Week 1 – Introduction to Finance

What is Finance?

→ Investigates how different eco entities evaluate investments and raise capital to fund them
within the existing infrastructures

Key Definitions
Corporate Finance concerned abt financial decisions of corporations

- Revolves ard buying behavior of real assets

→ Facilitated by borrowing (issuing of debt securities or equities)

Hence it is a study 3 types of decisions

1. Investment Decisions (Purchase of Real Assets=Cash Outflows)

- Activities that aim at generating revenues or to save costs
 → Evaluated by “Capital Budgeting” = Process of evaluating the desirability of
alternative real asset purchases
→ Involve management of Real Assets (management of existing asset pool)
o Ie Disney spent $14-16 billion in a new streaming platform Disney+

2. Financing Decisions (Capital Structure = Cash Inflows):

- How a firm aims to raise money to fund investment, dependent on :
→ Capital Structure Policy (bal act b/w debt & equity) → i.e Tesla IPO
1 Debt: Borrowed Funds e.g loans and bonds → linked to interest
expense on income statement
2 Equity: Ownership (shares of profit) e.g shares/stocks → dilution of
ownership share – eats into share of Net Income available
→ Involves management of Financial Assets
o Tesla’s IPO in 2010

3. Dividend Decisions:
- Whether firm should distribute or use existing C-F & assets (Net Income)
→ Managers evaluate whether shareholders are satisfied with current capital gains
or needs supplementary dividend paymers
- Dividends vs Buybacks
→ Involves management of Financial Assets
1 Note issuing dividends & financial instruments → cost feeds from
IBs
o CVA announced interim dividend of $1.5 per share

Risk = Uncertainty → getting a deviation from expectation i.e 12% return when 10% expected

Note: A financial manager would also be responsible for making working capital management
decisions (cash management decision).For example, how should day to day financial matters be
managed or if there are sufficient short-term resources to keep daily operations
What are companies?
Company = Business organized as a separate legal entity owned by shareholders

→ Limited Liability → Owners incur up to principal investment amount

→ Can make legal contracts, incur debt, lend etc w/o direct impact to owners

→ Many owners → complicated management → responsibility delegated to managers

who have the goal of satisfying Shareholder wants

What do shareholders want?

- Shareholders want 3 things (H/Ever Most Vulnerable Group)
1. Max shareholder wealth → investment in Asset must yield a higher
expected return that the cost of capital = minimum rate investors expect
2. Timing: To transform wealth into most desirable time pattern of
consumption
3. Risk: Effective management of risk characteristic of that consumption plan

How do these managers make decisions?

Objective + Valuations (Analysis of Investment Trade off = Opp Cost)

- Objective = Financial Managers should take every opportunity to make corporate

finance decisions that increase shareholder wealth

- Valuation: Financial managers should only invest in a project when:

Return > Minimum Return required by investors in Financial Market (S&P 500)
Or
Return > Hurdle Rate & Opportunity Cost of Capital
→ Inc in stock prices (incl in answer)

O/C Cost of Capital = Explicit (Cost of Capital) + Implicit cost of Capital (Not able to be
deployed to service other investment decisions)
Difference b/w maximizing profit & wealth
H/Ever Firm should differentiate b/w maximizing Profit vs Wealth

- Profit → Accounting concept (Rev – Cost) → More S/T

- Market Value of Shareholder Wealth (Firm’s Value) – eq of demand and supply

= Sum of all Expected Future Cash Flows to shareholders ater adjusting for
time value of money

→ Linked to the core financial decisions nut more so investing decisions

→ Hence maximizing firm value req extensive knowledge of:

1. Understanding of how Assets, Debt and Equity are priced in

financial markets
2. Understanding of how Capital Markets work (and how to value
assets in these)
3. Properly assess and account for the role of time and uncertainty

This conflict can manifest when managers decide to maximize S/T profits through cutting R&D
& employee training costs → decrease future profits and hence Shareholder’s Wealth.

- Hence profit maximization is not well defined

Other Company Structures

Characteristics Sole Partnerships Company/Cooperation’s

Proprietorships
(Priv & Public)

Size Small (1 owner) Small-Large (2-hundres of Very Large, potentially public

partners) ally listed

Eg Retail Shops, Law-Firms, Accounting Multinational companies

Local Repair firms, Family-Owned
shops Businesses -> Agents have
the authority to act for
other partners
Onus of Decision Owner Depends-on Structure of Board of Directors or
Making Partnership Business Professionals who
own little to no stock

Liability of Owners Unlimited Unlimited Limited (Separate Legal Entity

– ability to sign contract and
engage in transactions )

Life of Org Limited Limited Continuous

Ads 100% profits Less Regulated than Access to large Capital

companies Market: Equity and Debt
Least Regulated
& easily set-up Access to more capital,
(ABN sign-up) knowledge, experience an
skill

Note: once partnership is

terminated and a new
partnership is formed

Disads Limited Growth Limited-Growth More Costly to start-up

Opportunity Opportunity
Heavily Regulated by ASIC &
Unlimited corporate-regulations
Liability (Corporations Act 2001)

Personal tax rate

capped at 45% v
30% corporate
cap tax

Note: Two Types of Owners

1. General Partners
a. Actively manages the business (e.g dtod basis)
b. Unlimited liability
2. Limited Partners
a. Not actively manage the business – no management authority and can’t legally be
involved in the managerial decision making the business
Nature of Assets
1. Real Assets
- Assets that can be put to productive use to generate a return
2. Financial Assets
- Assets that represent a claim to a series of cash flows against an economic unit

How is the value of this determined

→ Market Value Balance Sheet

- Market Value of Firm’s Assets = Market value of all Debts Outstanding + Market
Value of Equity (market cap)
- A=D+E
o Derived from Accounting Equation (Eco Res = All Monetary Claims)
o H/ever in Finance → replace book value with current market value of
A,V&E
o This makes up the diff in Book Value v Market Value

→ The financial manager (particularly the CFO) needs to determine the best way to

make corporate finance decisions. They need to balance investments in real and

financial assets to optimize returns and manage risks. But first, they need a goal.

Key Players in a corporation

CEO CFO
Reports directly to the BOD which is Reports directly to the CEO and is
accountable to the company’s owners responsible for all of a company’s financial
matters

Agency Relationships starts with Shareholders

- Appoint → Directors (BODs)

 o required to be independent from shareholders (NYSE & NASDAQ),
recommended in Au
➔ Advise + Appoint & Monitor Top Managers (CEO,CFO,COO)
o Monitoring is carried by internal and external auditors to
ensure Shareholder value is maximized and capital is used
efficiently
→Managers responsible for strategic directions & DtoD ops.

Modern Structure

- More of a matrix rather than the traditional hierarchy

How can this structure potentially this conflict with Maximising

Shareholder Value?
H/ever This structure gives rise to the Agency Problem

- Managers acting in their own interest rather than maximizing value (Other ppl
money problem)

→ Incurred when

1. Separation of ownership & control

2. Shareholders incur costs to monitor managers & constrain their actions

What are these Costs

1. Reduction of Managerial Effort
2. Inefficient investment policies
a. Over- Investment
b. Under-investment
3. Extraction of Resources
a. Excessive monetary rewards & perks
4. Earnings manipulation/creative accounting

Modern Day Example: Enron’s Accounting Fraud

 - Enron began losing money in 1997 but disguised it by using inappropriate accounting
methods
- Shares quickly plummeted → bankruptcy → after scandal was found out
-

How to mitigate
Corporate Governance: the laws, regulations, institutions, and corporate practices that

protect shareholders and other investors

→ eg. legal and regulatory requirements, compensation plans, board of directors,

monitoring, takeovers, shareholder pressure, auditors, lenders

1. Aligning the interests of management and shareholders: Board of directors represent

shareholder’s interest in major company decision, e.g., the board can hir or fire the CEO

2. Management compensation: a significant portion of management compensation can be

tied to firm performance e(e.g stocks, bonus)

3. Managerial labor market pressure: Poor managers may find it difficult to find another job

4. Encouraged internal competition for promotion

5. Large Shareholders to actively monitor the firm or Monitoring via auditors and lenders

6. Shareholder Approval:0 Target shareholders must approve many major actions taken by
the board

7. Hostile Takeover: Low stock prices entice a Corporate Raider to buy enough stock to
have enough control to replace current management

H/ever Equity Linked Management can be controversial

→ Pros
 - Used as a mechanism to align interests with shareholders
- Reducing manger’s tendency to focus on S/T goals

→ Cons

- Provide incentive for managers to manipulate stock prices

- Stock option grants may encourage excessive risk taking

Hostile Takeover
- Means of disciplining managers who do not prioritise the shareholder’s interests
o One company attempts to takeover a company againstthe wishes of the target
company’s BOD and management

Pros

- Can address agenecy conflict by replacing ineffective management

- Threat of takeover → promotes accountability amongst management team → better
governance practices
- Disciplinary mechanism → forcing management to improve performance and reduce
agency problems

Stakeholder Theory
- Developed by Edward Freeman (2008)

- Sees business as a set of relationships

→ where managers are req to satisfy all
relationships rather than solely focus on
maximizing shareholder’s wealth

→ Asserts that for any business to be successful,

it must create value for its customers, suppliers,
employees, communities and financiers
Tutorial 1

Lecture 2 – Financial Mathematics

- Aim to Convert Single or Multiple Cash Flow derived from an asset that will be
received at diff points into a singular value

→ Used to make rational choice b/w different options

Determine the maximum amount an investor is WTP or forego]

Timeline:

- Linear representation of the timing of potential cash flows

- Assume that you made a loan to a friend. You will be repaid in two payments, one at the end of
each year over the next two years

- Inflows are positive cash flows (+)

- Outflows are negative cash flows (-)

Time Value of Money

- Diff b/w money today & money in the future why
 - Accounted for by Discounting = Process of moving C-F back in time

→ Discount Rate = The rate of interest or return used in computing the PV

1
→ Discount factor: DF = (1+𝑟 𝑛 → measures the value of present value of $1
𝑛)

of one dollar received in n years

Ie DF = $0.9342 for 2 years → investors WTP to pay $0.9342 today for
delivery of $1 in 2 years

3 Rules of Valuing C-F

1. Only C-F from the same time period can be compared

2. Current C-F must be compounded

3. Future C-F must be discounted

Types of Interest
1 Simple Interest
- Money earned on the initial amount (Principle)

→ 𝐹𝑉 = 𝑃𝑉 ∗ (1 + 𝑟)𝑛

→ If Simple Interest is Applies to period less than a year

𝐷𝑇𝑀
- 𝐹𝑉 = 𝑃𝑉(1 + (𝑟 ∗ ))
365

Note: R = Discount Rate

2 Compound Interest
- Interest is paid on interest accrued + principle

→ FV = PV * (1 + 𝑟)𝑛
 𝐹𝑉
- Can be rearranged to give. 𝑃𝑉 = (1+𝑟)𝑛

3 Continuous Interest
- Theoretical case where I is calculated at every single point in time

→ FV=PV*𝑒 𝑟𝑡

Future Value of Multiple Amounts

Present Value of Multiple Amounts

Perpetuities
 - A stream of cash flows that deliver a fixed constant payment each year forever
(infinite)

→ The first cash flow does not occur immediately, rather it arrives at the end of the first

period

→ Assume for the perpetuity, the interest earned (C=r*PV) is withdrawn each period

o This amount withdrawn will be smaller and smaller in present terms, so a

limiting sum can be determined

Return on perpetuity (r) = cash flow / present value

↳ Rearranged: PV = C/r

→ A growing perpetuity is a stream of cash flows that occur at regular intervals and grow at a

constant rate forever

⇢ While r>g:

𝐶
- PV=𝑟−𝑔

Other Types of Perpetuities

1. Growth Perpetuity:
- C-F expected to grow at a constant rate
𝐶𝐹
- 𝑃𝑉 = 𝑟−𝑔

2. Delayed Perpetuity
𝑃𝑉𝑖𝑚𝑚𝑒𝑑𝑖𝑎𝑡𝑒
- 𝑃𝑉 = (1+𝑟)𝑛

- N number of periods that did not include the perpetuity

Annuities
- Special case of multiple CF streams where C-F are of equal size & occur regularly
- The stream consists of N periodic payments of C, starting at the end of the current
period and ending at period N, with per period interest rate of r
 - Annuity Factor: Difference b/w the PV of 2 perpetuities, with one that starts N
years from now “Annuity factor” is the term in brackets of the PV of annuity
equation
↳ PV = C * PVAF where PVAF is present value annuity factor
→ Annuity factor is the sum of all discount factors that deliver within the
period

↳PVAFn = DF1 + DF2 + DF3 + ... + DFn

𝑃𝑉
→ AF= 𝐶

Features
1. Finite life/ regular no of payment periods
2. Regular payment intervals that are evenly spaced
3. Constant dollar value of payment (level cash flow)

Types of Annuities

1. Ordinary Annuity
- C-F occur at the end of the period
1−(1+𝑟)−𝑛
- PV = A( ) or old formula
𝑟
(1+𝑟)𝑛 −1
- FV= A ( )
𝑟

- Examples

2. Annuity Due
- C-F occur at the beginning of each period
1−(1+𝑟)−(𝑛−1)
- PV = 𝐴0 + A ( 𝑟
) or
(1+𝑟)𝑛 −1
- FV = A ( )(1 + 𝑟)
𝑟

- Examples: Rent or Lease Payments

3. Deferred Annuity
- The first C-F is an annuity is delayed by X periods
1−(1+𝑟)−𝑛 (1−(1+𝑟)−(𝑁−𝑥+1 )
- PV = A*( 𝑟
)/(1 + 𝑟)𝑥−1 = C * [ 𝑟

- Where x is the number of periods where the cash flow is inccured

 4. Growing Annuity
- C-F grow at a constant rate until maturity
𝐶𝐹 (1+𝑔)𝑛
- 𝑃𝑉 = 𝑟−𝑔 ∗ (1 − (1+𝑟)𝑛 )

- 𝐸. 𝐺 𝑀𝑢𝑙𝑡𝑖 𝑌𝑒𝑎𝑟 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑠 𝑜𝑟 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 𝑤𝑖𝑡ℎ 𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠

5. Continuous Annuity
- Payment is evenly spread throughout the period of payment
- Banks on the theoretical concept of continuous intrests

1 − 𝑒 −𝑟𝑡
𝑃𝑉 = 𝐶( )
𝑟

6. Equivalent Annuity
- Comparison of mutually exclusive opportunities with unequal lives
- Done by calculating the PV of a CF stream
- Then determining an annuity whose PV is equal to this C-F stream

Exam Note:

- For an annuity to manipulate t/n u have to ensure C-F is the same → if not find the
effective intrest rate
- In a growing perpetuity the more payments are made → more valuable the perpetuity
- Doesn’t matter when u pay a perpetuity

- PV of 5th year of a loan takes care of that year hence when finding amount needed
find FV of the previous year

- Ensure of C-F Included in the formula are from Year 1 and above

- N = no of payments , n = number of periods →careful of the period N = Year of

the Ending Cash Flow– Beginning of the Cash Flow +1

- When paying off a loan → Year 4/5= PV4 → discounted by a square

How to pick b/w Annuity and Perpetuity

Example of a amortization table

Net Present Value → Used to make Investment

Decisions
- Difference b/w PV of cash inflows & PV of cash outflows of investment
project/decision

→ NPV = PV(benefits) - PV(Costs) = PV(All project cash flows)

o PV does not account for non-operating cash flow (not incl interest payments
etc)
→ For 1 yr = 𝐶0 + 𝐶1 ∗ 𝐷𝐹
Note: If I/R change expand the whole thing & adjust DFn for each period.

- To Calculate
1. Forecast Cash Flow
2. Estimate O/C of capital (ROR of equally inv in the market)
3. Discount future C-F
4. NPV>0 → good investment + adds worth to company
𝑛
𝐶𝑡
𝑁𝑃𝑉 = 𝐶0 + ∑
(1 + 𝑟𝑡 )𝑡
𝑡=1

Applications
- Valuing an investment opportunity

Sets benchmark for Hurdle Rate which can be used to compare with investment ROR → if inv
ROR (Profit/Capex)% > FV (O/C of capital)→ good investment

→ To find how much an investment generate we take discount its Cash Flow to the O/C of
Capital

→ This PV represents the current selling price of your investment decision/real asset

Comparing Different Financing Arrangements

1. Nominal Interest Rates

- Quoted annual I/R adj to match frequency of payments/compounding by taking a
proportion of the quoted nominal rate
→ 10% p.a compounded semi annually = 5% per half-year

2. Effective Interest Rates

- Accounts for the true amount of I that is earned on both reinevested interest and
principal over a year
- Used when having to switch from yearly to monthly or semianually
 𝑟𝑛𝑜𝑚 𝑚𝑛
Effective Rate = (1 + ) −1
𝑚

- Where:
m = the number of compounding periods underlying the nominal rate
n = the period/s of the effective rate

Week 3 Financial Mathematics II

Deriving the implied I/R

1. 𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)𝑛
𝐹𝑉 1
2. 𝑟 = (𝑃𝑉)𝑛 − 1

Helps determine

1. Return on an investment
2. Loan I/R

Finding DTM to achieve a certain FV

1. 𝐹𝑉 = 𝑃𝑉 (1 + 𝑟)𝑛
𝐹𝑉
ln (𝑃𝑉)
2. 𝑛 =
ln (1+𝑟)

Determining value of C-F

- Use of annuities → gives constant C-F ez to calculate

- Note: Repayment structured so that each payment contains payment of a portion of

the principle + interest
 - At Maturity → Principle paid off
o To describe how a borrowed amount (principal) is paid down over the life of
the loan, we use an amortisation table

- Note 2.0 : At any time the principle owing on the loan is the present value of the
loan repayment cash flow
o PV of CF2-CF1 = Amount of Interest Paid

Steps

1. Note the type of annuity

2. Work backwards to find C

 3. From there u can find principle owed which as NOTE 2.0 denotes = PB loan
repayment C-F

4. RMB total paid = Principle Paid + Interest (Found using Amortization table)

Note: Amortization remains the same

Different types of rates

1. Annual Percentage Rate (APR) - Amount of Simple I earned in a year

W/O Compound effect
2. Effective Annual Rate (EAR) - Total Amount of Interest earned at the
end of one yr
- Rate used in the formulas for PV and FV

given an APR with certain compounding

intervals (M/N) and certain payment

intervals (M/N).
3. Effective n periodic rate (r or - Yearly rate that a borrower (saver)
EPR) effectively pays (earns) given an APR
with certain compounding intervals. It is
“what you get.”

1. APR
- In AU if rates are reffered to on a p.a basis its usually APR
- ≠ 𝑅𝑂𝑅 as it does not account for the effects of compounding → Can’t be used as
discount rate
- APR is usually a nominal I/R

Example
You invest $100 for one year at a rate of 12% p.a. compounding monthly, how much would you
have at the end of the year? What’s the rate of return?

FV = 100 * (1 + 0.12./12)12

Solution

You have earned an effective rate of 12.68% instead of 12%

- 12% is the return earned based on $100 principal

Amount

- 0.68% is earned as interest on interest

2. EAR

𝐴𝑃𝑅 𝑚
- EAR = (1 + ) -1
𝑚

- Where m is the compounding period

- As m gets larger → EPR gets larger
- Note → like in the name this coverts monthly weekly and periodic rates → yearly

APR vs EAR:

• Both annual interest rates

• APR ≤ EAR given EAR has the compounding effect

• APR = EAR when the interest rate is compounded once per year

3. Equivalent n period rate (EPR)

- Used when Cash Flow is not annual
- EPR = (1 + 𝐸𝐴𝑅)𝑛 -1

𝐴𝑃𝑅 𝑚𝑛
→ = (1 + ) -1
𝑚
Note: For amounts that continuously compound the EAR = 𝑒 𝑥 − 1

Fischer Equation
- Used to convert Real I/R given inflation to Nominal I/R hence can be used to
find nominal Real asw.

- 1 + 𝑟𝑛𝑜𝑚𝑖𝑛𝑎𝑙 = (1 + 𝑟𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 ) (1 + 𝑟𝑟𝑒𝑎𝑙 )

Note: Unless stated otherwise all rates given in the course are nominal

Lecture 4 – Valuation of Bonds

What is Debt?
- Bill: S/T debt instruments that promise payment of the principle within a year
- Bond: L/T debt instruments that have promised future payments and a future date
of maturity.
→ Owners of bond get back a principle at maturity
→ If the firm fails to pay the promised future interest and principal payments,
the bond trustee can classify the issuer as insolvent and force them into
bankruptcy

Bond Terminology
Face Value/Par Value/Principle of the bond: The total amount paid barring interest/intial
value of the bond when issued (must be paid at maturity)

- Amount is used to compute Coupon Payment based upon the Coupon Rate.

Coupon Rate: % of the principle paid to the lender at a predetermined date/period

- Can be variable
- Set by the issuer & stated on the bond certificate
- Can be floating (variable) → based upon other variables to hedge against risk or fixed
- Stated as the APR
- Not the discount rate

Coupon Payment

- Form of interest payments

𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒∗𝐶𝑃𝑁 𝑅𝑎𝑡𝑒

CPN payments = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐶𝑃𝑁 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟 (𝑛)

Maturity Date: Date where final payment should be made where all the initial principle must be
paid off
Bond Certificate: states the terms of the bond; amounts and dates of all payments

Yield to maturity (YTM): The market required rate of return for bonds of similar risk and
maturity

- The discount rate used to value a bond

- Quoted as an APR
- If compounding period is not specified assumed the compounding period is
semiannually

Bond Yield: Bond yield is the return an investor realizes on an investment in a bond.

𝐴𝑛𝑛𝑢𝑎𝑙𝑘 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

- = 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒

How to Valuate Bonds

The value of a bond is equal to the PV of the interest payments and contractually promised
principal discounted back to the present using YTM

- Bond is a type of fixed-income security

Timeline

- Sum of Discounted C-F (CPN) up until maturity date, note with typical bond
structure the principle is paid at maturity hence CPNn (CPN +Face Value) as
denoted above
- H/ever call options & Sinking Fund Provisions

Hence

𝐶𝑃𝑁 (1 − (1 + 𝑟𝑐𝑝𝑛 )−𝑁 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒

𝑃𝑉 = +
𝑟𝑐𝑝𝑛 (1 + 𝑟𝑐𝑝𝑛 )𝑛

Where:
 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒∗(𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒)
1. CPN = 𝑁𝑜 𝑜𝑓 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑌𝑇𝑀 𝑌𝑇𝑀 𝑚𝑛
2. r =cost of debt = or (1 + ) −1
𝑀 𝑀

3. n = no of coupon payments a year

Note:

1. Bond Prices are quoted as a percentage against its par value

2. One year hence → price one year from now → discount back to that period to to the
current period

𝑃𝑉𝑛 − 𝑃𝑉0 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝑅𝑒𝑡𝑢𝑟𝑛 (𝑛) = ∗ 100%
𝑃𝑉0

3. YTM can also be estimated using the following formula

𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒

𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 +
𝑌𝑇𝑀 ≈ 𝑡
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 + 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒
2

Zero-Coupon Bonds
- Bonds that pay a single fixed amount at a fixed date in the future (day of maturity)
– they issue no CPN
o Only 2 C-F
1 The bond’s market price at the time of the purchase
 2 Face value at maturity
- Zero-coupon bond will always sell at a discount, so also called pure discount bonds

Bond Pricing Behaviors

- Price of the bond in relation to its face value depends on YTM and coupon rate

- Most issuers of coupon bonds choose a coupon rate so that the bonds will initially
trade at, or very close to, par

↳ After the issue date, the market price of the bond will change over time

1. Relationship b/w Coupon Rate & YTM

↳ If coupon rate>YTM: price>face value “sold at a premium”

↳ If coupon rate<YTM: price<face value “sold at a discount”

↳ If coupon rate=YTM : price=face value “sold at par”

- Most issuers of coupon bonds choose a coupon rate so that the bonds will initially
trade at, or very close to, par

↳ After the issue date, the market price of the bond will change over time

2. Relo b/w I/R & YTM → Bond Prices

→ A (non-linear) inverse relationship exists between bond prices and bond yields (interest
rates)

↳ So, as interest rates increase, the price of bonds will decrease

This is because:

- I/R inc → higher ROI in similar risk investment → investor want more → inc in
YTM → makes bond less valuable relative to the O/C of capital

Note: Relo b/w Bond Prices & YTM dependent on the length & effective life of the bond. For
instance, if a bond makes a longer lifespan meaning a majority of the C-F occurs at the end the
change in price becomes less muted.
 3. Time to Maturity & Price
- As time to maturity decrease the price of the bond reaches closer to face value as
there are less additional CPN (C-F) to be gained

4. Relo b/w YTM & Return

- Dec in YTM than Return on Bonds>YTM
- Inc in YTM than Return on Bonds>YTM

Note: Par point: the point where the interest rate equals the yield to maturity, so P=F

Duration & Volatility of the Bond

- Duration is determined through the Macaulay duration formula

- Determined as the weighted average of the times to each of the cash paymets called
T

- The weight for each C-F is the PV of the respective C-F divided by the total PV

- The weighting coefficients are the PVs of the individual cash flows, divided by
the total PV of the cash flow stream
o This gives the proportion of each cash flow in the total cash flow stream
1 Duration is measured in units of time (usually years)

1∗ 𝑃𝑉(𝐶1 ) 2∗ 𝑃𝑉(𝐶2 ) 3∗ 𝑃𝑉(𝐶3 ) 𝑇∗ 𝑃𝑉(𝐶𝑛 )

Duration = 𝑃𝑉
+ 𝑃𝑉
+ 𝑃𝑉
+…+ 𝑃𝑉

Note: The longer the duration of the bonds the more it is affected by YTM changes

→ I/R Risk as L/T bonds lock in the previous YTM rate → changes affect more C-F
whereas S/T mature sooner, allowing investors to reinvest their principal at higher rates if
interest rates rise.

- Higher the CPN rate the higher the Duration → Modified Duration → Higher
Volatility (Inverse Relationship)
 o This is because a majority of PV derived from time at the end of the
duration.
- Higher the Yield → Lower the Duration → lower modified duration → less
volatility.

Modified Duration
→ Modified duration is a formula that expresses the % change in the value of a security in
response to a change in interest rate

𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 (%) =
1 + 𝑌𝑖𝑒𝑙𝑑
Note: The Modified Duration can also be found by finding the derivative of the I/R yield curve

Why is it important?

- Good measure of degree of I/R risk

- Volatility is higher at lower interest rates, and lower at higher interest rates

Bond Risks

1. I/R Risk

- As previously touched upon movements in I/R → affects YTM → affects Bond

Prices

- Can decrease value of investment

2. Credit Risk

Credit risk: the risk of default → the bond’s cash flows are not known with certainty
 ↳ This is because (in the case of corporate bonds) firm’s financial status is unknown

- Firms are not free of default or bankruptcy, and in this case, the bondholders will not
receive all cash flows

To quantify this risk companies & countries → have their bonds credit rated

Usually by Moody’s, Standard & Poor’s

(S&P), and Fitch.

Bonds rated BBB and above are called

investment grad

Higher the rating the less likely that bond

is going to default → h/ever higher risks
bonds have a higher premium
(speculative grade/junk bonds)

Rating depends on

1. Risk of Bankruptcy
2. Debtholders claim in the case of bankruptcy
3. Reinvestment Risk

Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows
received from an investment, such as coupon payments or interest, at a rate comparable to their
current rate of return.

4. Inflation Risk
- If Inflation increases → spot rates increase → increase in YTM → if outpacrs
Coupon Rate → decrease Price

Bond Risk Characteristics

1. Maturity (price sensitivity)

For a given change I/R → L/T more price sensitive that S/T bonds

• Long-term (i.e. higher N) bonds have greater price volatility than short-term bonds
 o This is because there are more years of uncertainty → higher risk

• I/R risk increases as maturity increases, but at a decreasing rate

2. Bond risk characteristic II: coupon payments

For a given change in interest rates, prices of lower-coupon bonds change more than higher
coupon bonds.

- The lower the bond’s coupon rate, the greater the proportion of the bond’s cash flow
investors will receive at maturity

- All other things being equal, a given change in the I/R will have a greater impact on
the price of a low-coupon bond than a higher-coupon bond with the same maturity

Hence: The lower a bond’s coupon rate, the greater its price volatile; hence, lower coupon
bonds have greater I/R risk.

Total Yield
- A bond yield is the return an investor realizes on a bond.

→ To calculate the total yield for a bond, the yield for a treasury bond of similar maturity is

added to the spread rating provided by bond rating companies

↳ YTMMaturity yr. Rating = Spread + YTMTreasury bond of like maturity

↳ eg. For 5 year bond: US treasury yield is 1.74%, and a AA bond has a spread of 50

basis points (0.50%)

> So: YTM5 yr. AA = 0.50 + 1.74 = 2.24%

→ Higher credit rating = lower yield = higher price

Term Structure of Interest Rates = Yields
- When discounting typically same I/R is used → h/ever good to differentiate b/w
L/T & S/T I/R

- This relationship between S/T rates and L/T is called the Term Structure I/R

- Spot Rates: Rate of C-F in that specific year.

- Series of Spot Rates traces out to Term Structure of the Bond

- Spot rates come first. Yields to maturity come later, after bond prices are set.

Expectation Theory

- States that in a well functioning bond market, S/T bonds yield the same returns as
L/T bonds ceteris paribus
- The expectations theory implies that the only reason for an upward-sloping term
structure is that investors expect short-term interest rates to rise
- The only reason for a declining term structure is that investors expect short-term
rates to fall.

Law of One Price:

- The law of one price states that the same commodity must sell at the same price in a
well- functioning market. Therefore, all safe cash payments delivered on the same
date must be discounted at the same spot rate.

- The law of one price says that investors place the same value on a risk-free dollar
regardless of whether it is provided by bond A, B, or C

- As Term Structure is the summation of the Spot Rates → Upwards Sloping →

Higher YTM at maturity
Stripped Bonds (Strips):

- These are bonds that have been divided into separate securities, each representing a
single payment. The U.S. Treasury can split a regular coupon bond into multiple
smaller bonds, each corresponding to an individual coupon payment or the final
principal payment.

Example with an 8% Bond of 2021:

- An 8% bond maturing in 2021 can be stripped into:

o Eight semiannual coupon strips, each paying $40.
o One principal strip, paying $1,000 at maturity.

The combined cost of these strips in November 2017 was slightly higher than the cost of buying
the whole 8% bond. This makes sense because both investments yield the same cash flows.

Expectation Theory of the Term Structure

- It states that in well-functioning bond markets investment in a series of short-
maturity bonds must offer the same expected return as an investment in a single
long-maturity bond.

- Only if that is the case would investors be prepared to hold both short- and long-
maturity bonds.

TIPs
- TIPS = Treasury Inflation-Protected Security
↳ Yield increases by rate of inflation
↳ The real return of a TIPS bond = nominal return of a normal bond

Bond Theorem Applications

- If rates are expected to increase
o Investors tend to not invest in long duration bonds
 - If you are an investor → expectations to I/R decline → may want to invest in low
coupon L/T bonds
o Price of L/T zero-coupon bonds will increase more than any other type of
bond

Week 5 - Valuation of equity and equity

capital markets

Equity Capital Markets

- Markets that trade equity (stocks) instrument
- Can be broken down to 2 Markets:

Primary Market: Markets in which corporations raise funds through new issues of share

- IPO: Firms initially going public and list their shares to be publicly traded on stock
market for the first time

- SEO (seasoned equity offering): New equity issued by an already publicly traded
company

Secondary Market: Markets that trades financial instruments once they are issued
 - Investors uses stock exchanges as the medium to buy and sell shares

Trading practices:
1. Price Driven Exchange System
- Market Makers (IBs and security brokers) quote the price
- Guarantee the execution of order
- E.G Forex Market

2. Over-driven Trading System

- Display all buy and sell orders, more transparent
o e.g. ASX, Tokyo, Shanghai stock exchange
- Orders are matched by market makers according to rules (price, time and order
priority)
• No guarantee that all orders will be executed

In an Over-Driven Trading System

- Market Information is public

- Has Bid Price and Ask Price
o Highest Bid Price is displayed first
o Lowest Ask Price is displayed first
o Bid-Ask Spread is the gap b/w the highest bid price and lowest ask price
3. Hybrid
- Mix of both prices driven and Over-driven

Process of Trading Shares

1. Investor contacts a stockbroker who opens an account which they can deposit too
 2. Investor places an order with the broker either via phone or by the internet (or
automated by an algorithm) → two types
o Limit Orders: Order to execute the trade at a certain limit
o Market Order: Order to sell immediately at the price
3. Stockbroker attempts to execute the order via a counterparty (person on the other side
of the trade) → trading is a zero-sums game

4. Settlement takes place, where the ownership of shares is transferred in exchange for a
transfer of cash

Major Market Participants

1. Buying & Selling parties who could be an individual, investor or institution
2. Stockbroker who provide trading services.
- Could be a conduit to the party or acting as the client’s agent
3. The securities exchange who facilities for trading and acts as a self-regulatory body

Stock
Stocks entitle a person to ownership of a company

- Entitles stockholder to a portion of the company’s assets and generated profit = to

the proportion of stock they own
o Shares are the units of stock
- Stocks to a company: If the company has a good idea, it can raise capital by selling
off future profits in the form of shares
- Stocks to an investor: Gives cash to company’s
o In return, the investor gets a contract stating how much of the company they
own
o Growth in the value in stock and this benefit of value can be realised when
investors sell the stock
o Investors are also entitled to receive dividends
- Can be Public or Private
 o Common stock: ownership shares in a publicly held corporation & are
traded through
1 Electronic Communication Networks (ECNs) - a number of
computer networks that connect traders with each other and allow
electronic trading
2 Exchange-Traded Funds (ETFs) - portfolios of stocks that can be
bought or sold in a single trade
3 Standard & Poor’s Depository Receipts (SPDRs/’spiders’) - ETFs
which are portfolios tracking several Standard & Poor’s stock market
indexes

Essential Terminology
1. Book Value: Net worth of the company according to the Balance Sheet (Total Assets
– Total Liabilities)
2. Dividend: Cash Distribution of profits to shareholders
3. P/E Ratio: Price to earnings ratio (price per share/earnings ratio)
4. Market Value Balance Sheet: Financial statement that uses market value of assets and
liabilities
a. “ttm” stands for “trailing twelve months”

What is Price
- Price you are trading on the stock exchange is called market share price
o What you pay to buy/sell an asset
What is this influenced by

- Supply and Demand → Stock prices will increase if people wish to buy

H/ever as consequence of being priced by supply and demand → share’s market price is subject
to being priced by speculation

→ Increase or decrease the price of the stock on top of its intrinsic valu
How to decide if a stock is worth buying
If its intrinsic value > Market value

IV= Value represented by financial models

MV= Value decided by market participants

Note:

- To account for transactions cost → within 30% of MV for IV is considered

priced

General Stock Market Principles

- Diff between intrinsic value of a stock to its market price offers a arbitrage
opportunity
Hence no arbitrage is when

𝑃𝑟𝑖𝑐𝑒 (𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 𝐼𝑛𝑡𝑟𝑖𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 (𝑆𝑒𝑐𝑢𝑟𝑢𝑡𝑦) = 𝑃𝑉 (𝐴𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦)

How are stocks and associated securities priced

- Just like for any asset, the price of a share is the present value of its future cash flows
o i.e. the present value of the dividends and the eventual sale price
= Dividend + Stock Price when sold

→ PV (shares) = PV(expected future dividends)

- Investors will buy a share if: 𝑃𝑜 + 𝑟𝑃𝑜 = 𝐸(𝐷𝑖𝑣1 ) + 𝐸(𝑃1 )

↳ Cash invested + cash return required = cash expected to be received (Div
Payment + Capital Appreciation

Dividend Cash Flow Model

Timeline
This is called the Dividend-Discount Model (DDM) because we are discounting future
dividends

- The stock’s discount rate (𝒓𝒆) is the rate of equity return investors can expect to
earn on securities with similar risk
o Or the percentage yield that an investor forecasts from a specific
o investment over a set period of time
o Otherwise known as market capitalization rate

1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
𝐶𝐴𝐺𝑅 = ( )𝑛
𝐵𝑒𝑔𝑔𝑖𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

How to Find the Equity Discount Rate

Method 1: Dividend Discount Model
1. Using one period investment total return = true return/growth of the stock over
period

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 𝑅𝑎𝑡𝑒 = 𝑟𝑒

𝐷𝑖𝑣 𝑃1 −𝑃0
- 𝑟𝑒 = +
𝑃0 𝑃0
𝐷𝑖𝑣1 +𝑃1
- = −1
𝑃0
 𝐷𝑖𝑣1
- = + 𝑔 (under the DDM)
𝑃0

𝐷1
𝐼𝑉 =
𝑅𝑒 − 𝑔

- Discount Rate has already factored in the capital gain rate

o As it includes P already in the formula

Method 2: Capital Asset Pricing Model

𝑟𝑒 = 𝑟𝑓 + 𝛽𝑖 ∗ [𝐸 (𝑅𝑚𝑘𝑡 ) − 𝑟𝑓 ]

- Risk-free rate = 𝑟𝑓
- Market portfolio expected return – market = 𝐸(𝑅𝑚𝑘𝑡 )
- Beta of the investment → determines risk = 𝛽𝑖
- Market risk premium → accounts for the Time Value of Money = Return above
the risk free rate = [𝐸(𝑅𝑚𝑘𝑡 ) − 𝑟𝑓 ]

Problems

- Makes unrealistic assumptions and relying on a linear interpretation of risk vs. return.

How can this be linked back to finding the Price?

- This Formula Can be applied to find the price
→ Using Expected Price & Dividend cash flows from Next Year

𝐸(𝐷𝑖𝑣2) 𝐸(𝑃2 ) 𝐸 (𝐷𝑖𝑣1 ) 𝐸 (𝑃1 )

𝑃1 = + & 𝑃0 = +
1+𝑟 1+𝑟 1+𝑟 1+𝑟
𝐷𝑖𝑣1
Note: 𝑃0
is called the Dividend yield

- Then P2 can be substituted in, and so on up to PH (where H is the final period)

↳ Each time, the dividend will be discounted by another factor of (1+r)

𝐻 ∞
𝐸(𝐷𝑖𝑣𝑡 ) 𝐸(𝑃𝐻 ) 𝐸(𝐷𝑖𝑣𝑖 )
𝑃0 = ∑ + & ∑
(1 + 𝑟)𝑡 (1 + 𝑟)𝐻 (1 + 𝑟)𝑡
𝑡=1 𝑖=1
 - When the price of a Stock > Discounted Model → Valuation Bubble exists

Note: As the time horizon of the investments increase → PV of the future price decrease & PV
of the dividends increase

How are Dividends Distributed Estiamted?

Constant Dividend The firm will pay a constant dividend together (e.g pref shares)
→ Computed using the perpetuity formula
Constant Dividend Dividend payments will increase by a certain percentage every
Growth period
→ Using growth annuity
Changing Growth Rates Dividend growth not constant initially but eventually settles to
becoming consistent

Constant (zero) growth - preference share

- If dividend are expected at regular intervals forever, this is like a preference share
and is valued as a perpetuity
o Size of preference of shares dividend is fixed → states as a dollar value or a
percentage of preference share’s the par value

𝐷𝑖𝑣
𝐼𝑉0 =
𝑟𝑒

Constant Dividend Growth

- Forecasting Dividend is difficult → fluctuating nature of dividend decisions

o Hence use of a constant growth model → simplifies process

- 𝐷𝑖𝑣0 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑗𝑢𝑠𝑡 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑡𝑖𝑚𝑒 0 – shouldn’t be included as part of share

price (ex-div price)
Finding Divided (Do) and how Dividend Decisions are made
- Dependent on Dividend Decision – made by BOD
o If reinvested well & company grows
→ Higher Capital Appreciation
→ Potentially higher future Dividend Payments
o Similarly if size of Dividend Payments larger per share → Value of the stock
rises

How this Dividend Decision Quantified & Recorded and how is Growth determined:

- Found in the Financial Statements of a Company

o In the form of DPS (Dividends per Share) & EPS(Earnings Per Share)

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷𝑜𝑙𝑙𝑎𝑟 𝐴𝑚𝑜𝑢𝑛𝑡 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑁𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡)

𝐷𝑃𝑆 = , 𝐸𝑃𝑆 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

- Dividend Payout Ratio → Ratio of Earnings paid as Dividend Each Year

𝐷𝑃𝑆
𝐷𝑃𝑅 =
𝐸𝑃𝑆

Hence: DPS = EPS * DPR

Reinvestment = EPS – DPS (Money Retained per share assumed to be reinvested )

Note: Existing Cash Flow can be either:

- Retained the cash

- Pay the cash to shareholders as dividends

DPR v RR
Assuming the number of shares outstanding is constant, the firm can do 2 things to increase its
dividend (Dividend Decision T1):

1 Increase its earnings (net income)

2 Increase its dividend payout rate

→ If all earnings are reinvested

 ∆𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑁𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑚𝑒𝑛𝑡 ∗ 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐺𝑟𝑜𝑤𝑡ℎ

If not → this could be found using the Retention (Plough-Back) Ratio/Rate :

= 1 − 𝐷𝑃𝑅

𝐷𝑃𝑆
1−
𝐸𝑃𝑆

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
=1−
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Hence from the plough back rate one can estimate change in earnigs

∆𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ∗ 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 ∗ 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

∆𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Hence Earnings Growth Rate = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
= 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 ∗ 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐺𝑟𝑜𝑤𝑡ℎ

→ Hence

𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒(𝑅𝑅) ∗ 𝑅𝑂𝐸

- Otherwise known as the Sustainable Growth Rate

𝐸𝑃𝑆 (𝐴𝑠𝑠𝑒𝑡𝑠−𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠)
NOTE: ROE = 𝐵𝑜𝑜𝑘−𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 ∗ 100%

- Hence if asked to find the dividend per year (given book value of company per share +
ROE)
o Find EPS = Book Value Per Share * ROE
o The using EPS find Dividend
• DPS = EPS * DPR
- If dividend payout rate is constant, then growth rate in dividends = growth of
earnings

Present Value of Growth Opportunites

Retaining and reinvesting some earnings can lead to a higher share price than if the earnings

were all paid as dividends

- Difference between these is the Present Value of Growth Opportunities (PVGO)

 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝑃𝑉 𝑜𝑓 𝑙𝑒𝑣𝑒𝑙 𝑠𝑡𝑟𝑒𝑎𝑚 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 𝑃𝑉 𝑜𝑓 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑖𝑒𝑠

If a large portion of the stock’s prices comes from PVGO → it is considered a growth stock

Constant Growth Model

→ Use a Gordon Growth Model or a Constant Growth Model

- Utilises the Growing Perpetuity Formula

- Expected return is also called the cost of equity capital
- Use r from above

𝐷𝑖𝑣1
𝑃0 =
𝑟−𝑔

Effect of Growth on Valuation of Stock via Mode Changing Grwoth

Rates
Typically

→ Company starts off with high opportunities for growth

→ They typically retain all earnings in this case to maximize growth opportunities & capitalize
upon investment opportunities

→ Once company matures their growth slows

- At some point the company’s earnings exceed their investment needs and companies
will begin to distribute dividends (i.e Apple)

As a result, → we can’t use a typical DDM model but instead we use a Constant Growth Model
to calculate the price of the stock once growth rate stabilizes (Constant Dividend Growth)

= 𝑃𝑉 𝑜𝑓 𝑙𝑒𝑣𝑒𝑙 𝑠𝑡𝑟𝑒𝑎𝑚 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 𝑃𝑉 𝑜𝑓 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑖𝑒𝑠

Multistage DDM
- Used for stocks with Changing Growth Rates
- Allows for assumption of multiple stages of growth
o For instance, a two Stage Model allows for
1 An initial phase where the growth rate is not a stable growth rate
2 Subsequent steady state where ‘g’ is stable and expected to remain for
the long term

Terminal Value (PV at a Future Point in Time)

𝐷𝑖𝑣𝑁+1
𝑇𝑉 =
𝑟𝑒 − 𝑔

Value of the stock

𝑁
𝐷𝑖𝑣𝑡 𝐷𝑖𝑣𝑁+1 1
𝑉𝑎𝑙𝑢𝑒 = ∑ 𝑡
+ ( )
(1 + 𝑟) 𝑟𝑒 − 𝑔 (1 + 𝑟)𝑁
𝑡=1

Logic

1. Near-term dividends are forecasted and valued

2. Constant-growth DCF formula is used to forecast the value of the shares at the start
of the long run
3. The near term dividends and the future share value are then discounted to present
value in order to arrive at the equilibrium value of the share of stock

Limitations of the DDM

There is always uncertainty

1. Forecasting a firm’s future earnings and dividends

2. Forecasting dividend growth at a terminal period
 3. Dividend payout policy is at management’s discretion.

Other Means of Valuations = Value Multiple Approach/Comparables

Valuation multiple:

- A ratio of firm’s value to some measure of the firm’s scale or cash flow
- Applied across firms within a particular industry or customer segment for
comparasion

Method of Comparable:

- Estimate the value of a firm based upon on the value of comparable firms or
investments that we expect generate similar cash flows at similar risk levels

Done Through

𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
P/E Ratio:
𝐸𝑃𝑆

o How much are investors willing to pay for $1 of earnings?

There are Two Types

1. Trailing P/E
- Earnings over the last 12 months
𝑃
𝑇𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝑃/𝐸 = 𝐸𝑃𝑆𝑜
𝑜

2. Forwards P/E
- Expected Earnings in the coming 12 months

𝑃
Forwards P/E = 𝐸𝑃𝑆𝑜 = (𝐷𝑖𝑣1 /𝐸𝑃𝑆)/(𝑟𝑒 − 𝑔) = 𝐷𝑃𝑅/(𝑟𝑒 − 𝑔)
1

→ Div 1 to re – g = Gordon growth model

Note: - Firms with high growth rates, and which generate cash well more than their investment
needs so that they can maintain high payout rates

- High P/E multiples

Legend:

→ VE = value of ordinary shares of the firm

→ P/E = estimated appropriate price-earnings multiple for firm (eg. based on average of
comparable firms)

→ E1 = estimated earnings per share (yr 1)

Limitations of multiples:

- When valuing a firm using multiples, there is no clear guidance about how to
adjust for differences in expected future growth rates, risk, or differences in
accounting policies

- Comparable only provide information regarding the value of a firm relative to other
firms in the comparison set

Lecture 6 Dividend Payout policy and

Dividend imputation system
Dividend Payments

Dividend Policy
- Corporations typically pay dividends twice a year in Australia (Quarterly in US(

Type

Regular Dividends An interim dividend halfway through the year and a final dividend at
the end of year (in US its quarterly)
Special Dividends Additional one-off dividends to shareholders
Stock Dividends Paid in shares of stock
- Increases the No of shares outstanding → reducing the
stock price (equity dilution)

How are they reported (units)

- DPS = Dividend per share → Dollar amount per share

𝐷𝑃𝑆
- Dividend Yield → 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 → used the share price of the previous year
𝐷𝑃𝑆
- DPR = 𝐸𝑃𝑆 → Used for g and rr calcs
Chronology

1. Declaration Date
- Firm announces its dividend, as well its report and payments
2. Ex Dividend
- Date where buys of stock are not entitled to the next dividend
o 2 days b4 date of record
o Buying after the date means shareholder is not entitled to the next scheduled
dividend payment
3. Record Date
- Where dividend is recorded to have been paid → record of transaction with list of
shareholders who are getting paid

4. Payment Date
- Date where dividend payment is made per the inttial Declaration Date

Categories Dividend Policies

- Refers decisions made by corporations & their managers on whether to reinvest into
the company or to convert their net income to shareholder earnings (dividend)
o Done if investing opportunity are no longer as attractive as getting a liquid
return on investment

Categories

Regular A company pays our dividends at a consistent rate

- DPR quantifies the dividend policy decision by measuring the
proportion of profits after tax is paid out as dividends
Stable Div Company aims to pay the same rate or a slowly increasing dividend rate in
Policy spite of earnings volatility
Residual Div Company pays out dividends only after all capital expenditures and working
Policy capital needs are met
- Similar to Regular Dividend Policy → comparing both options
h/ever not a consistent rate → prioritizes investment
Hybrid Policy When companies used a combination of the policies above
 No Policy When companies reinvest all their earnings

Note: To adjust the dividend rates a company should have in mine whether earnings are able to
go into investment decisions which are able to generate higher returns than the O/C of Capital

- Hence firms should only look to decrease payments when there is potential
investment decisions which could be made with positive NPV → raising stock price

Example of how to calculate effectiveness of dividend payout

- Price change is driven by ROE → IRR

- Cost of Equity ( r ) < ROE → decision has NPV

Note: Growth rate doesn’t dictate investment decisions and dividend policy decisions

How does DPR influence dividend policy

- DPR dictates and showcases the aims & stage of a business whether its looking to
distribute a large portion of earnings to shareholders ot if it’s a growth company
looking to continually reinvest
 o Growth phase → higher reinvestment → lower/zero DPR
o Mature companies with fewer growth opportunities → lower reinvestment
→ higher DPR
- DPR dictates a compmany’s financial health and future prospects

Note:

- If a company changes dividend policy → Stock prices is expected to change

otherwise the decision is not material
o Change in price is a mechanism of evaluating how good decision is

- Special Dividends → DPR < 0 → company draws from their assets rather than just
earnings

Empirical Study Lintner Study (1956) – How companies decide the amnt of
dividend paid
- Study by Litner establishes that in setting dividends, executives:

1. Set L/R target payout ratio

2. Focus on the change in dividends
3. Based dividends on L/R forecast profits and are consequently reluctant to change
dividends
4. Reluctant to cut dividends

Hence Lintner asserted that

A stable dividend policy can be stable dividend policy adjustment towards a target payout
ratio based on L/T sustainable earnings

- A target payout ratio is a goal that represents the proportion of earnings a company
intends to distribute (payout) to shareholders dividends over the L/R

→ Hence
1
∆ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 = (𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ∗ 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠) ∗ 𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑚𝑒𝑛𝑡 𝐹𝑎𝑐𝑡𝑜𝑟 (𝑛 𝑦𝑒𝑎𝑟𝑠 )

𝐷1 = 𝐷0 + ∆ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠0−1
Formula for St able Policy

- Send positive signal to the market

- Common policy used by many managers

Constant dividend payout ratio vs Stable dividend policy

- Although constant dividend payout ratio policy is easy to use → not commonly
adopted
o Bcuz → it assumes dividends to fluctuate with earnings in the S/T
1 Especially given frequently changing the dividend payment could
send mixed signals to the market
- Although managers do not actively maintain a constant DPR, DPR is still an
important metric that guides managers in making dividend decisions
o To investors, DPR signals the company’s growth potential financial health

- A stable dividend policy generally does not reflect short-term volatility in earnings
o Even if the earnings are temporarily decreased over the S/T , the company is
still expected to gradually increase its dividend

Why then is DDM still used if it operates under the constant dividend payout model

1. Pros
a. Simple & cost effective
b. Provides academic credibility by being grounded under the concept of time value
of money
2. Cons
a. Reliability of DDM decreases when there is high earnings and hence dividend
volatility
i. Nor appropriate especially for companies with high growth rates

Adaptations: if a company has fluctuating DPR/growth rates, a multi-stage DDM can be

utilized
Impact of Dividend Policy on Shareholder Wealth
Miller and Modigliani (1961)

→ Mathematically proved that under a number of assumptions Dividend Policy has no

impact on shareholder wealth

- Depended on a number of condition

The conditions under which dividend policy is IRRELEVANT (perfect market condition_

1. There is no transaction costs (i.e. cost of issuing shares – ie commission to IB)

- i.e. flotation costs: costs in selling shares to the public that include underwriters’
fees, legal costs, registration expenses, and possible negative price effects) often
estimated to be as much as 4% to 10% of the capital raised
2. All market participants (e.g. management and shareholders) have the same information
- i.e. no one can use superior information to trade stocks to generate an abnormal
return
3. There are no personal or corporate taxes
- U.S. and Australia have different tax systems on dividends

How?

If a company wants to increase dividends it either

1. Curs back on investments in current projects → Dec future C-F → Dec stock prices
2. Issue new shares to finance current projects in order to free up case → inc No of share
→ dec share value
- Either way the increase in dividend will be offset by a decline in the price of shares
→ leaving shareholders no better or worse off
Proof of Dividend Irrelevance Theory

Issuing New Shares

Important:

- Note that DPR = 100% → means all net income is already exhausted
o To raise dividend → dig into equity
- Amount Needed = ∆𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 ∗Amount of Share (how much extra u have to
pay share → thinking of the rest of issued shares as those pas t the ex-
dividend date)

Imputation Tax System

Classical (U.S) Imputation (AU))
Companies pay tax at the corporate level on Companies pay tax at the corporate level on
their income their income
Dividends are paid out with franking credits
Shareholders pay tax at their personal representing the amount of company tax that
(marginal) rates on the dividends that are paid as already been paid
our
Shareholders pay tax at their personal
(marginal) rates on the sum of the cash
dividend and franking credits (i.e grossed up
dividends)
 - Avg Au Corp Tax = 30%
- US share buybacks more popular due to the double tax system
- Franking Credit carried on and u only have to pay the gap b/w your income tax and
corporate tax
- If company is unfranked → u have to pay all your income tax
o If it is franked company has already paid tax → u can lodge a return

Franking Credit:

- A tax credit passed on to investors by companies that have already paid

corporate income tax
o Individuals receive = Dividend Amount + Franked Credits
 → Credits can be used to offset personal tax liabilities
• Hence income is not taxed twice

𝑪𝒐𝒓𝒑𝒐𝒓𝒂𝒕𝒆 𝑻𝒂𝒙 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

𝑮𝒓𝒐𝒔𝒔 − 𝒖𝒑 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 =
𝟏 − 𝝉𝒄

- τc is the tax rate at corporate level and τp is the tax rate at personal level
- Dividend Before Tax = Gross Up Dividend

Note: A gross-up dividend is a term used to describe a dividend combined with franking credits

𝑫𝒊𝒗𝑨𝑻𝒄
𝑭𝑪 = 𝑮𝒓𝒐𝒔𝒔 𝑼𝒑 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 − 𝑫𝒊𝒗 𝑨𝑻𝒄 = ( ) ∗ 𝝉𝒄
𝟏 − 𝝉𝒄

- τc is the tax rate at corporate level and τp is the tax rate at personal level
- Div AT refers to Dividend After Corporate Tax

Eligibility of Franking Credits

- The eligibility for receiving and utilizing franking credits depends on the jursidction
and specific tax laws
o Indiv taxpayers who are residents for tax purposes are eligible to receive
franking credits (Residents is important)
o Corporations based in Au/NZ can also receive franking credits , which can
then be passed on to their shareholders → when dividends are issue
1 Encourage investment in domestic firms
- When conducting a intrinsic valuation under the DDM → one should incl the value
of franking credit

Types of Franks

- Not all dividends are Fully Franked, Company could only be paying partial
corporate tax b4 the dividend is distributed to shareholders
o Multiple sources of income are associated with the company’s operations,
only a portion of these incomes are subject to taxation in Australia
o Loss carryovers that offset the company’s tax payments
o Corporate Strategy
How to value franking credits (𝜑)
- 75% of dividends had attached franking credits (from 1998-2005)
o But only 71% of imputation credits distributed are redeemed
- φ measures market values distributed credits to one dollar (0.3-0.57 usually), kinda of
like a proportion of ppl who take use of franking
o e.g. φ = 0.4 means market values distributed credits at 40 cents in the dollar
- When incorporating the imputation credit into the equity valuation, one should
consider how the market values the franking credit on average and factor that into
the pricing of shares

𝐷1 + 𝐹𝑟𝑎𝑛𝑘 𝐶𝑟𝑒𝑑𝑖𝑡
𝐼𝑉0 =
𝑟𝑒 − 𝑔

𝝉
𝐷1 [1 + 1 −𝑐𝝉 ∗ %𝐹𝑟𝑎𝑛𝑘𝑒𝑑 ∗ 𝜑]
𝒄
𝐼𝑉0 =
𝑟𝑒 − 𝑔

- %Franked → What the company pays out

- 𝜑 how the market takes advantage of it

Tutorial Notes:
- Free Cash Flow is operating cash flow left over after all positive-NPV investments

- As dividend is only paid when FCF is positive → all positive NPV investment
should be invested for an increase in value
Lecture 7: Risk and Return

Key Definitions

1. Market Risk Premium = Nominal return on stocks – nominal return on bills

2. Total Gross Return on an Asset: Total amount of money received over a period of
proportion of the cost of acquiring the asset

Realized Rate of Returns

One Period: Capital Gain + Dividend Yield

- Used to calculate the rate of growth of equity valuation between time t to time t+1
(concurrent years)
- Derived from the fact that r = Dividend Yield of Next Year + Capital Gain Rate
𝐷𝑖𝑣𝑡+1 𝑃𝑡+1 −𝑃𝑡 𝐷𝑖𝑣𝑡+1 +𝑃𝑡+1
- 𝑟𝑡,𝑡+1 = 𝑃𝑡
+ 𝑃𝑡
→ 𝑟𝑡,𝑡+1 = 𝑃𝑡
−1

- Pt = Closing Price of Previous Day/Period

- Pt+1= Current Price or Price of next day/period

This is the calculation of the stock’s realized return during a holding period

- Sometimes called the rate of return

Similarly

- When finding the net return of an investment

 o Total Return R = Amount Received/Amount Invested

→ Calculates a stock’s realized return during a holding period (ROR)

Average Rate of Return - More than One Period: Geometric Rate of

Return
- If you hold a stock beyond the date of the first dividend

If rates of return → answers what is the growth rate of the investment rather than the
historical
𝑛
1
𝑟𝑔𝑒𝑜 = [∑(1 + 𝑟𝑖 )𝑛 ] − 1
𝑖=1

- This method measures the periodic growth rate

- Represents the average rate at which an investment grows over a given period

Cumulative Historical Realized Growth

Historical Realized Return -

- Used when the holding period of a stock exceed when the holder receives their
first dividend payment
o To focus on the return of a single security → assumption that all money
received from dividends are reinvested into the share to earn a ROR
In this case you can compute the Historical Realized Return
𝑛

𝑟𝑐𝑢𝑚𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 = [ ∑(1 + 𝑟𝑡 )] − 1
𝑖=1

- Accounts for both capital gains and dividend contributions to the realized
return
- This method relative to the Geometric Average Realized Return → measures the
total cumulative growth rate

DIFFERENCE:
- Geometric Rate of Return looks at an average rate
- Geometric Mean looks at a cumulative rate
Expected Return
Arithmetic Average – Historical Time Series
- Arithmetic mean of all expected rate of returns with a time period of one holding
period = What investors expect to earn from an investment in the future
→ Used when predicting a rate of return from forecasted rates of return
→ Rates are derived from historical rates (Historical Time Series)
- This cumulates to find an expected return E(r)

𝑛
1
𝐸(𝑟) = ∑ 𝑟𝑡
𝑛
𝑡=1

- Usually an annual return rate

What is the Difference B/W Geo and Arith Average Return

- The geometric average of return can be more sensitive to volatile returns
- Geometric Average is a better description of the long run realized return to
evaluate the historical performance of an investment
- When estimating the future expected return of an investment – The arithmetic is
better

Expected Return
- Historical Return is less important if you have estimates about the future

- Each possible return has some likelihood of occurring

- This information is summarised with a probability distribution which assigns a

probability 𝑃𝑟 with each possible 𝑅𝑠𝑡𝑎𝑡𝑒 that will occue

𝐸[𝑅] = ∑ 𝑝𝑖(𝑟) ∗ 𝑅
𝑟=𝑖
- Return we would receive on average if we could repeat the investments many times,
drawing the return from the same distribution each time
o E(R) → balancing point of the distribution
Pros

- Easy to calculate
Cons

- High Degree of Subjectivity → estimation of probability

- Individual stocks tend to be even more volatile than large portfolios and many have
been existence for only a few years, providing little data with which to estimate
returns

o Hence why historical data is not a good estimator for future date → large
amounts of estimation error

Concept of Risk
- Risk measures the degree of uncertainties to what extent actual outcomes deviate
from expected outcomes

- If the possible return values all lie close to the expected value there is less risk than
when there is a large dispersion in values, i.e there is a probability of making
more/less from the expected return

Expected (mean) return and risks

- Total Risks can be measured by the variance or standard deviation of returns

- Variance is the average squared difference b/w the individual realized returns and
the expected return

- Standard deviation = Volatility

- Stdev easier to interpret because it is in the same unit as the return itself

2
𝑉𝑎𝑟 (𝑥) = 𝐸(𝑅2 ) − (𝐸(𝑅))
2
∑𝑛𝑡=1(𝑟𝑡 − 𝐸(𝑅))
𝑉𝑎𝑟 (𝑋) =
𝑛−1

𝑆𝑡 𝐷𝑒𝑣 (𝑅) = √𝑉𝑎𝑟 (𝑋)

 𝑛 2
∑ (𝑟𝑡 − 𝐸(𝑅))
= √ 𝑡=1
𝑛−1

Interpreting using Historical Data

- Past volatility data provides indication of future volatility of returns

- Assume return follows a normal distribution, we can use the risk & return to
understand the asset performance

Expected Return and Risk

- The total risk is the weighted average of the possible return deviation from the
Expected value, where the weights are determined by the probability that it occurs

Portfolio Risk and Return

- Investors usually invest in a number of assets (a portfolio)
- Holding a portfolio of assets → reduces investment risk but often with no effect on
overall returns because:
 o Within the portfolio individual assets are more volatile than the overall
portfolio
o Poor returns on some assets could be offset by stronger returns on others
o The overall portfolio return is smoothed out

Portfolio Return
- Portfolio expected return is a weighted average of all the expected returns of the
assets held in the portfolio,
o Where weights correspond to the proportion of. The portfolio accounted by
each component assets
- Let 𝑤𝑖 (omega) → proportion of the portfolio invested in asset I (𝑤𝑖 ′𝑠 mus sum to
1) & n is the number of securities in the portfolio
𝑛

𝐸(𝑅𝑝 ) = ∑ 𝑤𝑖 𝐸(𝑅𝑖 )
𝑖=1
𝑛
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖
∑ 𝑤𝑖 = 1 𝑎𝑛𝑑 𝑤𝑖 =
𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝑖=1

Portfolio Risk
- Combined Risk of each individual asset
Risk of a portfolio is measured by the variability or dispersion of the portfolio return around
its mean or expected value

- Unlike the expected return of a portfolio, risk of a portfolio is not a simple

weighted average of the risk of individual security returns → correlation b/w
returns

Hence portfolio risk depends on

- The variance of each asset (𝜎𝑖2 )

- The weigh of each asset (𝑊𝑖 )
- Correlation b/w the returns of the assets in the portfolio (𝑝𝑖.𝑗 )

Covariance
- Covariance is a raw measure of the degree of association b/w two variables

- Covariance is computed as the expected product of the deviations of the returns on

two stock from their means
 - If COV > 0 → returns move in the same direction
- If COV < 0 → returns move in opposite directions
- COVAR is measured in the same units as the variance → can’t know if a covariance
of say 100 means strong or weak relationship

Correlation
- Correlation can also be used as it provides a numerical number which can be
integrated to find the relationship b/w two series
𝑐𝑜𝑣(𝑖, 𝑗)
𝑝(𝑖, 𝑗) =
𝑉𝑎𝑟(𝑖 )𝑉𝑎𝑟(𝑗)

Interpretation

- If p = +1, the securities are perfectively positively correlate → when one asset is up
the other is also up in perfect proportion
- If p = -1 the securities are perfective negatively correlated → two assets move in
opposite directions in perfect proportion
 - If p = 0 the returns on the two assets unrelated

Portfolio Risks

- The risk of a portfolio is related to the riskiness of the stocks and the degree of
covariance or correlation
- The variance of a returns in a 2stock portfolio

Derived from

𝑉𝐴𝑅(𝑎𝑋 + 𝑏𝑌) = 𝑎2 𝑉𝐴𝑅(𝑋) + 𝑏2 𝑉𝐴𝑅(𝐵) + 2 ∗ 𝑎 ∗ 𝑏 ∗ 𝐶𝑜𝑣(𝑋, 𝑌)

Risks and Correlation

A = (10%,5% asset)
Hence put stdev first
If u combine both
assets all the line plots
all the possible
portfolio combinations
(varying levels of
weights)
Plots all the possible
levels of E (R) and risk
at all weights

- Linear Line A and B → is when p=1 and as u move along the line u put more weight
on b
- As u move from starting point A → B shows all possible E(r) and risk as u
increasingly put more into B at each correlation level

Gains from Diversification: Key Points

- Combining two securities whose returns are perfect positively correlated results only
in risk averaging

- The gain from diversifying is closely related to the correlation coefficient value
 o The degree of risk reduction increases as the correlation b/w the rates of
return on two securities decreases
- Risk Reduction occurs by combining securities whose returns are less than perfectly
correlated
o The greatest risk reduction is achieved when portfolio asset returns have a
correlation of -1

3 Asset Portfolio Return and Risk

- If risks now includes asset’s 3 risk and plus asset’s relation with assets 1 and 2

Types of Risk and Diversification

Total Risk = Systematic Risk + Unsystematic Risk
1. Unsystematic Risk
- Also known as diversifiable risk as it can be eliminated to a large extent through
portfolio diversification
 - This is the firm-specific risk due to such factors as management’s action, supply of
raw materials, employee relations and regulations etc
Risks are:

- Unique
- Idiosyncratic
- Firm-specific

2. Systematic Risk
- Known as undiversifiable risk or market risk because it cannot be reduced
through the inclusion of more securities in a portfolio
- That part of the variance is caused factors influencing the market
o GNP
o Interest Rates
o Consumer Expectations
o Purchasing Power
- Sensitivity to Systematic Risk = Beta of a stock
o Measures how sensitive a business’s cash flow and revenues are to
general business conditions

Types of Firms
Type 1: Firms who are only exposed to idiosyncratic and unsystematic, company specific risks
Type S: firms have only systematic risk.

Common vs Independent Risk

- Diversification: Averaging or reducing risk by creating a portfolio that includes
multiple investments

What risk does this remove

If you put all eggs in one basket, you lose all the eggs if that basket has a hole in it.
 ▶ If you spread your eggs in different baskets. The chance that every basket has a hole in
it is low, and you won’t run a risk of losing all your eggs ⇒ you reduce the independent risk of
baskets having a hole.

▶ What if there is an earthquake, you drop all the baskets and lose all your eggs ⇒ that’s
a common risk affecting all the baskets ⇒ you can’t eliminate this risk

- The risk premium for diversifiable risk is zero, so investors are not compensated for
holding firm-specific risk.
o Arbitrage opp → increased buying → pushes up the price → decreases return
→ decrease E(r) → until risk free rate is reached

Hence the risk free prem of a stock is independent from its’ firm specific/unsystematic risk

- Because investors can → eliminate non-systematic risk for free

This principle implies that a stock’s volatility, which is a measure of total risk (that is, systematic
risk plus diversifiable risk), is not especially useful in determining the risk premium that investors
will earn.

Topic 8: Capital Asset Pricing Model

Portfolio Construction
Key Assumptions for Portfolio Theory is that → we are Passive Investors

1. Assume everyone has perfect information

 2. Assume everyone can borrow and lend at the same Rf
3. Maximise Returns whilst Minimising Risk

Dominance Principle
- Occurs when a particular portfolio has a
o Higher E(R) or equal to E(R) of another portfolio
o Lower or equal to standard deviation than its comparative portfolio
Absolute Dominance occurs when a portfolio dominates 2 principles
Borderline Dominance occurs when a portfolio dominates only 1 principle

Feasible Portfolios
- Refer to the set of all return and risk outcomes that can be achieved by combinations
of stocks in all possible ways
Movement from left to right
indicates shifting the weight
increasing from AGL to TLS
How does this shift

- Number of Assets
- Selection of unique assets

Opportunity Set of Risky

Portfolios: Set of feasible
portfolios
- Each point There are N
risky assets, the line becomes an
area
o Note: The area does not
touch Y axis as a risky portfolio
always has positive standard
deviation

- People will always look to invest in the border line of the variance frontier
o Minimize Risk → Passive Investors
- Hence the subset of feasible portfolios with the lowest risj at each level of expected
return should be focused on
o Called the Minimum Variance Frontier
1 The upper half of the minimum variance frontier
 • Is called the Efficient Frontier
o Subset of minimum variance portfolios with the
highest expected Returns at each level of risk

- Your risk tolerance

o Determines where in the efficient frontier you stand

Inclusion of a risk-free asset

- The introduction of a risk-free asset (𝜎 = 0) → expans the risk-return opportunities
available for investment
o New sets of feasible portfolios now exits
o Each new set of feasible portfolios is represented by a straight line from the
risk-free asset to a portfolio on the efficient frontier
E(R) v Dev new graph with risk free Asset
 - You can measure the weight of a risk-free asset against full portfolios
S

Sharpe Ratio
𝒓𝒑 − 𝒓𝒇
𝝈𝒑

- The portfolio with the highest Sharpe ratio (Reward to risk ratio)
o Is the portfolio where the line with the risk-free investment is tangential to
the efficient frontier of risk y investments
o Shows excess return per unit risk → returns per standard deviation increase
- Optimal Risky Portfolio is generated by the tangent line

- Borrowing refers to the use of leverage → to invest further

Optimal Portfolio
- The ORP has the highest sharp ratio: every investor will hold the same ORP
o = Market Portfolio → Perfect information
1 Contains all assets/stocks where the weight of each stock is the
market cap of company/total market cap
o Then we combined the optimal risky portfolio & risk-free asset by
lending/borrowing at the rf to obtain exposure that best suits the investor’s
preferences
1 This creates a line called the capital market line and the point of
tangency is the optimal risky portfolio
• Return = Market
 • Risk = Market

Capital Market line

Capital Asset Pricing Model

The CAPM
- The equation for the CML gives an expression for the expected return of any
efficient portfolio
𝑟𝑚 − 𝑟𝑓
𝑟𝑝 = 𝑟𝑓 (𝐼𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡) + (𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝐶𝑀𝐿)𝜎𝑝
𝜎𝑚
- This eation can be rearranged to give
𝜎𝑝
𝑟𝑝 = 𝑟𝑓 + (𝑟𝑚 − 𝑟𝑓 )
𝜎𝑚
 - Bp is the standard deviation of the portfolio over the standard deviation of the
market
o Shows the sensitivity of changes in Rp as opposed to Rm
o If market ROR increase by 1% E ® increase by B1 %
o Bp is the weighted average of all the individual betas

- This equation can be used to determine the expected return of any security
o Consistent with the notion that the E(R) is determined by its market risk

→ bcuz raitonal investors will hold portfolio which diversify enzymatic risk

→ Hence security should only be priced by its systematic risk

Hence

𝐸(𝑟𝑖) = 𝑟𝑓 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑟𝑖𝑠𝑘 ∗ 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑟𝑖𝑠𝑘

= 𝐵𝑜 ∗ 𝐸(𝑅𝑚 − 𝑅𝑓)

- Quantity of Risk
o Attributable to an asset is given by its B
1 For each unit of market risk faced , the investor expects to be
renumerated by a market rate of return over and above the risk-
free rate
Hence Risk Premium = Compensation of Taking an additional unit of risk
Beta = Exposure to market risk
Security Market Line
Security Market Line = Graphical representation of the relationship b/w market risk
(systematic risk) and price

- Once the risk-free rate and the expected return on the market have been estimated,
the expected return on a security can be calculated as a function l of its beta and
should be used to plot the SML

- Market Portfolio has a beta of 1

o Only price of sysmatic risk exists
In equilibrium

- No securities can lie below or above the CAPM

o If above ppl would sell
o If below ppl would buy until Security Market Line is reestablished

How To Estimate Beta

1. Risk-Free Rate
- Information comes from the RBA
2. Expected Return on the market more than the risk-free rate (Rm-Rf)
- Take average returns of particular indexes
3. Estimation of Beta
- Since the relationship b/w returns of a security and the market can be estimated by
quantifying the historical relationship
CAPM can more generally know as
 - Then a regression can be run to find beta
- CAPM implies the coefficient a = 0 → everything is fairly priced

- Since X is the Risk Free Premium and R is the difference in retrun of the security
and the risk-free rate → formula could be used

Returns of a Security
𝑃𝑡 − 𝑃𝑡−1 + 𝐷𝑖𝑣𝑡
𝑟𝑖,𝑡 =
𝑃𝑡−1
Returns of a Market
𝐼𝑡 − 𝐼𝑡−1
𝑟𝑚,𝑡 =
𝐼𝑡−1

- Note Risk Free Rate is quoted quarterly

- All data must have the same frequency
Example
Cost of Capital

Relationship between the Capital Market Line

Capital Market Line plots efficient portfolios to determine the expected return for efficient
portfolios based on their total risk

- Slope = Sharpe Ratio → higher the slope the better

SML plots all assets (individual or portfolio), to determine the expected return for efficient
portfolios base on their systematic risk (beta)

- Derived from the CML

Company’s Cost of Capital

- Company can raise funds through either debt or equity markets
o Companies use a combination of debt and equity financing
 o Investors req a return on their equity or their debt as compensation for
investing in the company.

→ Required return is a cost from the company perspective

Example:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 % =
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

- Cost of Capital % General Formula

𝑬 𝑫
= ∗ 𝒓𝒆 + ∗ 𝒓𝒅
𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒑 𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒑𝒕𝒊𝒂𝒍

𝑬 𝑫
𝑾𝑨𝑪𝑪 = ∗ 𝒓𝒆 + ∗ 𝒓𝒅
𝑬+𝑫 𝑫+𝑬
- Weight of equity * cost of equity + Weight of Debt * cost of debt
H/ever to find WACC

- Market Value must be used rather than book value to calculate weight
o Dependent on current share price
Why?

- Finance Value is forward looking → as Price is based on PV of Future Cash Flows

(when the company raised equity last time → what was the historical cost and value
of the capital provided
o Market Value of Equity = No of outstanding shares * Current Share Price
o Market Value of Debt = (No of outstanding bonds/debentures) * current
bond price
1 Debentures = Unsecured Debts (cost is always higher), not backed by
collateral and has a term of greater than 10 years.
2 Bonds = Secured Debts backed by collateral
- Book Value is backwards looking
Cost of Equity
Cost of Equity Capital is the minimum rate of return that investors expect to receive from
investing in a company’s shares

- Cost of equity for a company is a weighted average of the costs of different types
of shares that the company has outstanding at a particular point in time

Note: There are two types of shares 1. Ordinary Shares and 2. Preference Shares

- To find cost of equity, use

1. CAPM
2. Implied from the current stock price and company fundamentals

Approach 1: CAPM

- Market Information is used to estimate the cost of equity

- Identifying the appropriate B is more complicated if the ordinary share is not

publicly traded
- Problem may be overcome by identifying a comparable company with publically
traded shares in the same business with a similar amount of debt

o When a comparable company cannot be identified it is sometimes possible to

use an average of companies’ betas in the same industries
o It is not possible to directly observe the return on the market → use
historical data only as a proxy for return in the market

Dependent on Notation: New CAPM to adjust for diff revenues across markets is

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑟𝑓 + 𝛽 ∗ (𝐸𝑀𝑃𝑅 + 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑔 𝑜𝑓 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚𝑠)

 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆𝑡𝑑
𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑆𝑜𝑣𝑒𝑟𝑖𝑔𝑛 𝐶𝐷𝑆 ∗
𝐵𝑜𝑛𝑑 𝑆𝑡𝑑
- CDS = Credit Default Swaps
o Used to Measure a Country’s Credit Risk (incl political, eco factors)
1 Riskier markets have higher CDS
- Equity STD/Bond Std
o Used to measure a relative volatility of equity relative to debt (usually higher
→ equity is inherently riskier)
o Adjust to adjust credit risk exposed to Equity Investors
Approach 2: Implied from Current Stock Price

- Constant growth model assumes that companies pay dividends that grow at a
constant rate in the long run
- The value of a share can be expressed as
𝐷𝑖𝑣1 𝐷𝑖𝑣1
𝑃𝟎 = → +𝑔
𝑟𝑒 − 𝑔 𝑃𝑜

Limitation

- Reliant on assumption of Constant Growth

- Needs forecasts of Future Dividends
- Assumes the stock is priced

Cost of Equity: Preference Shares

- No growth given it is a hybrid financial product

Cost of Debt
- The cost of debt capital is the minimum rate of return that the firm’s creditors
demand when they lend money to the company.
o Found by using the Bond Pricing Formula
 𝐶𝑃𝑁 (1 − (1 + 𝑟𝑑 )−𝑁 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = +
𝑟𝑑 (1 + 𝑟𝑑 )𝑛

- H/ever corporate debt is often not actively traded and hence market values cannot
be easily observed
- Can’t solved by hand → has to use excel

Other Cost of Debt Approaches

1. Assume the debt is risk free rate and use as a proxy → bank loans = rf

𝑟𝑓 = 𝑟𝑑

- Applicable for smaller companies as they don’t usually use issue bonds hence entire
debt originates from bank loans
o Controversial Approach
2. Add a certain percentage to the Government Yield

𝑟𝑑 = 𝑟𝑓 + 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚

- Associated with the credit spread of bonds from various credit ratings
3. Calculate the cost for the company to issue debt
𝑛𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑟𝑑 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡
- Note only use long-term debt
o Used Closing Balance of L/T Debt and Starting Balance of L/T debt

Cost of Debt – Further Notes:

- In WACC calculations only include L/T debts

o Bonds, L/T Bank Loans
- The cost of a company’s L/T debt is estimated when the analyss is done
- Current cost of debt for a bond is from the market’s current assessment of its risk
o i.e. Yield to Maturity
- Rmb bond pay coupons semi-annually → need to convert rate
The After-tax Cost of Debt Capital
𝐴
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 ( ) = 𝑟𝑑 (1 − 𝑡𝑐 )
𝑇
- Tc = corporate tax rate

Weights and Capital Structure

Summary

𝑷𝒓𝒆 − 𝒕𝒂𝒙 𝑾𝑨𝑪𝑪 = 𝒓𝒆 ∗ 𝒘𝒆 + 𝒓𝒅 ∗ 𝒘𝒅

𝑾𝑨𝑪𝑪 (𝒂𝒅𝒋𝒖𝒔𝒕𝒆𝒅) = 𝒓𝒆 ∗ 𝒘𝒆 + (1 − 𝑡𝑐 )(𝒓𝒅 ∗ 𝒘𝒅 )

WACC’s Application

- Use in capital budgeting topic as the discount rate to calculate the NPV of the
projects
 - If a firm takes on a project, where the project is to share the same systematic risks
as the company a a whole, WACC will be appropriate discount rate for eval project
o Important to consider if the risks is associated with a project are the same as
those of the firm → accurately reflect the project’s risk

Leverage and Cost of Equity

Adjusting beta for Leverage

- Firm’s capital structure is not static

o Hence when capital structure change → so does the systematic risk of the
firm and the discount rate
- Need to adjust beta to be independent/considerate of a company’s capital structure
𝐷
𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 [1 + (1 − (1 − 𝑡𝑐 ) ∗ ]
𝐸
- Levered Beta considers financial risk
- Unlevered Beta measures a company’s business risk without considering debt,
indicating the level of inherent business risk

𝛽𝑙 = 𝛽𝑢

- If calc beta over long period of time → estimate might be volatile → need to use
levered beta

Imputation System and WACC

- WACC needs to be adjusted to reflect differences in tax systems
o Imputation vs standard → Imp provides investors with a tax shield
1 Hence investors may req less returns if they are able to utilize
franking credits
Lecture 10 Capital Budgeting Decision

Capital Budgeting
Analysis of potential projects to determine whether it can generate additional value for the firm

- Choose projects that will increase the value of the company

- Often L/T decision that involves large expenditures
o → decisions are difficult to reverse
o → choice of projects will determine the firm’s strategic directions

Types of Projects
1. Independent Projects
a. Project’s C-F are unrelated to a company ‘s operations
2. Mutually Exclusive projects
a. Accepting one project automatically means the other project is rejected
3. Contingent Projects
a. Acceptance of one project is dependent on the acceptance of another

Basic of Rationale behind Decision

- Cost of Capital = Minimum return that a project must earn for it to be accepted
o Underpinned by the concept of O/C → reflects the rate of return expected
by investors for their investment in projects and assets of similar risk profiles
 - Capital Rationing = Process of company putting restrictions and allocating its
resources given its resources and budget is finite and cannot be allocated to all
positive NPV projects
o → Implies Funding Opps (NPV>0) > Funds Available
o → Need to allocate resources towards projects that will generate the highest
value for shareholders
Techniques Available for Evaluation

- NPV analysis
- IRR
- Profitability Index
- Payback period (PBP) and discounted payback period (DPBP)

Method 1 Net Present Value

- Difference b/w the PV of benefit less the PV of costs
o Consistent wit the goal of maximizing shareholder wealth

Fundamentals

- NPV > 0 = Value generating for shareholders

- NPV < 0 = Value erroding for shareholders

1. For Independent Projects

- NPV > 0 = Accept
- NPV < 0 = Reject
2. For Mutually Exclusive Projects
- Choose the project with the highest NPV
Application

- Used for making capital investment decisions → reliant on the future forecasting
of cash flows
o Need to be aware and not to be too optimistic in projections making sure
each assumption for growth is grounded in logic and rationale
- Need to also correctly determine the discount rate (req of return)
o Too high → run the risk of rejecting a positive NPV project
o Too low → run the risk of acceping a negative NPV project
Steps
1. Estimation/Forecasts of a project’s Cash Flows
2. Determination of the investor’s cost of capital or required rate of return
3. Calculate the PV of future cash flows and make decisions based on fundamentals
Identifying the discount rate

- If project is fiunded → based on capital structure of the firm

o Use of WACC calculations is appropriate for determining the discount rate
conditional on
1 The systematic risk of the project = systematic risk of the
company
2 The projects use the same D & E weightings as the company capital
structure

- In a nutshell the discount rate of a project should reflect the level of risk of the
project

Method 2: Internal Rate of Return

- Refers to the Discount Rate that makes the NPV = 0

Decision Rule

𝐴𝑐𝑐𝑒𝑝𝑡 𝑖𝑓 𝐼𝑅𝑅 > 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛

𝑅𝑒𝑗𝑒𝑐𝑡 𝑖𝑓 𝐼𝑅𝑅 < 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛
- Rationale
o IRR represents the return associated with that project
o Easier to understand that NPV as it provides a rate of return
o Since based on concept of NPV → [rpvides the same decisions usually
Application of the Rule
1. Independent Projects
- IRR and NPV will usually provide the same decision if the cash flows of the
projects are conventional
Cash Flows are Conventional if

- Initial outlay at time zero paired with positive cash inflows in the next years
- Inverse relationship between NPV and cost of capital

2. Mutually Exclusive Projects

- Methods can yield different decisions and ranking of projects

Unconventional Cash Flows

- Unconventional cash flows could follow several diff patterns
o A positive initial cash flow followed by negative future cash flows
o Future cash flows incl both positive and negative flows
In this situation

- The IRR technique can provide multiple solutions

o Makes the result unreliable and should the technique should not be used to
accept or reject a project

Leads to IRR Pitfalls

1. Delayed Investments

How to Account for

- If projects with conventional cash flows

o Discount Rates are inversely Proportional to NPV → requires a higher IRR
to accept
- For projects with irregular Cash Flows particular negative future cash flow
 o Discount rates are proportional to NPC → requires a lower IRR than
discount rate to accept

2. Multiple IRRS

3. Non-Existent IRRS

4. Scale of Project
 5. Mutually Exclusive Projects
- A company may have multiple projects undue consideration
o Means they can only accept one project
- Know that discount rate will affect the NPV
o Means that NPV of 2 projects = each other at a certain discount rate
- This point is called the cross over point
- Depending upon whether the required rate of return is above or below this cross
point the ranking of the projects will be different

Thoughts on the method

- While the IRR rule has shortcomings for maing investment decisions, the IRR itself
remains a useful tool
o Measuring the average return of the investment and the sensitivity of the
NPV to any estimation error in the cost of capital
- When there is a conflict b/w the IRR and NPV you should focus on the NPV
decisions rules

Method 3: Profitability Index

- Profitability Index (Pi) – The PV of of an investment’s future cash flows divided
by its initial costs

𝑉𝑎𝑙𝑢𝑒 𝐶𝑟𝑒𝑎𝑡𝑒𝑑 ∑𝑛𝑖=1 𝑃𝑉

𝑃𝐼 = =
𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝐶𝐹0

- Accept if Pi > 1
Use

- Can be used to identify the optimal combination of projects to undertake

- For mutually exclusive projects opt for the higher profitability index
- H/ever should not be solely relied on as it doesn’t represent the best choice
given the level of capital constrating
o Use PI rankings
o NPV to find cumulative NPV
Method 4: The Payback Period Rule
- Amount of time it takes to recover or pay back the initial investment
o No of years it takes for the project’s initial investment to be recovered from
its cash flows
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑡𝑜 𝑟𝑒𝑐𝑜𝑣𝑒𝑟
𝑃𝐵𝑃 = 𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝑟𝑒𝑐𝑜𝑣 𝑐𝑜𝑠𝑡 +
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐷𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

- Used for non-mutually exclusive project → if the payback period is < than a pre-
specified length of time, you accept the project
o Otherwise reject the project

The Payback Period

- No economic rationale that links PBP to shareholder wealth maximisation

- For mutually exclusive projects: Rank projects on which has a shorter PBP
- The payback period analysis can lead to erroneous decisions because the rule
does not consider cash flows after the payback period.
o Ignores the project’s cost of capital and time value of money
o Ignores cash flows after the payback period
o Relies on an ad hoc decision criterion

The Discounted Payback Period

 - Fixes the weaknesses of the ordinary PBP method as it discounts future cash flow
accounting for the concept of the time value of money
- Tells management how long it takes for a project to reach positive NPV
- Does still ignore call cash flows after an arbitrary period

Application
- Companies use all the techniques
o Most popular is done through a DCF (using NPV and IRR)
o PBP method has also become popular
- Decisions made based on the project’s NPV are consistent with the goal of
shareholder wealth maximisation. The result shows management the dollar amount
by which each project is expected to increase the value of the company. For these
reasons, the NPV method should be used to make capital budgeting decisions.

- It can be helpful to evaluate the project using some of the other techniques in
addition to NPV because they can provide useful additional information.

In Practice
- Managers should conduct regular and ongoing reviews of capital projects currently
in progress
- Review should challenge the business plan, incl cash flow projections and
operating costs assumptions
- Management should systematically perform post-audit reviews on all completed
capital projects
- A post-audit examination compares the actual results with what was projected in the
capital budgeting proposal
- For failed projects → evaluation must be occurred for those responsible for those
implementing the project
Week 11 - Capital Budgeting Fundamentals

What Cash Flow should be used

- NPV depends on a project’s Free Cash Flow- The incremental effect of a project
on a firm’s available cash
o Do not use accounting income – Why?
1 Based on arbitrary revenue and expenses recognition rules by
accountants
• For instance deprecation
2 Revenue and Expenses on income statement done on accrual
accounting not cash based accounting
Hence use only Relevant Cash Flows

- C-F in included in NPV analysis should stem only from accepted projects
o Does not include financing cost

→ These are called incremental cash flows

- Concept of how much a Firm’s earnings are expected to change as a result of an

investment decision

Core Question = Ask yourself is this Cash Flow solely because of this project only
occurring if we accept the project

- If yes include
- If no don’t include
- If partially we include the part that occurs as a direct consequence of the project
→ Concept allows for capital budgeting decisions and analysis which isolate the project
from the firm’s operations

Sunk Costs (Not Included)

- Note the sunk cost of the feasibility study → outside of the project is excluded
from analysis as it does not contribute to the project directly
o Sunk costs are costs which occur regardless of whether a decision is made or
not – Examples are:
1. Fixed Overhead Expenses: Typically are fixed and not incremental
to the project and should not be included in the calculation of
incremental earnings
2. Past Expenses: Money that has already been spent is a sunk cost
and therefore is irrelevant to the analysis
3. Feasibility Study: Cost to determine whether there is market
demand for the product

Opportunity Costs (Included)

- Opportunity Cost- Refer to the foregone costs of using a resource which could’ve
otherwise been use in other productive pursuits
o Dollar Value of the best alternative use must be included as a cash
outflow in NPV analysis – as cost are consumed when undertaking the
project

Project Externalities/Side Effect (Included)

- A side effect is a positive or negative cash flow that relates to aspects of a
company’s business as a result of implementing a project
o E.g Cannibalization of sales when a new product displace sales of an
existing product

→ As these costs come as a direct consequence of the implementation of the project → they
must be included in the NPV calculations
Example of the Inclusion and Exclusion of these costs

Accounting for Depreciation Cost in Capital Budgeting

- Depreciation is deduced when calculating the taxable income but it is not an
actual cash flow
o The only effect depreciation has on NPV analysis is to reduce the tax
payable
How is it calculated
1. Straight Line Depreication (Prime Cost Method)
𝐴𝑠𝑠𝑒𝑡 𝐶𝑜𝑠𝑡
=
𝐴𝑠𝑠𝑒𝑡 𝐿𝑖𝑓𝑒 𝑆𝑝𝑎𝑛
2. Depreciated at a pre-determined rate (i.e. 10% per year): the asset’s cost to be
multiplied by the depreciation rate
𝐼𝑛𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 − 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 =
𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑓𝑜𝑟 𝑡𝑎𝑥 𝑝𝑢𝑟𝑝𝑜𝑠𝑒𝑠
- Note the initial cost includes a handling fee, shipping fees and installation fees etc.
(start-up costs)
Salvage Value and Gain on Sale
- Salvage Value = The amount the asset is sold for
→ Expected to generate a cash flow in the last year of the NPV analysis
→ Expected to generate tax on gain on sales
a. As without the asse the project no longer exists/is terminated

Calculations

- For the example above after 5 years the project should have:

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝐼𝑛𝑡𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 − 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 × 𝑁𝑜. 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑜𝑓 𝐴𝑐𝑡𝑢𝑎𝑙 𝑈𝑠𝑒

𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝐼𝑛𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦 − 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

Important

𝐺𝑎𝑖𝑛 𝑜𝑛 𝑆𝑎𝑙𝑒 = 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

Tax Consideration

𝑇𝑎𝑥 𝑜𝑛 𝐺𝑎𝑖𝑛 = 𝐺𝑎𝑖𝑛 𝑜𝑛 𝑆𝑎𝑙𝑒 ∗ 𝑡𝑐, 𝑤ℎ𝑒𝑟𝑒 𝑡𝑐 = 𝑐𝑜𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

 - Accounting for the Tax Payment we have
𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 = 𝐸𝐵𝐼𝑇 ∗ 𝑡𝑐,

Interest Expense (Not Included)

- In capital budgeting decisions → interest expense is not typically included
o The rationale is that the project should be judged on its owned rather than
how well it is able to be financed

Taxation (Included)
- Taxation represents a cash outflow and needs to be included in calculations
o Cash flows should be estimated on a after-tax basis
1 After-tax cash flows must be discounted using an after-tax rquired
rate of return
This is because Tax can influence a project in 3 Ways
1. Corporate Income Tax affects after-tax income
2. Depreciation → recognized as an expense → tax deductible = tax shield
a. To find amount jst multiple tc with depreciated value
3. Liquidation on Salvage Value → tax on gains or loss incurred

Net Working Capital (NWC)

= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝐼𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠 = 𝐶𝑎𝑠ℎ + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑅𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒𝑠 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠

- Represents the capital a business has access to for its day-to-day operations
o Capital required to fund current rejects

- Assume change in NWC occurs at the beginning of the period – change in NWC for
period 1 shows up at period 0 on the C-F table
- Don’t forget to include cash received when working capital is released at the end of
the project
Why is it important

- It reflects changes to a company’s account receivables and payables →

Translates to cash flow (indirect method of cash accounting)
 - We assume that working capital is recovered at the end of the project. In the last
year, the cash flow is equal to the ending balance of NWC.

Free Cash Flow Formula

𝐹𝐶𝐹 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 − 𝐶𝐴𝑃𝐸𝑋 − 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑞𝑢𝑖𝑟𝑚𝑒𝑛𝑡𝑠

- Operating cash flow = Revenue - Cash Expenses or EBITDA – Taxes

Why?

- Depreciation and Amortization is not a cash expense

- Interest is not included to reflect the true value and viability of the project
- Taxes are included as it is a cash expense

Important Notes

- TAX Expenses = EBIT * tax rate

- CAPEX = includes initial outlay & any flows from sales

Exclude: Non-Cash Expenses (D&A), Sunk Cost and Financing Costs

Include: Side Effect Cost (Externalities) and Opp Cost

Accounting for Inflation

- Inflation can reduce the purchasing power and hence worth of future cash flows
o Hence it affects the project’s profitability
Note to

- BE CONSISTENT with how inflation is treated → use nominal rates to

discount nominal cash flows
𝑟 = (1 + 𝑖 )(1 + 𝜋) − 1

Projects with Different Lives

- Mutually Exclusive projects may have different lives
o For instance
1 Proj A is 5 years and Proj B is 7 years
→ In this situation we can’t use NPV for direct comparison hence you have to make the
lengths the same by assuming repeated investments over an indentical period

- And the comparing the NPVs of their costs

- Alternatively one can standardize their projects length to reach 1 year

Method to Handle Different Lives Problem

𝑁𝑃𝑉
𝐸𝐴𝐴 =
1 − (1 + 𝑟)−𝑁
𝑟
Replacement Project Analysis
- Occurs when a firm decides to replace a existing asset with a new or better one
o H/ever → more complicated as you can liquidate and hence companies do
not wait for old machines to run out
- → Therefore analysis involves the sale of an asset when the new asset is in place is
required
Key Difference b/w a Replacements Project and an Expansionary project

Week 12 – Efficient Capital Market Hypothesis

Overview of Equity Capital Markets

Major Participants
1. Buying and Selling parties – could be individuals or institutions (eg., fund managers,
banks etc)
a. Direct Investment → Retail Investors
b. Indirect Investors→ investment in fund managers which are organization that
invests funds on behalf of investors (institutional investors)
i. Two Type of Mutual Funds
1. Passive – Funds are used to earn a similar return to the market
index (Combination of market portfolio and risk free)
2. Active – Funds used to outperform the market index → doesn’t
follow market index and efficient portfolio theory
Note: Hedge Funds→ does not invest for everyone → only for richer individuals → higher fees
due to more active stock picking
2. Stock-broker who provide trading services
a. Agency Trading. → Do not assume any position → only job is to match buyers
and sellers like real estate agents
b. Principal Trading Brokers (HSBC, deposit the stock of investors) → Business
transacted on the broker’s own account
Further:

- Facilitation - The broker takes the opposite side of a trader to a client to. Complete
a transaction
- House Trading – the broker buys and sells shares for their own investment
purposes

3. The securities exchange → facilitates buying and selling of stocks actings a self-regulatory
body (NYSE, NASDAQ. TSE, SSE)

Asset Valuations
- An assers value is defined by the PV of expected cash flows
𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦
𝐶𝐹
𝑉= ∑
(1 + 𝑟)𝑡
𝑡=1

→ Hence price in the market is

𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦
𝐸(𝐶𝐹)
𝑃= ∑
𝐸((1 + 𝑟)𝑡 )
𝑡=1

- Expected value everyone’s expectations and calculations of cash flow

o Probability is assigned to each cash flow value and discount rate
1 Earnings for instance → could adjust the probability of everything
2 Current Financials → could lead to shifts in the levered beta formula
→ leads to changes in probability distribution of future cost of equity
capital
Hence

→ Asset prices change as new expectation arrives which changes expectations of future c-f and
discount rates
Efficient Market Hypothesis (EMH)
- Expectation that in an efficient market security prices fully reflect all available
information

Two Components – Informational efficiency: The Degree → depnds on

1. Type of information is reflected
2. The speed of which new information is reflected
a. Market Rationality
Types of Information

- Historical Trading Data

- Publically available information
o Company financial statements, announcements, news
- Private Information
o Private Assessment of public information bu not know to th epblic
1 Private Research
2 Analyst Reports
o Inside Information know to people working for a company but not yet
made public

Market Efficiency

- Investors analyse and uncover information related to assets → that they follow and
forecast future cash flows and value of these assets
Information gathering is motivated by the desire for higher investment returns

- The act of trading based on this information has two important consequences
o The first investor to trade makes a profit
o Th e Trading process causes security prices to reflect the information
uncovered by market participants
Forms of Market Efficiency

- Weak Form
o Prices Reflect all information contained in the record of past prices and
volumes
1 Adjusts market activities for instance if jan is known to be a period of
higher return → many buyers in jan → prices increase reflecting this
expectation
2 Similarly → sellers will begin to rush to sell

→ Renders Technical Analysis

- Possible to trade on rpice patters in stock to generate systematic profit

o If a market form efficient : No → technical analysis → is already y reflected
in price
1 Not possible to make consistent profits → as this is random →
trading rules set up to detect and trade based on trends
- Semi-Strong Form
o Reflects all publicly available information
o Asset price react immediately to the release of new information that is
made public
• Supports fundamental analysis → publishing of financial
statements etc.
 o Makes it not profitable -> in a market that is at least
semi strong form efficient
o [Link] → if market is not fully strong efficient →
meaning the market is poor at processing publically
available information → leads to mispricing which
could be used to make trading gains

- Strong Form
- Market Reflects all private information
o For instance if buy orders are made perfectly available → market reaction
would react to buy orders of other people → lack or profit

Test of Market Efficiency

- A variety of trusts can be conducted to try to determine market efficiency
Testing Weak Form Efficiency

- Consensus is that ASX is weak-form efficient → academic research finds that it is

not possible to make systematic profits from relying on rules relying on price patters
in Australia
o Recent studies show that this is the case in other developed stock exchanges
outside fo those that are located in more emerging markets
Tests of Semi Strong Form Efficiency

- Largest Test is event studies which examines the behavior of prices around
information events or announcements
o The purpose of these studies are to analyse how quickly new information is
reflected in share prices and the returns possible for investors
1 US is considered one of the few potentially semi strong form efficient
stock markets

Tests of Semi Strong Form Efficiency

- If a market SFE – even insider trading will not yield any abnormal retursn as this
private information would already be reflected in share prices
o Fund managers or individuals are unable to consistenetly Outperform
o Even corporate insiders
Insider Trading
- Use of private information (strong form) that is confidential to unfairly benefit

Why is this important

- If market prices reflect only information of a particular type → we can profitfrom
trading on information not yet reflected on prices
o If prices already reflect this type of information trading on will not be
systematically profitable
- To compare market efficiency → compare intrinsic value with market prices