Time Value of Money S= Subscription Price Risk and Return 𝑡𝑐 = company tax rate

Simple interest N=#of existing shares entitled for 1 share Historical

𝐷1
𝐹𝑉 = 𝑃𝑉 + 𝐼𝑁𝑇 or 𝑃𝑉(1 + 𝑖 × 𝑛) G=r + End−Start
𝐷1
𝑃0 Return: Rt =
𝑆𝑡𝑎𝑟𝑡
Capital Structure
𝐼𝑁𝑇 = 𝑃𝑉 × 𝑖 × 𝑛 R= +g £R1+R2… Earnings Per Share:
𝑃𝑉 = 𝐹𝑉/(1 + 𝑖 × 𝑛) 𝑃0 Average Return: R =
n (𝐸𝐵𝐼𝑇 – 𝐼) × (1 – 𝑡𝑐 )
Dividend and Growth over Years
𝐷3 SD: S = √P(𝑅1 − 𝑅̅)2 + ⋯ + (𝑅𝑛 − 𝑅̅)2 /𝑛 − 1
D1 (1+r)-1 + D2(1+r)-2 + ( 𝑥(1 + 𝑟)^ − 2) 𝑁𝑜.𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑝𝑡𝑖𝑜𝑛 1
Compounded interest 𝑟−𝑔 𝑅̅ = average return Only allows changed in EBIT, doesn’t consider costs of
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 𝑅 = actual return for observation
𝐹𝑉 different debt levels
𝑃𝑉 = 𝑛
or 𝐹𝑉(1 + 𝑖)−𝑛 $ Return per share = Selling price - purchase price +
(1+𝑖) Capital Budgeting total dividends
1. Accounting Rate of Return Definitions
Effective annual rates (EAR) Average net profit WAAC: required return that pays all interest and
To convert a nominal rate to an effective rate Expected
(Initial Cost + Salavage)/2 Expected return: E(R)= ∑ 𝑃𝑖 × 𝑅𝑖 principal and compensates shareholders
𝐸𝐴𝑅 = (1 + 𝑖)𝑚 − 1; m = no. compounding periods Capital Budgeting: selecting projects that maximise
2
2. Payback Period (length) SD: 𝜎 = √∑ 𝑃𝑖 × [𝑅𝑖 − 𝐸(𝑅)] shareholder wealth
Annuities 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 Efficient Marketing Hypothesis: no one can consistently
(1+𝑖)𝑛 −1 𝑅𝑖 = return for state i
𝐹𝑉 = 𝑃𝑀𝑇 [ ] 𝑌𝑒𝑎𝑟𝑙𝑦 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 make abnormal profits
𝑖
𝑃𝑖 = probability of state i Modigliani and Miller: Suggests that overall cost of
PMT = annuity payment
n = number of payments 3. Discounted payback capital is constant regardless of debt, value is
Portfolio determined by real assets, especially as interest
i = per period interest rate Cash flows are converted to PV first to remove TVM
1−(1+𝑖)−𝑛 CAPM: E(R) = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 ) payments are tax deductible
𝑃𝑉 = 𝑃𝑀𝑇 [ ] problem
𝑖 Rf = risk free rate Risk Premium: excess after comparing returns to risk-
4. Net Present Value Rm = expected free asset (cash)
Perpetuities return market Systematic Risk: affects large number of assets being
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
PV = PMT/i − 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 + + B = beta of security attributed to unavoidable market factors
PMT(1 − (1 + i)−n)/i simplified (1 + %) (1 + %)2
Unsystematic Risk: affects single asset and can be
5. Internal Rate of Return “The current return eliminated by diversification
IRR is the rate of return that gives a 0 NPV on the market is 15% Covariance: degree of association between two
Debt Accept projects with a IRR > discount rate and the market risk premium is 6%” Correlation: standardises from -1 and +1 moving
Valuing short-term debt (bills) Reject projects with IRR < required return Rm=15%  Rm-Rf=6%  Rf=9% together is 1
PV = FV/(1 + rt) Capital Gains Yield: rise in price of a security (stock)
r = interest rate (market rate, or YTM) Profitability Index Expected Return: (𝑟𝑝 ) = ∑ 𝑊𝑖 × 𝐸(𝑅𝑖 ) IRR: estimate expected return given cash flow
t = time to mature PI = (NPV + Initial Cost)/Initial Cost Risk: Bp = ∑ 𝑊𝑖 × B

Valuing long term debt (bonds)

Accept if PI > 1
Capital Gains =
𝐸𝑛𝑑−𝑆𝑡𝑎𝑟𝑡 MC
Reject if PI < 1 𝑆𝑡𝑎𝑟𝑡
1−(1+𝑖)−𝑛 −𝑛
AAR measures profitability over cash flows
PV = PMT [ ] + FV(1 + 𝑖) Gov Bond = Rf Required return and SP have an inverse relationship
𝑖
Net After-tax Cash flow
RR is based on the dividend yield + capital gains yield
Discount: Price < FV Pre-tax CF (1 – 0.3) + Depreciation x 0.3 # 𝑆ℎ𝑎𝑟𝑒𝑠 𝑥 𝑃𝑟𝑖𝑐𝑒
Expected Portfolio Weight NPV = 0 when the discount rate used is the IR
Par: Price = FV 𝑆𝑢𝑚 𝑜𝑓 # 𝑠ℎ𝑎𝑟𝑒𝑠 𝑥 𝑃𝑟𝑖𝑐𝑒
Premium: Price > FV Tax on sale of an Asset
Acceptor (L) and Borrower (B) (WDV – SV) x 0.3 Market Risk Premium:
SV > BV = Profit or SV < BV = Loss 1. B = 1 so use that to find E(r)
Book Value (WDV) = Initial Cost +/- Acc Dep 2. E(r) - Yield
CF: CF-START + CF-LIFE (PV Annuity) + CF-END (PV)
Equity Effect of ventures = (# shares x $) + profit + profit
Share Price (no growth) OP Cost = - X Amount and + Avoided Tax Effect Weighted Average Cost of Capital
P=D/r Total Market Value of the firm: V = D + E + P
Share Price (constant Growth) NPV
P0 = D1 / (r – g) or P0 =
D0(1 + g)
(𝑟−𝑔) Profile
𝐷 𝐸
WACC = 𝑅𝑑 (1 − 𝑡𝑐 ) ( ) + 𝑅𝑒 ( ) + 𝑅𝑝 ( )
𝑉 𝑉 𝑉
𝑃
Rd= YTM
𝐷1
r= +𝑔 𝑅𝑑 = market return on debt finance
𝑃0
Doesn’t consider risk and needs dividends 𝑅𝑒 = market return on equity
Rights Issue 𝑅𝑝 = market return on preference shares Re = 3 ways
𝑁(𝑀−𝑆) 𝐷 = market value of debt 1. Constant dividend: 𝑅𝑒 = Div/𝑃0
Value of a Right: R =
𝑁+1
𝑅
𝐸 = market value of ordinary shares (no. issued × 2. Dividend growth: 𝑅𝑒 = (𝐷𝑖𝑣1/𝑃0 ) + g
Ex-Rights Price: Px = M - or Px = S + R current market $) 3. Risk: Re = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓)
𝑁
M=current share price 𝑃 = market value of preference shares
Rp = D / Po
 Start Over the life End
WAAC Example Purchase of Sales Sale of plant
Dividend Growth Example
Book value of Long-Term Debt ($4m), Preference G=0.20 for next 2 years then 0.045 after
plant 665,000 200,000
Shares ($1m), Ordinary Shares ($2m) R= 0.13
-1,500,000 Less costs P/L on sale
D0= 0.50
Inventory 350,000 90,000
The long term debt is perpetual and carries a fixed rate
-350,000 Tax saving Recovery of
of 8.5% pa. It is advised that the current replacement
30,000 inventory
cost for this type of debt is 7.25% pa
350,000
Market value = 4m × 8.5%/7.25% =4689655
Total - Total 345,000 Total
Current market require rate of return = 7.5%
1,850,000 1 − (1.08)−10 640,000
[ ]
0.08 (1.08)−10
The company has 1,000 ordinary shares on issue and
each share pays a constant dividend of 0.40 per year
(likely to stay this way indefinitely). The current market Capital Budgeting Costs
price of a share in $4.00 Standard Deviation Example Sale of old machine Inflow; Start
MV = 1m × $4 (market price) = $4000000 Example: the yearly share prices are 2006, $10; 2007, BV of old machine No
Current market require rate of return = 0.4/4 = 10% $16; 2008, $12; 2009, $18 Purchase price of new Outflow; Start
Average yearly return for 2007 = (16 – 10)/10 = 60% Installation cost Outflow; Start
Preference shares have a $10 FV, paying an annual Avg yearly return for 2008 = -25% Selling expense for new Outflow; Over
dividend of 5%. The last sale of one of the company’s Avg yearly return for 2009 = 50% Life
preference shares on the market was at a price of Average or 𝑅̅ = (60 + -25 + 50)/3 = 28.33% Market research No
$6.25 S= Sale of new product Inflow; Over Life
MV = 1m/10 × 6.25 = 625000 √(60 − 28.33)2 + (−25 − 28.33)2 + (50 − 28.33)2/ Depreciation expense No
Current market RRR = $10 × 5%/6.25 = 8% 3−1 Expense that remains No
Increase tax saving Inflow; Over Life
Weight × Required Rate of Return or Market Rate =
Reduced sales in existing Outflow; Over
Totals for WACC Expected Return Example products Life
Increase in sale from new Inflow; Over Life
Capital Budgeting Example Decrease cash operating cost Inflow; Over Life
New machine costs $1,500,000 and will be sold in 10
years for an estimated salvage value of $200,000. The Debt Finance:
tax allowable depreciation life is 15 years at 30% + -
- Access to capital - Dilutes control
Cash flow at start -1,500,000 markets - Demand for info
Depreciation expense = 1,500,000 ÷ 15 = 100,000 - Raise the firm’s - Increased Costs
Tax savings = 100,000 x 30% = $30,000 per year
Cash flow in year 10 (when sold) of -200,000
Equation of SML profile
Share Amount Invested E(r) Beta - Align managers’
Book value in year 10 is 1,500,000 – (10 x 100,000) = X
Y
35%
65%
7%
13%
0.5%
1.5 goal with
500,000 shareholders’
100,000 is accumulated depreciation - Market valuation
Tax affect = (500,000 – 200, 000) x 30% = 90, 000
500,000 – 200, 000 is BV – SV Equity Finance:
Annual cash operating costs are $500,000 and + -
expected cash sales are $950,000
- Quicker - Dilute control
After-tax cash inflow = 500,000 (1 – 0.3)
- Certainty in - Lower share
= 350,000
pricing price
After-tax cash outflow = 950,000 (1 –
Future Variability Example - Friendly hands - Max 15%
0.3) = 665,000
- Lower cost
Fixed cash costs will remain at $350,000 pa. Investment has 50% chance of 12%, 30% chance of
$350,000 of stock is required at the beginning of the 15%, 20% chance of -5%
year and this cost is reflected in operating cost E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5% Beta
Cash flow at start of -350,000 Standard deviation = Example
Cash flow at tend of +350,000 √[0.5(12 − 9.5)2 + 0.3(15 − 9.5)2 + 0.2(−5 − 9.5)2
The required rate of return is 8% = 7.36%
Discount rate for NPV