatility

0

10

20

30

40

50

60

1926

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

1998


The volatility of stocks is not constant from year to year.

Corporate Finance

9-20

Risk Statistics

There is no universally agreed-upon definition of risk.

The measures of risk that we discuss are variance and standard deviation.

The standard deviation is the standard statistical measure of the spread of a sample, and it will be the measure we use most of this time.

Its interpretation is facilitated by a discussion of the normal distribution.

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9-21

Normal DistributionA large enough sample drawn from a normal distribution looks like a bell-shaped curve.

Probability

Return onlarge company commonstocks

99.74%

– 3σσσσ– 49.3%

– 2σσσσ– 28.8%

– 1σσσσ– 8.3%

012.2%

+ 1σσσσ32.7%

+ 2σσσσ53.2%

+ 3σσσσ73.7%

The probability that a yearly return will fall within 20.1 percent of the mean of 13.3 percent will be approximately 2/3.

68.26%

95.44%

Corporate Finance

9-22

Normal Distribution

The 20.1-percent standard deviation we found for stock returns from 1926 through 1999 can now be interpreted in the following way: if stock returns are approximately normally distributed, the probability that a yearly return will fall within 20.1 percent of the mean of 13.3 percent will be approximately 2/3.

Corporate Finance

9-23

Normal Distribution S&P 500 Return Frequencies

0

2

5

11

16

9

1212

12

110

0

2

4

6

8

10

12

14

16

62%52%42%32%22%12%2%-8%-18%-28%-38%-48%-58%

Annual returns

Ret

urn

freq

uenc

y

Normal approximationMean = 12.8%Std. Dev. = 20.4%

Source: © Stocks, Bonds, Bills, and Inflation 2002 Yearbook™ , Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

8/18/2013

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Corporate Finance

9-24


This chapter presents returns for four asset classes:

Large Company StocksSmall Company StocksLong-Term Government BondsTreasury Bills

Stocks have outperformed bonds over most of the twentieth century, although stocks have also exhibited more risk.

Corporate Finance

9-25


The stocks of small companies have outperformed the stocks of small companies over most of the twentieth century, again with more risk.

The statistical measures in this chapter are necessary building blocks for the material of the next three chapters.

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Corporate Finance

10-0

Part 2The Capital Asset Pricing Model

(CAPM)

Risk, Return and Firm Cost of Capital

Chapter 4

Corporate Finance

10-1

Chapter Outline – Part 2Individual SecuritiesExpected Return, Variance, and CovarianceThe Return and Risk for PortfoliosThe Efficient Set for Two AssetsThe Efficient Set for Many SecuritiesDiversification: An ExampleRiskless Borrowing and LendingMarket EquilibriumRelationship between Risk and Expected Return (CAPM)Summary and Conclusions

Corporate Finance

10-2

Individual Securities

The characteristics of individual securities that are of interest are the:

Expected Return

Variance and Standard Deviation

Covariance and Correlation

8/18/2013

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Corporate Finance

10-3

Expected Return, Variance,and Covariance

Consider the following two risky asset world. There is a 1/3 chance of each state of the economy and the only assets are a stock fund and a bond fund.

Rate of ReturnScenario Probability Stock fund Bond fund

Recession 33.3% -7% 17%Normal 33.3% 12% 7%

Boom 33.3% 28% -3%

Corporate Finance

10-4


Stock fund Bond FundRate of Squared Rate of Squared

Scenario Return Deviation Return Deviation Recession -7% 3.24% 17% 1.00%Normal 12% 0.01% 7% 0.00%Boom 28% 2.89% -3% 1.00%Expected return 11.00% 7.00%Variance 0.0205 0.0067Standard Deviation 14.3% 8.2%

Corporate Finance

10-5




%11)(

%)28(31%)12(3

1%)7(31)(

=

×+×+−×=

S

S

rE

rE

8/18/2013

3

Corporate Finance

10-6




%7)(

%)3(31%)7(3

1%)17(31)(

=

−×+×+×=

B

B

rE

rE

Corporate Finance

10-7




%24.3%)7%11( 2 =−−

Corporate Finance

10-8




%01.%)12%11( 2 =−

8/18/2013

4

Corporate Finance

10-9




%89.2%)28%11( 2 =−

Corporate Finance

10-10




%)89.2%01.0%24.3(31

%05.2 ++=

Corporate Finance

10-11




0205.0%3.14 =

8/18/2013

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Corporate Finance

10-12



The Return and Riskfor Portfolios

Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks.

Corporate Finance

10-13

The Return and Risk for Portfolios

Rate of ReturnScenario Stock fund Bond fund Portfolio squared deviationRecession -7% 17% 5.0% 0.160%Normal 12% 7% 9.5% 0.003%Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%Variance 0.0205 0.0067 0.0010Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

SSBBP rwrwr +=

%)17(%50%)7(%50%5 ×+−×=

Corporate Finance

10-14





%)7(%50%)12(%50%5.9 ×+×=

SSBBP rwrwr +=

8/18/2013

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Corporate Finance

10-15





%)3(%50%)28(%50%5.12 −×+×=

SSBBP rwrwr +=

Corporate Finance

10-16




The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio.

%)7(%50%)11(%50%9 ×+×=)()()( SSBBP rEwrEwrE +=

Corporate Finance

10-17




The variance of the rate of return on the two risky assets portfolio is

BSSSBB2

SS2

BB2P )ρσ)(wσ2(w)σ(w)σ(wσ ++=

where ρBS is the correlation coefficient between the returns on the stock and bond funds.

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Corporate Finance

10-18




Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than stocks or bonds held in isolation.

Corporate Finance

10-19

Portfolo Risk and Return Combinations

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Por

tfol

io R

etur

n

% in stocks Risk Return0% 8.2% 7.0%5% 7.0% 7.2%10% 5.9% 7.4%15% 4.8% 7.6%20% 3.7% 7.8%25% 2.6% 8.0%30% 1.4% 8.2%35% 0.4% 8.4%40% 0.9% 8.6%45% 2.0% 8.8%

50.00% 3.08% 9.00%55% 4.2% 9.2%60% 5.3% 9.4%65% 6.4% 9.6%70% 7.6% 9.8%75% 8.7% 10.0%80% 9.8% 10.2%85% 10.9% 10.4%90% 12.1% 10.6%95% 13.2% 10.8%100% 14.3% 11.0%

The Efficient Set for Two Assets

We can consider other portfolio weights besides 50% in stocks and 50% in bonds …

100% bonds

100% stocks

Corporate Finance

10-20


5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%


Por

tfol

io R

etur

n


We can consider other portfolio weights besides 50% in stocks and 50% in bonds …

100% bonds

100% stocks

% in stocks Risk Return0% 8.2% 7.0%5% 7.0% 7.2%10% 5.9% 7.4%15% 4.8% 7.6%20% 3.7% 7.8%25% 2.6% 8.0%30% 1.4% 8.2%35% 0.4% 8.4%40% 0.9% 8.6%45% 2.0% 8.8%50% 3.1% 9.0%55% 4.2% 9.2%60% 5.3% 9.4%65% 6.4% 9.6%70% 7.6% 9.8%75% 8.7% 10.0%80% 9.8% 10.2%85% 10.9% 10.4%90% 12.1% 10.6%95% 13.2% 10.8%100% 14.3% 11.0%


% in stocks Risk Return0% 8.2% 7.0%5% 7.0% 7.2%

10% 5.9% 7.4%15% 4.8% 7.6%20% 3.7% 7.8%25% 2.6% 8.0%30% 1.4% 8.2%35% 0.4% 8.4%40% 0.9% 8.6%45% 2.0% 8.8%50% 3.1% 9.0%55% 4.2% 9.2%60% 5.3% 9.4%65% 6.4% 9.6%70% 7.6% 9.8%75% 8.7% 10.0%80% 9.8% 10.2%85% 10.9% 10.4%90% 12.1% 10.6%95% 13.2% 10.8%100% 14.3% 11.0%


















% in stocks Risk Return0% 8.2% 7.0%5% 7.0% 7.2%10% 5.9% 7.4%15% 4.8% 7.6%20% 3.7% 7.8%25% 2.6% 8.0%30% 1.4% 8.2%35% 0.4% 8.4%40% 0.9% 8.6%45% 2.0% 8.8%50% 3.1% 9.0%55% 4.2% 9.2%60% 5.3% 9.4%65% 6.4% 9.6%70% 7.6% 9.8%75% 8.7% 10.0%80% 9.8% 10.2%85% 10.9% 10.4%90% 12.1% 10.6%95% 13.2% 10.8%

100% 14.3% 11.0%

8/18/2013

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Corporate Finance

10-21


5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%


Por

tfol

io R

etur

n% in stocks Risk Return0% 8.2% 7.0%5% 7.0% 7.2%10% 5.9% 7.4%15% 4.8% 7.6%20% 3.7% 7.8%25% 2.6% 8.0%30% 1.4% 8.2%35% 0.4% 8.4%40% 0.9% 8.6%45% 2.0% 8.8%50% 3.1% 9.0%55% 4.2% 9.2%60% 5.3% 9.4%65% 6.4% 9.6%70% 7.6% 9.8%75% 8.7% 10.0%80% 9.8% 10.2%85% 10.9% 10.4%90% 12.1% 10.6%95% 13.2% 10.8%100% 14.3% 11.0%


100% stocks

100% bonds

Note that some portfolios are “better” than others. They have higher returns for the same level of risk or less. These compromise the

efficient frontier.

Corporate Finance

10-22

Two-Security Portfolios with Various Correlations

100% bonds

retu

rn

σσσσ

100% stocks

ρ = 0.2

ρ = 1.0

ρ = -1.0

Relationship depends on correlation coefficient

-1.0 <ρ < +1.0

If ρ = +1.0, no risk reduction is possible

If ρ = –1.0, complete risk reduction is possible

Relationship depends on correlation coefficient

-1.0 <ρ < +1.0

If ρ = +1.0, no risk reduction is possible

If ρ = –1.0, complete risk reduction is possible

Corporate Finance

10-23

Portfolio Risk as a Function of the Number of Stocksin the Portfolio

Nondiversifiable risk; Systematic Risk; Market Risk

Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk

n

σσσσIn a large portfolio the variance terms are effectively diversified away, but the covariance terms are not.

Thus diversification can eliminate some, but not all of the risk of individual securities.

Portfolio risk

8/18/2013

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Corporate Finance

10-24

The Efficient Set for Many Securities

Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios.

retu

rn

σσσσP

Individual Assets

Corporate Finance

10-25


Given the opportunity set we can identify the minimum variance portfolio.

retu

rn

σσσσP

minimum variance portfolio

Individual Assets

Corporate Finance

10-26

The section of the opportunity set above the minimum variance portfolio is the efficient frontier.


retu

rn

σσσσP

minimum variance portfolio

Individual Assets

8/18/2013

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Corporate Finance

10-27

Optimal Risky Portfolio with a Risk-Free Asset

In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills

100% bonds

100% stocks

rf

retu

rn

σσσσ

Corporate Finance

10-28

Now investors can allocate their money across the T-bills and a balanced mutual fund

Riskless Borrowing and Lending

100% bonds

100% stocks

rf

retu

rn

σσσσ

Balanced fund

Corporate Finance

10-29

Riskless Borrowing and Lending

With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope

retu

rn

σσσσP

rf

8/18/2013

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Corporate Finance

10-30

Market Equilibrium

With the capital allocation line identified, all investors choose a point along the line—some combination of the risk-free asset and the market portfolio M. In a world with homogeneous expectations, M is the same for all investors.

retu

rn

σσσσP

rf

M

Corporate Finance

10-31

The Separation Property

The Separation Property states that the market portfolio, M, is the same for all investors—they can separate their risk aversion from their choice of the market portfolio.

retu

rn

σσσσP

rf

M

Corporate Finance

10-32


Investor risk aversion is revealed in their choice of where to stay along the capital allocation line—not in their choice of the line.

retu

rn

σσσσP

rf

M

8/18/2013

12

Corporate Finance

10-33

Market Equilibrium

Just where the investor chooses along the Capital Asset Line depends on his risk tolerance. The big point though is that all investors have the same CML.

100% bonds

100% stocks

rf

retu

rn

σσσσ

Balanced fund

Corporate Finance

10-34

Market Equilibrium

All investors have the same CML because they all have the same optimal risky portfolio given the risk-free rate.

100% bonds

100% stocks

rf

retu

rn

σσσσ

Optimal Risky Portfolio

Corporate Finance

10-35


The separation property implies that portfolio choice can be separated into two tasks: (1) determine the optimal risky portfolio, and (2) selecting a point on the CML.

100% bonds

100% stocks

rf

retu

rn

σσσσ

Optimal Risky Portfolio

8/18/2013

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Corporate Finance

10-36

Optimal Risky Portfolio with a Risk-Free Asset

By the way, the optimal risky portfolio depends on the risk-free rate as well as the risky assets.

100% bonds

100% stocks

retu

rn

σσσσ

First Optimal Risky Portfolio

Second Optimal Risky Portfolio

0fr

1fr

Corporate Finance

10-37

Definition of Risk When Investors Holdthe Market Portfolio

Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (β)of the security.

Beta measures the responsiveness of a security to movements in the market portfolio.

)(

)(2

,

M

Mii

R

RRCov

σβ =

Corporate Finance

10-38

Estimating β with regression

Secu

rity

Ret

urns

Secu

rity

Ret

urns

Return on Return on market %market %

RRii = = αααααααα ii + + ββββββββiiRRmm + + eeii

Slope = Slope = ββββββββii

8/18/2013

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Corporate Finance

10-39

Estimates of β for Selected StocksStock Beta

Bank of America 1.55

Borland International 2.35

Travelers, Inc. 1.65

Du Pont 1.00

Kimberly-Clark Corp. 0.90

Microsoft 1.05

Green Mountain Power

0.55

Homestake Mining 0.20

Oracle, Inc. 0.49

Corporate Finance

10-40

The Formula for Beta

)(

)(2

,

M

Mii

R

RRCov

σβ =

Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.

Corporate Finance

10-41

Relationship between Riskand Expected Return (CAPM)

Expected Return on the Market:

Expected return on an individual security:

PremiumRisk Market += FM RR

)(β FMiFi RRRR −×+=

Market Risk Premium

This applies to individual securities held within well-diversified portfolios.

8/18/2013

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Corporate Finance

10-42

Expected Return on an Individual Security

This formula is called the Capital Asset Pricing Model (CAPM)


• Assume βi = 0, then the expected return is RF.• Assume βi = 1, then Mi RR =

Expected return on a security

=Risk-

free rate+

Beta of the security

×Market risk premium

Corporate Finance

10-43

Relationship Between Risk & Expected Return

Exp

ecte

d re

turn

ββββ


FR

1.0

MR

Corporate Finance

10-44

Relationship Between Risk & Expected Return

Exp

ecte

d re

turn

ββββ

%3=FR

%3

1.5

%5.13

5.1β =i %10=MR%5.13%)3%10(5.1%3 =−×+=iR

8/18/2013

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Corporate Finance

10-45


This chapter sets forth the principles of modern portfolio theory.The expected return and variance on a portfolio of two securities A and B are given by

By varying wA, one can trace out the efficient set of portfolios. We graphed the efficient set for the two-asset case as a curve, pointing out that the degree of curvature reflects the diversification effect: the lower the correlation between the two securities, the greater the diversification.The same general shape holds in a world of many assets.

ABAABB2

BB2

AA2P )ρσ)(wσ2(w)σ(w)σ(wσ ++=

)()()( BBAAP rEwrEwrE +=

Corporate Finance

10-46


The efficient set of risky assets can be combined with riskless borrowing and lending. In this case, a rational investor will always choose to hold the portfolio of risky securities represented by the market portfolio.

retu

rn

σσσσP

rf

M

Then with borrowing or lending, the investor selects a point along the CML.

Corporate Finance

10-47


The contribution of a security to the risk of a well-diversified portfolio is proportional to the covariance of the security's return with the market’s return. This contribution is called the beta.

The CAPM states that the expected return on a security is positively related to the security’s beta:

)(

)(2

,

M

Mii

R

RRCov

σβ =


8/18/2013

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Corporate Finance

15-0

Corporate Capital Structure

Chapter 5

Corporate Finance

15-1

Chapter Outline

The Capital-Structure Question and The Pie Theory

Maximizing Firm Value versus Maximizing Stockholder Interests

Financial Leverage and Firm Value: An Example

Modigliani and Miller: Proposition II (No Taxes)

Taxes


Corporate Finance

15-2

The Capital-Structure Questionand The Pie Theory

The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

V = B + S

If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible. Value of the Firm

S BS BS BS B

8/18/2013

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Corporate Finance

15-3

The Capital-Structure Question

There are really two important questions:1. Why should the stockholders care about maximizing

firm value? Perhaps they should be interested in strategies that maximize shareholder value.

2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?

As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.

Corporate Finance

15-4

Financial Leverage, EPS, and ROE

CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50

Proposed$20,000$8,000

$12,0002/38%240$50

Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)

Corporate Finance

15-5

EPS and ROE Under Current Capital Structure

Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%

Current Shares Outstanding = 400 shares

8/18/2013

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Corporate Finance

15-6

EPS and ROE Under Proposed Capital Structure

Recession Expected ExpansionEBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 5% 10% 15%ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

Corporate Finance

15-7

EPS and ROE Under Both Capital Structures

LeveredRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 5% 10% 15%ROE 3% 11% 20%Proposed Shares Outstanding = 240 shares


EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 5% 10% 15%ROE 3% 11% 20%Proposed Shares Outstanding = 240 shares

All-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares

Corporate Finance

15-8

Financial Leverage and EPS

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1,000 2,000 3,000

EP

S

Debt

No Debt

Break-even point

EBIT in dollars, no taxes

Advantage to debt

Disadvantage to debt

8/18/2013

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Corporate Finance

15-9

Assumptions of the Modigliani-Miller Model

Homogeneous ExpectationsHomogeneous Business Risk ClassesPerpetual Cash FlowsPerfect Capital Markets:

Perfect competitionFirms and investors can borrow/lend at the same rateEqual access to all relevant informationNo transaction costsNo taxes

Corporate Finance

15-10

Homemade Leverage: An ExampleRecession Expected Expansion

EPS of Unlevered Firm $2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300Less interest on $800 (8%) $64 $64 $64Net Profits $36 $136 $236ROE (Net Profits / $1,200) 3% 11% 20%

We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm.Our personal debt equity ratio is:

32

200,1$

800$ ==S

B

Corporate Finance

15-11

Homemade (Un)Leverage:An ExampleRecession ExpectedExpansion

EPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236Plus interest on $800 (8%) $64 $64 $64Net Profits $100 $200 $300ROE (Net Profits / $2,000) 5% 10% 15%

Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm.This is the fundamental insight of M&M

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Corporate Finance

15-12

The MM Propositions I & II (No Taxes)

Proposition IFirm value is not affected by leverage

VL = VU

Proposition IILeverage increases the risk and return to stockholders

rs = r0 + (B / SL) (r0 - rB)rB is the interest rate (cost of debt)rs is the return on (levered) equity (cost of equity)r0 is the return on unlevered equity (cost of capital)B is the value of debtSL is the value of levered equity

Corporate Finance

15-13

The MM Proposition I (No Taxes)

UL VV =∴

BrEBIT B−

receivefirmleveredain rsShareholde

BrB

receivesBondholder

The derivation is straightforward:

BrBrEBIT BB+− )(

isrsstakeholdealltoflowcash totaltheThus,

The present value of this stream of cash flows isVL

EBITBrBrEBIT BB=+− )(

Clearly

The present value ofthis stream of cash flows isVU

Corporate Finance

15-14

The MM Proposition II (No Taxes)

The derivation is straightforward:

SBWACC rSB

Sr

SB

Br ×

++×

+= 0set Then rrWACC =

0rrSB

Sr

SB

BSB =×

++×

+ S

SB +by sidesboth multiply

0rS

SBr

SB

S

S

SBr

SB

B

S

SBSB

+=×+

×++×+

×+

0rS

SBrr

S

BSB

+=+×

00 rrS

Brr

S

BSB

+=+× )( 00 BS rrS

Brr −+=

8/18/2013

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Corporate Finance

15-15

The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes

Debt-to-equity Ratio

Cos

t of

cap

ital: r

(%

)

r0

rB

SBW ACC rSB

Sr

SB

Br ×

++×

+=

)( 00 BL

S rrS

Brr −×+=

rB

S

B

Corporate Finance

15-16

The MM Propositions I & II(with Corporate Taxes)

Proposition I (with Corporate Taxes)Firm value increases with leverage

VL = VU + TC B

Proposition II (with Corporate Taxes)Some of the increase in equity risk and return is offset by interest tax shield

rS = r0 + (B/S)×(1-TC)×(r0 - rB)rB is the interest rate (cost of debt)rS is the return on equity (cost of equity)r0 is the return on unlevered equity (cost of capital)B is the value of debtS is the value of levered equity

Corporate Finance

15-17

The MM Proposition I (Corp. Taxes)

BTVV CUL +=∴

)1()(

receivefirmleveredain rsShareholde

CB TBrEBIT −×− BrB

receivesBondholder

BrTBrEBIT BCB+−×− )1()(

isrsstakeholdealltoflowcash totaltheThus,

The present value of this stream of cash flows isVL

=+−×− BrTBrEBIT BCB )1()(Clearly

The present value of the first term isVU

The present value of the second term isTCB

BrTBrTEBIT BCBC+−×−−×= )1()1(

BrBTrBrTEBIT BCBBC++−−×= )1(

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Corporate Finance

15-18

The MM Proposition II (Corp. Taxes)Start with M&M Proposition I with taxes:

)()1( 00 BCS rrTS

Brr −×−×+=

BTVV CUL +=Since BSVL +=

The cash flows from each side of the balance sheet must equal:

BCUBS BrTrVBrSr +=+ 0

BrTrTBSBrSr BCCBS +−+=+ 0)]1([Divide both sides byS

BCCBS rTS

BrT

S

Br

S

Br +−+=+ 0)]1(1[

BTVBS CU+=+⇒

)1( CU TBSV −+=

Which quickly reduces to

Corporate Finance

15-19

The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

S rrTS

Brr −×−×+=

SL

LCB

LW ACC r

SB

STr

SB

Br ×

++−××

+= )1(

)( 00 BL

S rrS

Brr −×+=

Corporate Finance

15-20

Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes

All-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Taxes (Tc = 35% $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950


EBIT $1,000 $2,000 $3,000Interest ($800 @ 8% ) 640 640 640EBT $360 $1,360 $2,360Taxes (Tc = 35%) $126 $476 $826Total Cash Flow $234+640 $468+$640 $1,534+$640(to both S/H & B/H): $874 $1,524 $2,174EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224

$874 $1,524 $2,174


EBIT $1,000 $2,000 $3,000Interest ($800 @ 8% ) 640 640 640EBT $360 $1,360 $2,360Taxes (Tc = 35%) $126 $476 $826Total Cash Flow $234+640 $468+$640 $1,534+$640(to both S/H & B/H): $874 $1,524 $2,174EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224

$874 $1,524 $2,174

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15-21


The levered firm pays less in taxes than does the all-equity firm.

Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

S G S G

B

All-equity firm Levered firm

Corporate Finance

15-22


The sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!

S G S G

B

All-equity firm Levered firm

Corporate Finance

15-23

Summary: No Taxes

In a world of no taxes, the value of the firm is unaffected by capital structure.

This is M&M Proposition I:VL = VU

Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders

)( 00 BL

S rrS

Brr −×+=

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Corporate Finance

15-24

Summary: Taxes

In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.

This is M&M Proposition I:VL = VU + TC B

Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

)()1( 00 BCL

S rrTS

Brr −×−×+=

Corporate Finance

15-25

Prospectus: Bankruptcy Costs

So far, we have seen M&M suggest that financial leverage does not matter, or imply that taxes cause the optimal financial structure to be 100% debt.In the real world, most executives do not like a capital structure of 100% debt because that is a state known as “bankruptcy”.In the next chapter we will introduce the notion of a limit on the use of debt: financial distress.The important use of this chapter is to get comfortable with “M&M algebra”.

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Corporate Finance

18-0

Corporate Dividend Policy

Chapter 6

Corporate Finance

18-1

Chapter OutlineDifferent Types of DividendsStandard Method of Cash Dividend PaymentThe Benchmark Case: An Illustration of the Irrelevance of Dividend

PolicyRepurchase of StockPersonal Taxes, Issuance Costs, and DividendsReal World Factors Favoring a High Dividend PolicyThe Clientele Effect:

A Resolution of Real-World Factors?What We Know and Do Not Know About Dividend PolicySummary and Conclusions

Corporate Finance

18-2

Different Types of Dividends

Many companies pay a regular cash dividend.Public companies often pay quarterly.Sometimes firms will throw in an extra cash dividend.The extreme case would be a liquidating dividend.

Often companies will declare stock dividends.No cash leaves the firm.The firm increases the number of shares outstanding.

Some companies declare a dividend in kind .Wrigley’s Gum sends around a box of chewing gum.Dundee Crematoria offers shareholders discounted cremations.

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Corporate Finance

18-3

Standard Method of CashDividend Payment

Record Date- Person who owns stock on this date received the dividend.

Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.

Cash Dividend- Payment of cash by the firm to its shareholders.

Corporate Finance

18-4

Procedure for Cash Dividend Payment

25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.

Declaration Date

Cum-dividend

Date

Ex-dividend

Date

Record Date

Payment Date

…

Declaration Date: The Board of Directors declares a payment of dividends.Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

Corporate Finance

18-5

Price Behavior around the Ex-Dividend Date

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.

$P

$P - div

Ex-dividend

Date

The price drops by the amount of the cash dividend

-t … -2 -1 0 +1 +2 …

Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date.

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Corporate Finance

18-6

The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy

A compelling case can be made that dividend policy is irrelevant.Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.

Corporate Finance

18-7

Homemade Dividends

Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.

Bob Investor owns 80 shares and prefers $3 cash dividend.

Bob’s homemade dividend strategy:Sell 2 shares ex-dividend

homemade dividendsCash from dividend $160Cash from selling stock $80Total Cash $240Value of Stock Holdings $40 × 78 =

$3,120

$3 Dividend$240

$0$240

$39 × 80 =$3,120

Corporate Finance

18-8

Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.

In the above example, Bob Investor began with total wealth of $3,360:

Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm.

In the above example, Bob Investor began with total wealth of $3,360:

share

42$shares80360,3$ ×=

240$share

39$shares80360,3$ +×=

80$160$share

40$shares78360,3$ ++×=

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend, and sale of 2 ex-dividend shares,his total wealth is still $3,360:

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Corporate Finance

18-9

Irrelevance of Stock Dividends: Example

Shimano USA has 2 million shares currently outstanding at $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid?

A 50% stock dividend will increase the number of shares by 50%:

2 million×1.5 = 3 million shares

After the stock dividend what is the new price per share and what is the new value of the firm?

The value of the firm was $2m × $15 per share = $30 m. After the dividend, the value will remain the same.

Price per share = $30m/ 3m shares = $10 per share

Corporate Finance

18-10

Dividends and Investment Policy

Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time).

Recall that on of the assumptions underlying the dividend-irrelevance arguments was “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”

Corporate Finance

18-11

Repurchase of Stock

Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.

Recently share repurchase has become an important way of distributing earnings to shareholders.

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Corporate Finance

18-12

Stock Repurchase versus Dividend

$10=/100,000$1,000,000=Price per share100,000=outstandingShares

1,000,000Value of Firm1,000,000Value of Firm1,000,000Equity850,000assetsOther

0Debt$150,000Cash

sheetbalanceOriginalA.Equity&LiabilitiesAssets

Consider a firm that wishes to distribute $100,000 to its shareholders.

Corporate Finance

18-13


$9=00,000$900,000/1=shareper Price

100,000=goutstandingShares

900,000FirmofValue900,000FirmofValue

900,000Equity850,000assetsOther

0Debt$50,000Cash

dividendcash shareper $1After B.

Equity&sLiabilitiesAssets

If they distribute the $100,000 as cash dividend, the balance sheet will look like this:

Corporate Finance

18-14


Assets Liabilities & EquityC. After stock repurchase

Cash $50,000 Debt 0Other assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000

Shares outstanding= 90,000Price per share = $900,000 / 90,000 = $10

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:

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Corporate Finance

18-15

Share Repurchase

Lower tax (but the IRS is watching)

Tender offersIf offer price is set wrong, some stockholders lose.

Open-market repurchase

Targeted repurchaseGreenmail

Gadflies

Repurchase as investmentRecent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.

Corporate Finance

18-16

Personal Taxes, Issuance Costs, and Dividends

To get the result that dividend policy is irrelevant, we needed three assumptions:

No taxesNo transactions costsNo uncertainty

In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent.Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains.

Corporate Finance

18-17

Firms Without Sufficient Cashto Pay a Dividend

In a world of personal taxes, firms should not issue stock to pay a dividend.

FirmStock

Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment BankersThe direct costs of stock issuance will add to this effect.

8/18/2013

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Corporate Finance

18-18

Firms With Sufficient Cash toPay a Dividend

The above argument does not necessarily apply to firms with excess cash.

Consider a firm that has $1 million in cashafter selecting all available positive NPV projects.

The firm has several options:Select additional capital budgeting projects (by assumption, these are negative NPV).

Acquire other companies

Purchase financial assets

Repurchase shares

Corporate Finance

18-19

Taxes, Issuance Costs,and Dividends

In the presence of personal taxes:1. A firm should not issue stock to pay a dividend.

2. Managers have an incentive to seek alternative uses for funds to reduce dividends.

3. Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends.

Corporate Finance

18-20

Real World Factors Favoringa High Dividend Policy

Desire for Current Income

Resolution of Uncertainty

Tax Arbitrage

Agency Costs

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Corporate Finance

18-21


The homemade dividend argument relies on no transactions costs.

To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a specified rate.

Corporate Finance

18-22

Resolution of Uncertainty

It would be erroneous to conclude that increased dividends can make the firm less risky.

A firm’s overall cash flows are not necessarily affected by dividend policy—as long as capital spending and borrowing are not changes.

Thus, it is hard to see how the risks of the overall cash flows can be changed with a change in dividend policy.

Corporate Finance

18-23

Tax Arbitrage

Investors can create positions in high dividend-yield securities that avoid tax liabilities.

Thus, corporate managers need not view dividends as tax-disadvantaged.

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Corporate Finance

18-24

Agency Costs

Agency Cost of DebtFirms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earns, cash flow and working capital above pre-specified levels.

Agency Costs of EquityManagers will find it easier to squander funds if they have a low dividend payout.

Corporate Finance

18-25

Real World Factors

Reasons for Low DividendPersonal TaxesHigh Issuing Costs

Reasons for High DividendInformation Asymmetry

Dividends as a signal about firm’s future performance

Lower Agency Costscapital market as a monitoring devicereduce free cash flow, and hence wasteful spending

Bird-in-the-hand: Theory or Fallacy?Uncertainty resolution


Corporate Finance

18-26

The Clientele Effect: A Resolution of Real-World Factors?

Clienteles for various dividend payout policies are likely to form in the following way:

Group Stock

High Tax Bracket Individuals

Low Tax Bracket Individuals

Tax-Free Institutions

Corporations

Zero to Low payout stocks

Low-to-Medium payout

Medium Payout Stocks

High Payout Stocks

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.

8/18/2013

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Corporate Finance

18-27

What We Know and Do Not Know About Dividend Policy

Corporations “Smooth” Dividends.

Dividends Provide Information to the Market.

Firms should follow a sensible dividend policy:Don’t forgo positive NPV projects just to pay a dividend.

Avoid issuing stock to pay dividends.

Consider share repurchase when there are few better uses for the cash.

Corporate Finance

18-28

Summary and ConclusionsThe optimal payout ratio cannot be determined quantitatively.In a perfect capital market, dividend policy is irrelevant due to the homemade dividend concept.A firm should not reject positive NPV projects to pay a dividend.Personal taxes and issue costs are real-world considerations that favor low dividend payouts.Many firms appear to have along-run target dividend-payout policy. There appears to be some value to dividend stability and smoothing.There appears to be some information content in dividend payments.

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