BS97318

Corporate Finance
Tutorial 2

MSc Finance and Accounting

Adrian Lam
y.lam16@imperial.ac.uk

Imperial College London

October 23, 2019

Logistics Decision Rule Cost of Equity Cost of Debt Market Value Pracitical Wrap Up

Logistics

Thank you for your feedback and comments

Updated office hour information on calendar
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Help and advice
Point to particular question
Class participation

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Plan for Today

1 Decision rules
2 Cost of equity
3 Cost of debt
4 Market value of debt and equity
5 Tips for practical exercise

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Formulae to Value Annuity

Ordinary annuity is a fixed sum of payments at the end of regular
intervals with a terminal date T
With a coupon (C ) that grows at rate (g ), required rate of return (r ),
and terminal date (T ), the present value (PV ) of an ordinary annuity
is given by the annuity formula

(1 + g )T
  
C
PV = 1−
r −g (1 + r )T

Perpetuity is a fixed sum of payment at the end of regular intervals

forever, i.e. no terminal date
Using similar notations from the above, the present value of a
perpetuity is given by the perpetuity formula:

C
PV =
r −g

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Valuing Future Cash Inflows: Graphical Illustration

Calculating present value

of future cash inflows
First cash inflow ($5)
starts one period ahead
Grow rate at 3%
Discount rate at 5%
Present value:
 
5
0.05 − 0.03
(1 + 0.03)4
 
× 1−
(1 + 0.05)4
= $18.51

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Tools to Evaluate Projects (I): the Net Present Value Rule

Net Present Value (NPV) Rule: Accept a project if it has a

positive net present value
NPV is the present value of net proceeds from undertaking a project
With coupon (C ), required rate of return (r ), period subscript (t) and
terminal date (T ), the NPV can be given by the NPV formula

T
X Ct
NPV =
(1 + r )t
t=0

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Tools to Evalue Projects (II): the Internal Rate of Return

Rule

Internal Rate of Return (IRR) Rule: Accept the project if the IRR
is high enough (e.g. higher than a hurdle rate)
IRR is the rate of return that forces the NPV to zero
IRR can be solved for by setting NPV = 0 in the NPV formula

T
X Ct
0=
(1 + r )t
t=0

Beware of multiple solutions stemming from alternating positive and

negative cash flows

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Cost of Equity

Equity financing
One way to finance a firm is to issue equity, transferring residual claims
(after wages, interests and taxes) to equityholder
At what rate of return will investors purchase equity?
One way to estimate the cost of equity is to use the capital asset
pricing model (CAPM)
The CAPM states that investors get compensated for time value of
money and non-diversifiable market risk

E (ri ) = rf + βi × (rM − rf )
|{z} |{z} | {z }
Risk-free rate Quantity of risk Equity risk premium,
i.e. price of risk

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Cost of Equity: In Theory and In Practice

What does it look like when we run a regression to estimate β

using CAPM?
With estimated intercept (âi ), estimated beta β̂ and residuals (eit )

rit = âi + β̂ × ERPt + eit

|{z} | {z } |{z}
Regression intercept, rM −rf = 0 in expectation
= αi +rf , by construction

The CAPM is “correct” if aˆi = rf (i.e. Jensen’s alpha, αi , which

measures portion of return in excess of compensation for market risk, is
zero)

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Beta (I): From Unleverd to Levered Betas

Why should we unlever/lever betas?
Firms with different capital structures have different betas
Unlevering betas help compare firms’ responsiveness to systemic risks
How to go from levered to unlevered beta and vice versa?
With value of levered firm VL , value of unlevered firm VU , tax rate τ ,
book value of equity E , book value of debt D, levered beta can be
expresseed as a function of unlevered beta and the debt-to-equity ratio
VL = VU + PVTax Shield
E + D = VU + τ D
E D VU τD
βE + βD = βU + βTS
E +D E +D |{z} VU + τ D VU + τ D |{z}
=0 =0
βL = βU (1 + (1 − τ )(D/E ))
|{z} | {z }
= βE Leverage effect

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Beta (I): An Illustrated Example

Merger and Acquisition

Company A and Company B decide to merge. Company A has $100M in
assets, with $50M in debt, $50M in equity and a beta of 1.0. Company B
has $100M in assets, with $70M in debt, $30M in equity and a beta of 2.
The corporate tax rate t is 40%. What is the beta for the merged entity
Company M?

A merger results in a new company. Since Company A and Company

B have different levels of debt, we have to:
1 Calculate unlevered betas for each company
2 Calculate size-weighted unlevered beta for merged entity Company M
3 Calculate capital structure for Company M
4 Lever up the unlevered beta for Company M to reflect impact of
capital strucutre

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Beta (I): An Illustrated Example

Compute the unlevered betas for Company A (βAU ) and Company B

(βBU )
With debt-to-equity ratio (D/E ), unlevered/levered superscripts (U)
and (L) and company subscripts (A), (B) and (M), we have

βAL 1
βAU = = 50
= 0.625
1 + (1 − t)(D/E )A 1 + (1 − 0.4) × 50
βBL 1
βBU = = 70
= 0.833
1 + (1 − t)(D/E )B 1 + (1 − 0.4) × 30

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Beta (I): An Illustrated Example

Calculating βM by value-weighting the unlevered betas

U FVA FVB
βM = × βAU + × βBU
FVA + FVB FVA + FVB
100 100
= × 0.625 + × 0.833
200 200
= 0.729

Computing the new capital structure (i.e. debt-to-equity ratio) for

company M
DM DA + DB 120
= =
EM EA + EB 80
3
=
2

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Beta (I): An Illustrated Example

U to the current debt-to-equity ratio

Levering up the βM

L U DM
βM =βM × (1 + (1 − t) × )
EM
3
= 0.729 × (1 + (1 − 0.4) × )
2
= 1.3854

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Beta (II): Pure Play Beta

What implications does holding cash have on firm risk?

With enterprise value (EV ), market value of operating assets (OA)
and market value of non-operating assets (C ),

EV = OA
= FV − C

Since a firm’s beta is the value-weighted sum of its components,

we can re-express the value equation in betas:

FV = OA + C
FV EV C
× βFirm = × βOA + × βC
FV FV FV

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Beta (II): Pure Play Beta

Since cash does not respond to market risk, βC = 0, we can simply

EV C
βFirm = × βOA + × βC
FV |FV {z }
=0 since βC equals 0
EV
= × βOA
FV
Since we know that EV = FV − C , we can plug this in:

FV − C
βFirm = × βOA
 FV 
C
= 1− × βOA
FV

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Debt-to-Equity Ratio and Firm Value

An Example
Imoaix, a not-cellphone company, is considering expanding its operations
into the (insert another type of business here) business. The beta for the
company at the end of 2016 was 1.2 with a debt-to-equity ratio of 1. The
(other type of business) is expected to be 25% of the overall firm value in
2016 and average beta of comparable firms is 1.5. The average debt to
equity ratio is 50% and the marginal corporate tax rate is 40%. Estimate
the beta for the company in 2016 assuming that it finances the (other
type of business) with a debt to equity ratio of 50%.

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Debt-to-Equity Ratio and Firm Value

Unlike the previous Company A/B/M example, you are not provided
with firm value or debt level or equity level
But we can still arrive at the new debt-to-equity ratio with the
information provided
DNot Cellphone
Using ENot Cellphone
= 1.0 and D
EOther = 0.5, can we write down the
Other

proportion of total debt relative to firm value?

Remember, firm value can be written as

FV = E + D

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Cost of Debt

Debt financing
The second way to finance a firm is to issue debt, i.e. a claim on
regular, fixed cash flows, which is more senior than equity
At what rate of return will investors purchase debt?
One way to estimate the cost of debt is to use a risk-based
estimatation method
If default risk is the only concern, with cost of debt rID , risk-free rate rf
and default spread si , we may write the cost of debt as

riD = rf + si

May use yield on one-year treasury securities as risk-free rate and credit
default swap (CDS) spread for default spread

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Book and Market Value

What is book value?

Accounting value of assets, liability and shareholder equity recorded at
cost (or applicable accounting principles/rules)
Historical perspective
What is market value?
Market/transaction/financial value of assets, liability and shareholder
equity according to trading activities
Forward-looking perspective
Book value versus market value of equity
Book value reflects historical proceeds the firm obtain by raising equity
(with annual adjustments for operational activities, e.g. retained
earnings, and financing activities, e.g. share repurchases)
Market value reflects reflects investors’ views on firm value

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Market Value of Equity and Debt

Market value of equity

With market value of equity for firm i as ViE , number of shares
outstanding as Ni and share price Pi ,

ViE = Pi × Ni

Market value of debt

Treating all debt as an annuity and apply to annuity formula to get its
present value
Interest expense as coupon
Book value as face value
Cost of debt as discount rate

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Market Value of Debt: An Example

Lam & Li Co., Ltd.

Lam & Li Co., Ltd., has the following payment schedule. It has a mix of
debt with varying maturities, but the projection of interest expenses and
principal repayment over the coming years are tabulated below. As a
medium-sized firm, it has a default spread of 5%. The current risk-free
rate is 5%. Calculate the market value of debt for Lam & Li Co., Ltd.

Year Interest Expense Principal Repayment

t+1 50 900
t+2 55 900
t+3 45 910
t+4 50 910

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Market Value of Debt: An Example

What is the cost of debt?
Cost of debt rD = rf + si = 5% + 5% = 10%
How can we simplify the calculations?
Assume we can treat the average cash flow (interest expense plus
principal repayment) as coupon and apply the annuity formula

Year Interest Expense Principal Repayment Cash Flow

t+1 50 900 950
t+2 55 900 955
t+3 45 910 955
t+4 50 910 960
Average 50 905 955

   
C 1 955 1
PV = × 1 − = × 1−
r (1 + r )4 10% 1.14
= $3027
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Practical: Expectations

What is the goal of the practical section?

Getting your hands dirty with data
Experimenting with the tools learned in class
What do I expect?
No right or wrong answers
Demonstrate you have mastered the tools (i.e. straight to the point
with “necessary and sufficient” information)
Clearly state the formulae you are using
Clearly state what your data sources are
Clearly state what assumptions you have made
Clearly state why you are using this number (e.g. why estimating beta
using 10 years instead of 25 years of data)

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Practical: Valuation (I/II)

Task
Compute the market value of the firm and enterprise value.

What is the formula for firm value?

FV = VE + VD

What do we need to calculate VE ?

Number of shares outstanding
Share price

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Practical: Valuation (II/II)

What do we need to calculate VD ?

What debt does Apple have?
Commercial paper
Corporate bonds
Operating leases (what about the value of the multiple year renewal
options?)
What is the required return on debt?
What is the default spread?
How to make the calculations simpler?
Can we write down the debt payments like the Lam & Li Co., Ltd.
example?
What assumptions do we need to use a single rD to discount all debt
issued by Apple?

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Practical: Valuation Example (I/II)

What is a commercial paper?

Unsecured short-term debt with maturities usually fewer than 270 days
Issued at a discount without coupon payment
How should we estimate the market value of commercial papers
issued by Apple?
Basic formula should look like
BVCP
MVCP =
1 + rCP

What do we know about Apple’s commercial paper?

Outstanding commercial paper: $11,977M (from Balance Sheet, p. 41)
Weighted-average annualised interest rate is 1.2% (from Note 6 on p.
58)
Cannot use this number directly!

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Practical: Valuation Example (II/II)

What do we not know about Apple’s commercial paper?
Detailed information on face values and maturities
How can we get around this?
Make assumptions! Assume that the weighted-average maturity is 90
days
∗
Applicable discount rate to use (rCP ) can be expressed as

∗ Stated T
rCP = rCP ×
360
What is the estimated market value of Apple’s commercial
paper?
11, 977
MVCP = 90
1 + 1.2% × 360
= $11, 407M

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Practical: Return on Invested Capital

What is the return on invested capital?

A profitability measure that gauges how effective the firm uses its
invested capital, i.e. total debt and equity
With return on invested capital (RoIC), book value of equity (BVE )
and of debt (BVD ), and cash (C ), return on invested capital can be
expressed as

(1 − τ ) × EBIT
RoIC =
BVE + BVD − C

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Coursework Submission

Deadline: 28th October, 2019, 16:00

Submission: Properly typed-up PDF via the Hub
Questions and Feedback?

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