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Finance 310

Chapter 1: Overview
3 areas of finance
money and capital markets; working for banks, insurance companies, mutual funds, and
investment banking firms, real estate
lending officer
credit analysts
asset liability manager
product manager, i.e. depository or credit products, i.e. residential mortgages, CDs, IRAs
investments; brokerage firms: selling stocks and bonds
or managing investment portfolios for investment banks, insurance firms, commercial banks
financial analyst: follow particular companies; do investment analyst reports
financial management or business finance; businesses, educational institutions, nonprofits,
government
financial analyst supporting particular products
working in Treasurers office; managing cash flows or investments
page 13: diagram for finance functions in a company
Even if you arent a finance major, finance will be helpful to you in any area of business
Marketing: developing sales forecasts, determining product performance
Accounting; often have to evaluate the balance sheets and income statements of companies
MIS; many of the software packages relate to either financial management or financial products
Entrepreneurship: need to develop a business plan; have to know how to do financial statements
and ask for funding from various sources
2 key trends in the area of finance:
globalization; financial markets, sales, off-shore production, etc.
technology; functions, products, and services
Responsibilities in the area of finance:
Forecasting and planning; for products, markets, line of business, divisions
Coordination and control; budgets, evaluation of performance
Investment and financing decisions; building new plant, using debt vs. equity
Risk management; hedging, use of derivatives, and futures
Dealing with financial markets; banks, investment banks, investors

Forms of business organization:


Sole proprietorship: 1person
Easy, quick, and cheap for form
Combine income into personal income and do taxes combined with personal taxes; no separate
taxation
Weaknesses:
Limited to age of owner
Transferability
Unlimited liability
Difficulty raising capital
Partnership:
2 or more people
same advantages and disadvantages as sole prop.
Slightly better access to capital because there are more people
Limited partnership: have general partners and limited partners
Limited partners are liable for only the amount of their investment; but they have no control.
That rests with the general partners.
Limited Liability Partnership: LLP: sometimes called LLC; limited liability corporations
Permitted in many states
All partners have limited liability; have same advantage as a corporation
Taxed at individual rate
Offers a lot of flexibility
Corporation:
Has a separate identity from the individual
Can transfer ownership
Limited liability
Greater access to capital
Disadvantages:
More costly and time-consuming to set up
Disclosure
Double taxation; taxed at corporate level and also at individual level when you get dividends
Control; now there are other shareholders who are also owners
S-corporation: form of incorporation for small firms
Have limited liability and taxed and personal rate

Used to be very popular but now many firms are converting to LLC which offers greater
flexibility
Goals of a corporation
Maximize shareholder wealth
Who are the shareholders? Stock holders; owners of the firm
Firms sometimes also have social goals, i.e. Ben and Jerrys; the environment or social causes
Other goals: customer service; LLBean
Good treatment of employees; Aetna
Best products for the best price; WalMart
All of these contribute to wealth maximization because they attract the best employees, increase
employee productivity, and attract customers which means more sales
Business Ethics: companys attitude toward customers, employees, stockholders, the community
at large
Must treat these parties in a fair and ethical manner
Many firms have strong codes for ethical behavior
Use employee training programs to teach ethical values of the company, i.e. sexual harassment,
respect for diversity, compliance issues, etc.
Many industries have serious sanctions for lapses in ethical behavior, i.e. the securities industry
and insider trading
Agency Relationships
We have said that stockholders are the owners of the firm. Realistically they cannot manage day
to day operations themselves so they appoint managers. Senior managers report to a Board of
Directors who are elected by the stockholders.
Where do stockholders get their returns?
Dividends and capital gains
Dividends come directly from firm earnings; part are paid out as dividends and part are retained
in company to fund further growth.
Want to maximize earnings because then there will be higher dividends
Capital gains refers to the difference between what you paid for a share of stock and what you
sell it for. Often based on the growth prospects of the firm which are related to the amount of
retained earnings you plow back in.
The actions of managers affect earnings and therefore stock price.
Other things that affect earnings?
State of the economy
Inflation and interest rates
Taxes

Government regulation
Optimism or pessimism about the stock market
An agency problem occurs when a managers does not own 100% of the stock.
How do we know that he will act in the best interests of shareholders?
He may want higher salary or perks
He may want a bigger rather than a more profitable firm
He may try to discourage mergers because he might lose his job
How to protect against agency conflict?
An active and involved Board of Directors
Managerial compensations: part of compensation can be based on company performance, i.e.
performance shares. Senior managers get shares of company stock based on performance.
Executive stock options: allows senior managers to purchase stock at some future time at a
given price.
Pressure from stockholders at annual meetings or agitation of institutional investors
Threat of firing; if performance does not meet certain standards
Threat of takeovers; if firm is not doing well stock price will fall making the company a cheaper
takeover target
Stockholders vs. Creditors:
There can also be conflicts here
Creditors have a claim on part of the firms earnings for payment of interest and principal on
loans
They have a claim on the firms assets in the event of bankruptcy
Stockholders (through managers) might try to increase their own returns by taking on very risky
projects. If they are successful they increase earnings but if they are not earnings may not be
sufficient to pay creditors.
Creditors sometimes impose covenants to prevent managers from taking too much risk,
covenants can relate to liquidity, leverage, or payment of dividends
Chapter 2
Financial Statements
Major financial statements: balance sheet, income statement, statement of cash flows

Financial statements are used to communicate information about assets; cannot necessarily watch
you assets all the time.
To whom:
Owners; shareholders
Debtors; banks
Managers
Taxing authorities; the government
Publicly held companies are required to report to their owners (shareholders) in a variety of
ways. Must publish an annual report; includes the major financial statements
Balance sheet: summarizes assets and claims against assets
Assets on left side; claims on right
Represents a snapshot in time
Listed in order of liquidity; most liquid first
See page 31.
Review the balance sheet accounts
Income Statement: summarizes performance over time
Includes revenues and expenses
Bottom line is called net income
See page 34
Review the income statement accounts
Statement of Retained Earnings: page 35
Earnings from the income statement after dividends flow into the retained income account on the
balance sheet
Balance sheets and income statements can be annual, quarterly, or monthly
Net income on the income statement is not the same as cash flow; some of the accounts are noncash charges, i.e. depreciation
To get cash flow:
take net income, subtract noncash revenues, add noncash charges

the easy way to get to net cash flow is to take net income plus depreciation
net cash flow is the actual cash produced by the business in a year
this gives you the cash flow available to stockholders
To get operating cash flow, start with EBIT vs net income. Take EBIT(1-T) + Dep (T)
This gives you the cash flow available to stockholders and bondholders; interest has not yet been
paid.
Net cash flow=operating cash flow ((Int)(1-T))
Statement of cash flows:
Because a company has high cash flow does not necessarily mean that it has high cash on the
balance sheet
Cash is used for a variety of purposes
To increase inventories
To reduce debt
To buy back stock
3 types of cash flows
operating
investing
financing
operating
net income
depreciation
changes in working capital accounts
investing
purchase or sale of fixed assets, i.e. land
financing
issuing or paying off debt or equity
paying dividends
see page 40.
Chapter 14: Financial Forecasting
Why do you forecast?
To anticipate future resource requirements
Employees
Plant and equipment

Inventories
Cash
Forecasted financial statements are called performas
Start with sales forecast
Look at historic trend
Look at analysts estimates
Look at events in the environment
Look at new initiatives; new markets, products
After sales go on to the income statement.
Use percentage of sales method
See page 538
Taxes and dividends are a fixed percentage
Keep interest constant on first pass
Go to balance sheet
See page 539
Assets will increase in proportion with sales.
Some liabilities will increase spontaneously
Accounts payable
Accruals
Notes payable, long term debt, common stock, and retained earnings do not increase
spontaneously
To get retained earnings, add current RE to new RE from the income statement
Add up the balance sheet
It will not balance
Need to close the gap with either notes payable, long term debt, or common stock
If you use debt, need to raise interest expense on the income statement
Recalculate income statement and retained earnings.
Recalculate balance sheet.
Scenario analysis: change an entire forecast
Best case, worst case, most likely case
Sensitivity analysis; change one item

AFN formula: can calculate external funds needed without forecasting the entire balance sheet
and income statement
Relationship between sales growth and financial requirements
Higher sales mean higher requirements
Higher dividends mean higher req.
Higher profit margin means lower req.
Higher capital intensity means higher req.
Chapter 15 Managing Current Assets
Working capital policy involves 2 basic questions
What level of CA to carry
How to finance
Working capital: current assets
Net working capital: current assets-current liabilities
Measure net working capital with current ratio and quick ratio
Working capital policy:
Target levels of Ca
How to finance ca
3 different current asset investment strategies:
see page 564
relaxed
moderate
restricted
explain each and when each is appropriate
components of working capital
cash
marketable securities
receivables
inventories
cash-hold for 2 major purposes
transactions
compensating balances
also for precaution and speculation

cash budget-see page 571


shows when cash comes in and when it goes out
marketable securities
short term, highly liquid investments
can be turned into cash quickly
Inventory
Include:
Supplies
Raw materials
Work in process
Finished goods
Want to have enough inventories to continue operations; do not want to lose sales
Want to minimize inventories because it is costly to hold them
Types of inventory costs: p. 582
Carrying costs
Ordering costs
Costs of running out of inventories
Types of inventory control systems
Red-line
Two-bin
Computerized systems; bar code
Just in time: keep minimal inventories and order as needed; must be able to get shipments
quickly
Receivables: when you sell to a customer on credit you create a receivable
This is cash that has not come in yet; represents a cost and a risk
DSO tells you on average how long it is paying customers to pay
Aging schedule; page 588
Shows ages of different classes of receivables
Need to look at what percentage is very overdue
Credit policy-4 elements
Credit period
Credit standards
Collection policy
Discounts
Collections can be costly; need to weigh cost against the additional cash you will receive

Discounts are usually given to encourage customers to pay early; these also have a cost but they
speed up the receipt of cash
Chapter 16 Financing Current Assets
2 types of current assets
permanent; never drop below this level
temporary; to satisfy seasonal needs
strategies for financing:
maturity matching: match life of asset with life of liability
aggressive: finance all of temp and some of permanent with current liabilities
conservative: finance all of permanent and some of temp with long term debt or equity; finance
only peaks with current liabilities
see page 608
Advantages of using short term debt
Cheap
Flexible
Easier/faster to get loans
Disadvantage:
Availability
Refinancing risk; rising interest costs
Sources of short term financing
Accruals; money you owe that you have not paid yet
Accounts payable; trade credit. Money you owe to your suppliers
Both of these are spontaneous sources of financing
If you do not take discounts on accounts payable, it is very costly. See formula page 613
Effects of trade credit on financial statements; see page 615
Bank loans: have to pay interest, fees, compensating balances
May need to put up collateral; receivables or inventory; this is called a secured loan
Line of credit: you are approved for an amount; can borrow up to that level
Choosing a bank: banks vary by size, willingness to assume risk, geographic territory and
industry specialization
May also provide other types of services and counseling

Commercial paper; short term unsecured debt issued by larger, very strong companies. This is
usually a cheaper source of short term debt than bank loans. Only available to a small number of
companies however.
Homework:

15-7 (595), 15-8 (595) ST-2 (630) 16-6 (631)

Chapter 4: The Financial Environment, Markets, Institutions, and Interest Rates


Often hear the term financial markets; this is the market for financial assets vs other types of
physical assets.
Different components:
Money market
Capital market
Mortgage market
Primary: where stock is issued for the first time
Secondary market: market in which previously issued stock is traded
Types of financial instruments; see page 110-111
Vary by maturity
Risk
Interest rate
Financial intermediaries: channel capital from people who want to invest to people who want to
borrow
Types:
Commercial banks
Investment banks
Insurance companies
Finance companies
Mortgage companies
Credit unions
Pension funds
The stock market: this is where stocks are traded
Organized exchanges:
NYSE
American Stock exchange
Over the counter market: OTC
This is not a physical location but rather an electronic network
Brokers and dealers who participate in the OTC are members of National Association of
Securities Dealers. Their network is know as NASDAQ; NASD Automated Quotation System

The cost of money:


When an interest rate is quoted, there are various components
In general, the greater the risk, the higher the interest rate
K*: risk free rate of interest with no inflation
KRF: risk free rate adjusted for inflation
IP: inflation premium; expected inflation over the life of the security
DRP: default risk premium; what is the likelihood they will not pay
LP: liquidity premium; how easy is it to convert into cash
MRP: maturity risk premium; how long is it until maturity
K=KRF+DRP+LP+MRP
Inflation premium: usually use the short term or long term government bond rate as a proxy;
incorporates short and long term inflation expectations
DRP: bonds are rated; lower the rating the greater the risk of default
Term structure of interest rate: shows the relationship between long and short term rates of
interest. Usually is upward sloping; long term rates are higher than short term.
This is called a normal yield curve
Downward sloping yield curve is called an inverted yield curve; usually preceeds a recession
See page 132
2 theories behind the yield curve:
expectations theory: if people expect interest rates to go up in the future, yield curve will be
upward sloping
liquidity preference: people prefer greater to lesser liquidity; therefore they are willing to accept
lower rates on short term instruments
Other factors that influence interest rates:
Federal Reserve Policy: raise or lower discount rate
Increase or decrease the money supply
Federal deficits: government is competing for money with private sector; drives up interest rates
Trade deficit; have to borrow to finance the deficit; this drives up interest rates
How do interest rates affect companies?

If rates are low they will be willing to borrow


High rates mean high interest expense
High rates mean they are reluctant to grow, invest, borrow
Homework: handout; 4-6, 4-11 (143), 4-1 (144) 4-12 (145)
Chapter 5: Risk and Rates of Return
All investments are expected to produce cash flows
These vary in riskiness
Some are very sure; others less so
In general investors are risk averse; that means they prefer less to more risky investments. If you
increase the risk, you have to increase the interest rate (reward) that you pay people. This is the
principle behind the Security Market Line.
Every stock has an expected rate of return
The expected return is the sum of the probabilities of possible returns X those returns
See page 152, 153
This may vary from the actual rates of return
Extent of the variation is a reflection of the riskiness of the stock
The greater the variation from the expected return, the greater the risk
See page 155, 156
Variation is measured by standard deviation from the expected return
See page 161; some investments are much riskier than others; higher standard deviations
Risk premium; this is the amount beyond the risk free rate that you have to pay people to get
them to invest in your particular security.
A portfolio is a collection of stocks
The return on the portfolio is the weighted average returns of the stocks included in the
portfolio; see page 164.
Risk of a portfolio is less than the risk of an individual stocks
Different stocks in the portfolio have different returns; when some go up others will go down.
This is called the benefit of diversification. Stocks do not move in the same directions by the
same amount.
Correlation; the extent to which 2 stocks move together
If perfectly you have a correlation of 1.0
If in the reverse have a correlation of 1.0
You want stocks that are not perfectly correlated in your portfolio
2 types of risk in the market

diversifiable: unsystematic. Can make this go away with a diversified portfolio. Avoids
difficulties of individual companies
market risk: systematic. Cannot diversify this away. Some events cause the entire market to
move. The extent to which your stocks moves with the market is its systematic risk.
Measured by beta. The degree to which your stock moves up or down with the market on
average. Beta of 1.0, beta of 0.5, beta of 2.0.
See page 174.
The greater the riskiness of the stock, the higher the return that will be demanded.
In finance, when we talk about risk, we are talking about volatility or variability around the
expected return.
Chapter 6 Time Value of money
Money is worth more in the future than it is today
Why?
You get interest
Compounding; you get interest on interest
$5 invested at 10%
for one year it is 5 (1.10)
2 years 5(1.10) (1.10) etc. =(1.10)2
this is called compounding
this gets cumbersome
can also use future value interest factors
see Table A3
find intersection of interest rate and number of years
this is the FVIF
FV=PV(FVIFk,n)
If I invest a certain amount today, what will it grow to in n years at k rate of interest?
$35000, 10 years, 12%
You know the present value, interest rate, and number of years
Show them how to do it on calculator: p. 207
Present value is the reverse: this is called discounting
How much do you have to invest today to grow to a certain amount in the future?

I know how much I need for the future, how much do I have to put away today?
i.e. I know that in 10 years I want to take a trip that will cost $10,000. At a 7% rate, what do I
have to invest today for it to grow to $10,000?
PV=FV(PVIFk,n)
You know the future value, interest rate and number of years
Show them how to do it on calculator
Punch in n, I, and FV, then hit PV
Future value of an annuity: this is a stream of equal payments vs. just one payment
Example retirement savings; you put $2000 in a ira every year for 25 years at 8%
FVA=PMT (FVIFAk,n)
Know payment, number of years, and interest rate
We have been dealing with single payments, either compounded or discounted.
What if we are dealing with a series of payments, i.e. $2,000 every year in an IRA
Present value of an annuity: you want to know what a stream of payments will equal in present
value terms
You win the lottery which will give you $100K per year for 20 years. At a 15% discount rate
what is the stream of cash flows worth to you today?
PVA=PMT(PVIFAk,n)
Know payment, interest rate, and number of years
With an annuity, you usually assume that the payments are made at the end of the year. For
many types of loans, however, you have to pay at the beginning of the period, i.e. the beginning
of the month.
This is called an annuity due. Calculate it for a regular annuity and then add one period;
multiply by 1+i
Future value of an annuity
You deposit $2,000 in an IRA every year at 8% for 25 years. How much will you have when you
retire?
You want to know how much you will have at some point the the future. What will be the future
value.

FVA=PMT(FVIFAk,n)
Know the payment, number of years and interest rate
Semi-annual compounding
We have been assuming that compounding occurs once a year. This usually is not the case. With
bonds, for example, they pay interest twice a year or semi-annually. If it is semi-annual
compounding, you need to double the periods (n).
If it compounds quarterly, multiply the periods by four, i.e. 4 years at quarterly compounding
equals 16 periods.
An annuity assumes equal cash flows each year. What if the cash flows are not equal?
Have to discount them individually.
Take each cash flow times the PVIF for that interest rate and year. Add them up and you have
the present value of the cash flows.
Problems, 6-1, 6-2, 6-3, 6-4, 6-5, (235)
6-32, 6-33, 6-35, 6-36 (238)
6-37a (238)
Chapter 8: Stocks and Their Valuation
Stockholders are the owners of the company; net income belongs to them either in the form of
dividends or retained earnings
Each stockholder can vote on important matters; have control
Receive copy of Annual Report and are invited to Annual Meeting
Elect a Board of Directors to represent them and oversee management
Can remove management if they feel they are not effective
There can be different classes of stock, i.e. Class A or Class B; have different rights and
privileges, i.e. voting, dividends, etc.
For privately held companies, the stock is closely held; owned by only a small group of
individuals
For publicly held companies, the stock is much more widely held
When a company issues stock to outsiders for the first time it is called going public
New stock is issued in the primary market
Used or outstanding stock is traded in the secondary market

See table 8-1: page 302; most new stock is issued between $8-12; want it to be affordable
enough so people can buy it. When more people want the stock than there is stock available it is
said to be oversubscribed. Usually institutional investors get the first shot rather than individual
buyers, i.e. pension funds, mutual funds.
Stockholders hope to get dividends and capital gains
They are not guaranteed anything unlike bondholders.
Dividends often depend on earnings.
Each stock represents 2 types of cash flows:
Dividend cash flow
Capital gains cash flow
Total return = dividend yield and capital gains yield
D1/P0 + P1-P0/P0
Ways to value a stock:
Zero growth model: assumes that dividends will always be the same:
P0=D/ks
Ks= the required rate of return; considers risk and returns on other types of investments
See page 307 for example
Most investors hope that a company will show some growth in earnings and dividends, however.
Constant growth model: assumes that dividends and capital gains will growth at a constant
growth rate, g
P0=D1/ks-g
Or : P0=D0(1+g)/ks-g
If you already know the price and anticipated growth rate, you can solve for required rate of
return, ks
Ks=D1/P0 +g
Non-constant growth
Dividends grow by a different amount each year

Discount each of the dividends separately (multiply div by PVIF)


Take final dividend: D/ks-g; then discount this; multiply by PVIF
The value is the sum of the PVs of the dividends and the PV of the final value.
Efficient Markets Hypothesis: holds that stocks are always in equilibrium
Required rate of return equal expected rate of return
EMH says that it is impossible to constantly beat the market; market adjusts to new information
rapidly
If markets are efficient, stock prices will rapidly reflect all available information
Different levels of market efficiency:
Weak Form: all information contained in past price movements is fully reflected in current
market prices
Semi-strong Form: current market prices reflect all publicly available information
Strong Form Efficiency: current market prices reflect all pertinent information, whether publicly
available or privately held. Under this set of assumptions, even corporate insiders could not earn
abnormal returns.
Research indicates that the market is efficient in the weak form and semi-strong form; not strong
form; insiders can still access private information and earn abnormal returns.
Preferred Stock: this is a hybrid
Has characteristics of both bonds and stocks
Pays a dividend but the dividend is fixed
Usually do not have voting privileges
If dividends are suspended; have to pay preferred dividends in arrears before you can start
paying common dividends again
Get paid off before common stockholders in the event of liquidation
V=D/k
K=D/V
Problems: ST-3, 8-1, 8-2, 8-3 on page 332
8-5, 8-6, 8-7 on page 333
Chapter 9: Cost of Capital

Like every other resource used for a company, capital has a cost
What do I mean by capital?
Debt: kd
Equity: ks
Preferred stock: kp
These are called capital components; each has a cost
Debt: debt has a tax advantage over equity from a cost perspective because interest payments are
tax deductible; dividends are not
Therefore you are interested in the aftertax cost of debt
Kd (1-t)
Preferred Stock has characteristics of both debt and equity
It pays a dividend which is fixed; but the dividend can be suspended
Also, preferred dividends are not tax deductible
Cost of preferred: kp=d/p (remember this is the zero growth model)
Common Stock is more complicated.
On approach is the CAPM
Ks=krf + b(km-krf)
Need to estimate each of these components.
Usually the long term T-bond rate is used to Krf
Use the return on the S&P 500 for Km
B=beta. Measures the riskiness of the individual firm. Can get firm betas from various sources,
i.e. Value Line, Merrill Lynch
Alternatively you can use the industry beta
None of these measures is exact, however.
A second approach is the Bond Yield plus Risk Premium Approach
Take the yield on the companys bonds and bump it up by 3-5%.
Research has indicated that stocks have this kind of premium over a companys debt
Obviously this is also a very subjective approach.
The third approach is called the DCF method.
When we valued stocks:

Po= d1/ks-g
Can also solve for ks
Ks=D1/Po + g
It is usually easy to figure out D1 and Po but g can be a problem
Can use historical performance if growth is relatively stable.
Alternatively, use analysts estimates for growth
When we are considering the cost of capital, we also have to consider flotation costs. These are
the fees charged by investment bankers.
For equity, you can add these fees to the amount raised to calculate Ks. See page 348.
Also can adjust the DCF method to include flotation costs:
Ks=D1/Po(1-F) + g
The cost of raising new debt and equity can be substantial. See page 347.
For this reason, many companies choose to retain earnings and use them as a source of financing.
Retained earnings are not free, however. Investors still expect to get Ks on them. This is their
opportunity cost. If the company is not going to earn at least Ks, it is better off paying out net
income as dividends so shareholders can invest on their own.
Capital Structure is the mix of long term debt and equity. Look on the balance sheet. This is the
capital used to finance long term (fixed assets)
Capital Structure is the percentage of each, long term debt, preferred, equity.
Weighted Average Cost of Capital is a firms overall cost of capital which takes into
consideration how much of each capital component the firm uses as well as their costs.
See formula. Page 350.
Each new dollar raised represented those percentages of debt, preferred, and equity. It is also
called the Marginal Cost of Capital.
What factors affect cost of capital?
Cant control
Interest rates
Tax rates

Can control
Mix
Dividend Policy
Types of projects you invest in; risky or safe
The cost of capital is also called the Hurdle rate; a project has to promise this return in order to
be funded. See page 354.
In a multi-divisional company, each division may have its own cost of capital because different
divisions may have different levels of risk.
Problems: page 367 9-1, 9-1, 9-3, 9-5, 9-9
Chapter 12: Capital Structure
Capital structure is the mix of long term debt and equity that you use to finance the company.
Target capital structure: this is the proportion of each that you aim for. Why? At the target
capital structure you minimize the WACC, maximize stock price, and maximize the value of the
firm.
Target capital structure depends on:
1. Business risk: volatility of earnings
2. Tax position: interest is tax deductible; some firms need tax shields more than others
3. Financial flexibility: how easily can you raise capital; do you have access to both debt and
equity
4. Managerial conservatism or aggressiveness. Debt maximizes EPS but also increases risk.
Stock means giving up control
2 types of risk affect a company:
Business Risk: Volatility of earnings. Differ by industry and within industries.
Effect of booms and recessions, new products, competition, labor strikes, fires, etc.
Airlines, nuclear power companies have high business risk
Grocery stores have low business risk.
Business risk relates to the extent to which your costs are variable versus fixed. This is called
operating leverage. A small change in sales will result in a large change in operating income.
Firms with high operating leverage have high business risk. How can you determine? Calculate
breakeven
Q=F/P-V
This tells you how many units you have to sell to cover your fixed costs. The higher the number,
the higher your operating leverage.

See page 454. Firms with the higher fixed costs has more variability of earnings. Returns can be
higher but also much lower. This means that the firm with the higher fixed costs is riskier.
Financial risk; also called financial leverage. This is the risk you add if you use debt. No debt,
no leverage. EBIT is the same but net income differs because you have to deduct interest
expense.
See page 457. Variability of ROE is greater for the leveraged firm. This adds to the firms risk.
The use of debt has the potential to increase returns to stockholders because you are spreading
net income over a smaller number of them. It also concentrates losses on this same number of
stockholders. They bear more risk because debt holders are guaranteed that they will be paid.
Determining the Optimal Capital Structure
This is the mix of debt and equity that maximizes the stock price
Debt places net income at risk because interest expense is deducted from EBIT. As you add
increasing amounts of debt the cost of debt increases because the firm is becoming more risky.
See page 461.
At the same time the cost of equity also increases because the firm is becoming more risky.
See page 462. Variability of EPS is greater for the firm with debt.
Leverage is good up to a point. Increases the return to stockholders.
At some point, however, the add risk of too much debt raises the price of both debt and equity
and eliminates this benefit. See page 465. Want the mix that maximizes stock price. This does
not occur at 100% debt.
The higher the debt level, the greater the difficulty in servicing debt. TIE declines and lenders
will not lend any more or will lend only at very high rates of interest. See page 470.
See page 468. At the optimal capital structure you minimize WACC and maximize stock price.
This does not necessarily occur at the maximum point for EPS.
Factors to consider relating to capital structure: See page 477-78.
Capital structures differ widely between industries and within industries; in general more
profitable firms use less debt. In addition, firms that are less capital-intensive use less debt. See
page 481.
Homework
Page 482 12-1, 12-2, 12-3, 12-4
Page 484 12-3, 12-55, 12-6
Chapter 10 Capital Budgeting

What is a capital project?


Replace a piece of equipment
Replace a piece of equipment with an upgraded version
Expand existing product or markets
Expand new products or markets
Safety/environmental projects
Steps:
Determine the cost of the project. This is the cash flow out.
Determine the cash flows in.
Discount the cash flows in and subtract them from the cash flow out. If the result is positive, you
should do the project. Means it has a positive net present value, NPV.
See page 377; projects s and l
How do you evaluate these cash flows?
Payback period. At what point do you recoup your initial investment? See formula p. 378.
Net Present Value Method: discount each cash flow at the cost of capital. Subtract total from
cash flow out. If the result is positive, you should do the project. Has a positive NPV.
Internal Rate of Return: this is the interest rate that makes the discounted cash flows in equal to
the cash flow out. The net present value is zero. Can do it on a financial calculator.
Decision Rules:
If the NPV is greater than 0, do the project. You are increasing the value of the firm.
If the IRR is greater than the cost of capital, do the project. You are earning at a higher rate than
you are spending.
Problems: page 400 10-1, 10-2, 10-6, 10-9 (NPV only), 10-15 (NPV only)
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