Finance  
 
 
 
 
 
 
 
 
 
 
 
 
 
Notes  2013  
 
 
Compiled  by  Jörg  Stegemann  
  

Table  of  Contents  

1.  The  basic  idea,  scope  and  tools  of  finance ............................................................. 5  
Market  interest  rate ...............................................................................................................................................5  
Present  value ............................................................................................................................................................5  
The  financial  exchange  line.................................................................................................................................................. 6  
Investing .....................................................................................................................................................................6  
Investments  and  the  financial  exchange  line ............................................................................................................... 7  
Net  Present  Value  (NPV) .......................................................................................................................................8  
Internal  Rate  of  Return  (IRR) ..............................................................................................................................8  
Short  cuts  in  multiple-­period  analysis .............................................................................................................9  
Annuity ......................................................................................................................................................................................... 9  
Perpetuity.................................................................................................................................................................................... 9  
Bond  pricing ........................................................................................................................................................... 10  
Yield  to  maturity.....................................................................................................................................................................10  
Coupon  effect  on  the  yield  to  maturity .........................................................................................................................10  
Term  structure  of  interest  rates ......................................................................................................................................10  
Yield  curve.................................................................................................................................................................................10  
Spot  interest  rates..................................................................................................................................................................10  
Forward  interest  rates.........................................................................................................................................................11  
Duration .....................................................................................................................................................................................11  

2.  Fundamentals  of  company  investment  decisions .............................................12  

Corporate  equity................................................................................................................................................... 12  
The  market  value  of  common  shares ............................................................................................................................12  
Price/earnings  ratio..............................................................................................................................................................12  
Payout  ratio ..............................................................................................................................................................................13  
Investment  decisions .......................................................................................................................................... 13  
All-­‐equity  corporations .......................................................................................................................................................13  

3.  Earnings,  profit  and  cash  flow .................................................................................14  

Cash  flows................................................................................................................................................................ 14  
Operations  cash  flow ............................................................................................................................................................14  
Free  cash  flow..........................................................................................................................................................................14  

4.  Company  investment  decisions  using  the  weighted  average  cost  of  capital
.................................................................................................................................................15  
APV ............................................................................................................................................................................ 15  
Adjusted  Present  Value .......................................................................................................................................................15  
WACC......................................................................................................................................................................... 15  
Weighted  Average  Cost  of  Capital...................................................................................................................................15  
SML  (Security  Market  Line)............................................................................................................................... 16  

5.  Estimating  cash  flows  for  investment  projects ..................................................17  

Working  capital..................................................................................................................................................... 17  
Current  assets..........................................................................................................................................................................17  
Current  liabilities ...................................................................................................................................................................17  
Net  working  capital ...............................................................................................................................................................18  
Operating  cash  flow ............................................................................................................................................. 18  
 Taxes......................................................................................................................................................................... 18  
Fixed  assets............................................................................................................................................................. 18  
Free  Cash  Flow  (FCF) ........................................................................................................................................... 18  
Ungeared  free  cash  flow  (FCF*) ....................................................................................................................... 19  
Terms  and  abbreviations  used ........................................................................................................................ 19  
Cash  flows..................................................................................................................................................................................19  
Market  values...........................................................................................................................................................................19  
Discount  rates..........................................................................................................................................................................19  

6.  Applications  of  company  investment  analysis...................................................20  

Payback  Period...................................................................................................................................................... 20  
Discounted  payback  period ...............................................................................................................................................20  
Average  (accounting)  Return  On  Investment  (AROI)............................................................................... 20  
IRR  vs.  NPV.............................................................................................................................................................. 20  
Mutually  exclusive  investment  decisions ....................................................................................................................21  
Cost-­Benefit  Ratio................................................................................................................................................. 21  
Profitability  Index ................................................................................................................................................ 22  
Renewable  Investments ..................................................................................................................................... 22  
Inflation  and  company  investment  decisions ............................................................................................. 22  
Nominal  prices ........................................................................................................................................................................22  
Real  prices .................................................................................................................................................................................22  
Investment  interrelatedness ............................................................................................................................ 23  
Depreciation........................................................................................................................................................... 23  
Straight-­‐line  method.............................................................................................................................................................23  
Double  declining  balance  method...................................................................................................................................23  
Sum  of  digits  method............................................................................................................................................................23  
Economic  income  (EVA,  Economic  Value  Added) ...................................................................................... 24  
Strength  of  economic  profit  measures..........................................................................................................................24  
Problems  with  economic  profit  measures ..................................................................................................................24  

7.  Risk  and  company  investment  decisions.............................................................25  

Beta ........................................................................................................................................................................... 25  
Operational  gearing ..............................................................................................................................................................25  
Financial  gearing ....................................................................................................................................................................25  
Capital  Asset  Pricing  Model  (CAPM)............................................................................................................... 26  

8.  Company  dividend  policy ..........................................................................................27  

Dividends  and  market  frictions....................................................................................................................... 27  
Taxation  of  dividends...........................................................................................................................................................27  
Transaction  costs  of  dividend  payments .....................................................................................................................27  
Flotation  costs .........................................................................................................................................................................28  
Combined  frictions ................................................................................................................................................................28  
Other  considerations  in  dividend  policy ...................................................................................................... 28  
Dividends  and  signalling.....................................................................................................................................................28  
Dividends  and  share  repurchase.....................................................................................................................................29  

9.  Company  capital  structure........................................................................................30  

EBIT-­EPS .................................................................................................................................................................. 31  
Capital  structure  and  capital  cost  (without  taxes).................................................................................... 31  
Miller  &  Modigliani .............................................................................................................................................. 32  
Arbitrage ................................................................................................................................................................. 32  
Capital  structure  decisions  and  taxes............................................................................................................ 32  
Capital  structure  and  company  value  (with  taxes) .................................................................................................33  
Capital  structure  and  capital  cost  (with  taxes) .........................................................................................................33  
Capital  structure  and  agency  problems ........................................................................................................ 34  
 Default  and  agency  costs.................................................................................................................................... 34  
More  agency  considerations ............................................................................................................................. 35  

10.  Working  capital  management...............................................................................36  

Risk,  return  and  term.......................................................................................................................................... 36  
Assets...........................................................................................................................................................................................36  
Financings .................................................................................................................................................................................36  
Combining  risk  and  rates  of  return  on  assets  and  financings.............................................................................36  
Mix  of  long-­‐  and  short-­‐term  assets.................................................................................................................................37  
Management  of  cash  balances.......................................................................................................................... 37  
General  solution  to  the  cash  management  problem ...............................................................................................38  
Management  of  short-­term  financings.......................................................................................................... 38  
Financial  ratios...................................................................................................................................................... 38  
Current  ratio.............................................................................................................................................................................38  
Quick  ratio.................................................................................................................................................................................38  
Profit  margin ............................................................................................................................................................................39  
Return  on  total  assets...........................................................................................................................................................39  
Return  on  specific  assets ....................................................................................................................................................39  
Return  on  owner’s  equity ...................................................................................................................................................39  
Fixed  to  current  asset  ratio................................................................................................................................................39  
Debt  ratio...................................................................................................................................................................................39  
Times  interest  earned ..........................................................................................................................................................39  
Inventory  turnover................................................................................................................................................................39  
Average  collection  period...................................................................................................................................................39  
Fixed  assets  turnover ...........................................................................................................................................................40  

11.  International  financial  management ..................................................................41  

Exchange  rates  and  the  law  of  one  price ...................................................................................................... 41  
Spot  and  forward  exchange  rates ...................................................................................................................................41  
Exchange  rates  and  interest  rates...................................................................................................................................41  
Forward  exchange,  interest  rates  and  inflation  expectations ............................................................................41  
NPV  calculations  for  international  investments ........................................................................................ 41  
Method  1:  Discount  foreign  cash  flow...........................................................................................................................41  
Method  2:  Convert  to  local  cash  flow ............................................................................................................................42  
Hedging  international  cash  flows ................................................................................................................... 42  
Risk  profile  for  shareholders ............................................................................................................................................42  
Financial  sources  for  foreign  investment..................................................................................................... 42  

12.  Advanced  topics:  Options  and  agency ................................................................44  

Option  characteristics......................................................................................................................................... 44  
Call  option .................................................................................................................................................................................44  
Put  option ..................................................................................................................................................................................45  
Relationship  between  exercise  and  market  values  of  options ...........................................................................45  
Option  valuations ...................................................................................................................................................................46  
Black–Scholes  option  pricing  model .............................................................................................................. 47  
Put-­call  parity ........................................................................................................................................................ 48  
Applications  of  option  valuations ................................................................................................................... 48  
Real  options............................................................................................................................................................ 49  
Real  call  option........................................................................................................................................................................49  
Real  put  option ........................................................................................................................................................................50  
Swaps ........................................................................................................................................................................ 50  
Exotics ...................................................................................................................................................................... 51  

A:  Acronyms........................................................................................................................52  
 
1.  The  basic  idea,  scope  and  tools  of  finance  
 
In  a  developed  economy  most  people  participate  frequently  in  financial  markets.  
Individuals  borrow  from  and  lend  to  financial  institutions  such  as  banks.  
 
A  financial  market  allows  people  to  shift  resources  between  points  in  time.  
Someone  lending  money  shifts  his  consumption  into  the  future  while  someone  
borrowing  shift  his  consumption  from  a  point  in  the  future  into  the  present.  

When  some  participants  wish  to  bring  future  resources  to  the  present  by  
borrowing,  and  others  wish  to  shift  present  resources  to  the  future  by  lending,  
the  possibility  of  beneficial  transactions  is  obvious.  The  parties  to  the  transac-­‐
tion  must  decide  on  the  amount  of  future  resources  to  be  exchanged  for  present  
ones.    

Market  interest  rate  

 
The  financial  market  makes  that  decision  for  participants  by  setting  the  market  
interest  rate.  The  market  interest  rate  is  the  rate  of  exchange  between  present  
and  future  resources.  
 
It  tells  participants  how  many  pounds  are  expected  to  be  provided  in  the  future  
for  each  pound  of  resources  provided  now.    The  relative  demand  and  supply  of  
resources  to  be  borrowed  and  lent  determines  the  market  interest  rate.  
 
There  is  actually  no  such  thing  as  the  market  interest  rate.  There  are  many  
market  interest  rates,  all  of  which  exist  at  the  same  time.  The  reason  why  there  
can  simultaneously  be  many  market  interest  rates  is  that  interest  rates  can  cover  
different  lengths  of  time  in  the  future,  and  different  riskinesses  of  transactions.  
 
For  example,  it  is  entirely  possible  that  the  interest  rate  for  borrowing  across  a  
two-­‐year  period  is  different  from  that  for  borrowing  across  a  one-­‐year  period,  
because  of  the  relative  demand  and  supply  of  lendable  resources  over  those  
times.  

Present  value  
 
Present  value  is  defined  as  the  amount  of  money  you  must  invest  or  lend  at  the  
present  time  so  as  to  end  up  with  a  particular  amount  of  money  in  the  future.    
 
Finding  the  present  value  of  a  future  cash  flow  is  often  called  discounting  the  
cash  flow.  Discounting  is  done  by  dividing  the  future  cash  flows  by  the  appropri-­‐
ate  market  interest  rate.  Cash  flows  that  occur  multiple  periods  in  the  future  need  
to  be  divided  multiple  times.  
 
Present  value  is  also  an  accurate  representation  of  what  the  financial  market  
does  when  it  sets  a  price  on  a  financial  asset.    

The  financial  exchange  line  

 

 
 
One  cannot  change  present  wealth  merely  by  transacting  (borrowing  and  lending  
at  the  market  rate)  in  the  financial  market.  Though  borrowing  and  lending  will  
move  us  up  and  down  the  financial  exchange  line,  and  thereby  allow  us  to  choose  
the  time  allocation  of  our  present  wealth  that  makes  us  most  happy,  such  
transactions  cannot  move  the  line  and  therefore  cannot  change  our  wealth.    

Investing  
 
Investing  in  real  assets  can  change  our  present  wealth  because  it  is  not  necessary  
to  find  someone  else  to  give  us  part  of  their  wealth  in  order  for  ours  to  increase.  
 
Investing  in  real  assets  such  as  productive  machinery,  new  production  facilities,  
research,  or  a  new  product  line  to  be  marketed,  because  it  creates  new  future  
cash  flows  that  did  not  previously  exist,  can  generate  new  wealth  that  was  not  
there  before.  
 
Investments  are  not  free;  we  must  give  up  some  resources  in  order  to  undertake  
an  investment.  If  the  present  value  of  the  amounts  we  give  up  is  greater  than  the  
present  value  of  what  we  gain  from  the  investment,  the  investment  will  decrease  
our  present  wealth.  
 

Investments  and  the  financial  exchange  line  

 

 
 
The  exchange  line  has  been  shifted  outwards  from  the  origin  by  the  investment  
and  is  parallel  to  the  original  line.  (It  is  parallel  because  the  market  interest  rate,  
which  determines  the  line’s  slope,  has  not  changed.)  
 
Any  outward  shift  in  the  exchange  line  signals  a  good  investment,  and  any  
outward  shift  is  an  increase  in  present  wealth,  any  investment  that  increases  
present  wealth  is  a  good  one.  That  is  simply  another  way  of  saying  what  we  said  
earlier:  investments  are  desirable  when  they  produce  more  present  value  than  
they  cost.  
  
Net  Present  Value  (NPV)  
 
The  difference  between  the  present  values  of  the  cash  inflows  and  outflows  of  
an  investment  is  the  net  present  value  (NPV)  of  the  investment.  The  NPV  is  a  
reflection  of  how  much  the  investment  differs  from  its  opportunity  cost.  It  is  the  
present  value  of  the  future  amount  by  which  the  returns  from  the  investment  
exceed  the  opportunity  costs  of  the  investor.  
 
The  NPV  is:  
 
1. The  NPV  of  an  investment  is  the  present  value  of  all  of  its  present  and  
future  cash  flows,  discounted  at  the  opportunity  cost  of  those  cash  flows.  
These  opportunity  costs  reflect  the  returns  available  on  investing  in  an  al-­‐
ternative  of  equal  timing  and  equal  risk  
2. The  NPV  of  an  investment  is  the  change  in  the  present  wealth  of  the  wise  
investor  who  chooses  a  positive  NPV  investment,  and  also  of  the  unfortu-­‐
nate  investor  who  chooses  a  negative  NPV  investment  
3. The  NPV  of  an  investment  is  the  discounted  value  of  the  amounts  by  which  
the  investment’s  cash  flows  differ  from  those  of  its  opportunity  cost.  When  
NPV  is  positive,  the  investment  is  expected  to  produce  (in  present  value  
total)  more  cash  across  the  future  than  the  same  amount  of  money  invested  
in  the  comparable  alternative.  
 

Internal  Rate  of  Return  (IRR)  

 
The  IRR  tells  us  how  good  or  bad  an  investment  is  by  calculating  the  average  
per-­period  rate  of  return  on  the  money  invested.  
 
A  more  specific  definition  of  the  IRR  is  that  it  is  the  discount  rate  that  equates  the  
present  values  of  an  investment’s  cash  inflows  and  outflows.  From  our  earlier  
discussion  of  NPV,  this  implies  that  IRR  is  the  discount  rate  that  causes  an  
investment’s  NPV  to  be  zero.  
 
The  IRR  and  NPV  techniques  usually  give  the  same  answers  to  the  question  of  
whether  or  not  an  investment  is  acceptable.  But  they  often  give  different  
answers  to  the  question  of  which  of  two  acceptable  investments  is  the  better.  
 
 
 
To  review  what  we  have  discovered  about  the  IRR  technique:  
 
1. IRR  is  the  average  per-­‐period  rate  of  return  on  the  money  invested  in  an  
opportunity  
2. IRR  is  best  calculated  by  finding  the  discount  rate  that  would  cause  the  NPV  
of  the  investment  to  be  zero  
3. To  use  IRR,  we  compare  it  with  the  return  available  on  an  equal-­‐risk  in-­‐
vestment  of  comparable  cash-­‐flow  timing.  If  the  IRR  is  greater  than  its  op-­‐
portunity  cost,  the  investment  is  good,  and  we  accept  it;  if  it  is  not,  we  reject  
the  investment  
4. IRR  and  NPV  usually  give  us  the  same  answer  as  to  whether  an  investment  
is  acceptable,  but  often  different  answers  as  to  which  of  two  investments  is  
better.  

Short  cuts  in  multiple-­‐period  analysis  

Annuity  
 
A  constant  annuity  is  a  set  of  cash  flows  that  are  the  same  amounts  for  a  given  
number  of  future  periods,  e.g.  £1000  per  year  for  a  three-­‐year  period.  Together  
with  a  discount  rate  (e.g.  10%)  we  can  look  up  the  annuity  factor  in  annuity  
tables,  in  this  case  2.4869.  
 
The  cash  flow  sum  times  the  annuity  factor  gives  us  the  present  value  of  the  cash  
flows:  £2’486.90.  

Perpetuity  
 
Perpetuity  is  a  cash  flow  stream  that  is  assumed  to  continue  for  ever.  Perpetuity  
present  values  are  used  because  they  are  so  easy  to  calculate.  The  formula  for  the  
present  value  of  a  perpetuity  is:  
 
  CF  
PV  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐  
     i  
 
PV     Present  Value  
CF     Cash  Flow  
i     Interest  rate  
 
The  above  formula  assumes  that  the  cash  flows  will  be  constant  for  each  future  
period.  That  is  not  very  representative  of  actual  patterns  of  cash  flows  that  we  
see.  If  we  assume  that  the  cash  flows  will  continue  for  ever,  but  will  grow  or  
decline  at  a  constant  percentage  rate  during  each  period,  the  perpetuity  
formula  becomes:  
 
         CF  
PV  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
(i  –  g)  
 
g     Constant  per-­‐period  growth  rate  of  the  cash  flow  

Bond  pricing  
Yield  to  maturity  
 
The  Yield  to  Maturity  is  the  IRR  of  the  bonds’  promised  cash  flows.  The  yield  to  
maturity  is  the  rate  that  discounts  a  bond’s  promised  cash  flows  to  equal  its  
market  price,  and  is  the  ‘average  per-­‐period  earning  rate  on  the  money  invested  
in  the  bond’.  
 
The  yield  to  maturity  is  expressing  not  only  the  earning  rates  but  also  the  
amounts  invested  in  the  bonds  across  time.  

Coupon  effect  on  the  yield  to  maturity  

 
The  coupon  effect  on  the  yield  to  maturity  gets  this  name  because  the  size  of  the  
coupon  of  a  bond  determines  the  pattern  of  its  cash  flows,  and  thus  how  its  
YTM  will  reflect  the  set  of  spot  rates  that  exists  in  the  market.  

Term  structure  of  interest  rates  

 
The  term  structure  of  interest  rates  is  the  set  of  spot  interest  rates  that  exist  in  
the  market.  

Yield  curve  
 
The  set  of  YTMs  is  known  as  the  yield  curve.  

Spot  interest  rates  

 
In  financial  markets,  interest  rates  that  begin  at  the  present  and  run  to  some  
future  time  point  are  called  spot  interest  rates.  
 
Spot  rates  are  denoted  with  dsn,  denoting  the  rate  between  now  (d)  and  n  periods  
in  the  future.  
Forward  interest  rates  
 
Interest  rates  that  begin  at  some  time  point  other  than  now  are  called  forward  
rates  (because  of  their  location  forward  in  time).  Forward  rates  are  denoted  with  
nfm,  denoting  the  rate  between  n  and  m  periods  in  the  future.  
 
The  relationship  between  spot  and  forward  rates  can  be  made  clearer  with  an  
example:  
 
(1  +  i2)2  =  (1  +  df1)  *  (1  +  1f2)  
 
Here  the  2  year  spot  rate  gives  the  same  result  as  using  the  future  rates  from  now  
to  1  year  and  between  1  year  from  now  and  two  years  in  the  future.  

Duration  
 
Duration  is  the  number  of  periods  into  the  future  where  a  bond’s  value,  on  
average,  is  generated.  The  greater  the  duration  of  a  bond,  the  farther  into  the  
future  its  average  value  is  generated,  and  the  more  its  value  will  react  to  changes  
in  interest  rates.  
 
We  can  calculate  the  duration  of  a  bond  by  ‘weighting’  the  time  points  from  which  
cash  flows  are  generated,  by  the  proportion  of  total  value  generated  at  each  time.  
 
                 DCF1                      DCF2      DCF3  
Duration  =  1  *  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  +  2  *  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  +  3  *    -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  +  n  *  …  
                 Price                  Price     Price  
2.  Fundamentals  of  company  investment  decisions  
Corporate  equity  
 
-­‐ Equity  is  a  residual  claim  
This  means  that  there  is  no  specific  contract  that  mandates  any  payment  to  
shareholders.  
The  shareholders  are  entitled  only  to  vote  for  the  directors  of  the  company  
and  to  expect  that  the  company’s  directors  and  management  make  deci-­‐
sions  in  the  best  interests  of  the  shareholders.  
-­‐ Equity  has  limited  liability  
This  means  that  the  possible  losses  that  a  shareholder  can  incur  are  limited  
to  the  value  of  the  shares  that  the  shareholder  owns.    
 
The  net  result  of  these  characteristics  is  that  the  shareholders  of  a  company  do  
not  have  a  contract  to  which  they  can  refer  for  developing  an  idea  of  how  much  
money  they  can  expect  to  receive  or  when  they  may  receive  it.  

The  market  value  of  common  shares  

 
Dividends  alone  are  the  basis  for  the  value  of  a  company’s  common  shares  in  the  
financial  markets.  In  other  words:  the  market  value  of  the  shares  of  a  company  is  
the  present  value  of  its  future  dividends.  
 
The  price  per  share  can  be  calculated  as  follows:  
 
      Dividend  per  share  
Price  per  share  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
        (re  –  g)  
 
re     Return  on  equity  (equity  discount  rate)  
g     Dividend  growth  rate  

Price/earnings  ratio  
 
The  price/earnings  ratio  is  simply  the  earnings  per  share  divided  by  the  price  per  
share,  i.e.:  
 
     EPS  
P/E  ratio  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
    Price  
  

Payout  ratio  
 
The  payout  ratio  specifies  how  much  of  the  earnings  (per  share)  are  paid  out  to  
shareholders  in  the  form  of  dividends:  
 
               Dividends  per  share  
Payout  ratio  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
               Earnings  per  share  

Investment  decisions  
All-­‐equity  corporations  
 
Regardless  of  who  contributes  the  money  to  fund  a  project  (old  or  new  share-­‐
holders)  the  investment’s  NPV  will  go  to  the  old  shareholders.  New  sharehold-­‐
ers  will  profit  from  future  dividends.  
 
 
 
3.  Earnings,  profit  and  cash  flow  
Cash  flows  
 
Financial  cash  flows  are  the  cash  amounts  that  are  expected  to  occur  at  the  times  
for  which  the  expectations  are  recorded.  They  are  not  to  be  confused  with  the  
accounting  numbers  that  are  generated  for  quite  different  purposes.  

Operations  cash  flow  

 
Rule  for  “Operations”  cash  flows  is  that  they  be:  
1. paid  in  cash  that  year  
2. deductible  for  taxes  that  year  
3. not  a  payment  to  a  capital  supplier  

Free  cash  flow  

 
The  free  cash  flow  (FCF)  is  the  amount  of  cash  that  can  be  taken  by  capital  
suppliers  from  the  company  as  a  result  of  the  investment  while  leaving  all  of  the  
plans  of  the  company  unchanged.  
 
 
 
 
4.  Company  investment  decisions  using  the  weighted  
average  cost  of  capital  
APV  
Adjusted  Present  Value  
 
The  APV  does  not  require  that  the  proportions  of  debt  and  equity  be  known,  
but  does  require  that  the  interest  tax  shields  of  the  project’s  debt  be  
estimated.    
 
APV  =  All  equity  value  +  Interest  tax  shield  –  Present  cost  
 
What  is  the  value  of  the  interest  tax  shields?  Discount  the  cash  flows  at  the  
appropriately  risk-­‐adjusted  discount  rate.  Since  the  interest  tax  shields  are  
contingent  upon  the  interest  payments,  their  risk  must  be  the  same  as  the  debt  
cash  flows  (i.e.  the  same  as  the  YTM  (market  value)  of  the  bonds  issued).  
 
Required  value  for  calculating  the  APV  are:  
-­‐ Cost  of  equity  
Required  to  calculate  the  base  value  for  all-­‐equity  financing  
-­‐ Amount  of  debt  
Required  to  calculate  the  tax  shield  
-­‐ Cost  of  debt  
Required  to  calculate  the  present  value  of  the  tax  shield  

WACC  
Weighted  Average  Cost  of  Capital  
 
The  weighted  average  cost  of  capital  (WACC)  is  the  discount  rate  that  reflects  the  
1. Operating  risks  of  the  project  
2. Project’s  proportional  debt  and  equity  financing  with  attendant  financial  
risks  (rates)  
3. Effect  of  interest  deductibility  for  the  debt-­‐financed  portion  of  the  project.  
 
Companies  using  the  WACC–NPV  are  those  willing  to  specify  the  expected  
proportions  of  debt  and  equity  in  terms  of  their  market  values,  but  they  do  not  
know  exactly  what  the  claims  will  be  worth  until  after  the  analysis  is  complete.  
 
It  does  not  require  that  the  amounts  of  debt  to  be  issued  are  known,  nor  does  
it  require  that  the  market  values  of  any  of  the  resulting  claims  be  estimated  
beforehand.  The  only  information  necessary  comprises  estimates  of  
-­‐ The  required  rate  for  equity  
-­‐ Debt’s  after-­tax  cost  rate  
-­‐ The  all-­‐equity  free  cash  flows  
-­‐ The  proportions  intended  for  debt  and  equity  financing.    
 
      Debt  market  value  
WACC  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐    *  Debt  cost  
    Total  market  value  
 
    Equity  market  value  
  +  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  *  Equity  required  rate  
    Total  market  value  
 
Debt  cost  =  Debt  required  return  *  (1  –  Corporate  income  tax  rate)  
 
For  calculation  of  the  proportions  of  debt  and  equity  the  market  value  has  to  be  
used,  NOT  the  amounts  paid  into  the  project!  

SML  (Security  Market  Line)  

 
The  SML  is  a  measure  of  risk  and  return.  What  it  shows  is  that  the  investor  will  
receive  a  higher  return  for  taking  on  a  higher  risk.  
 
5.  Estimating  cash  flows  for  investment  projects  
 
The  basic  idea  to  keep  in  mind  is  that  we  must  include  all  of  the  changes  that  are  
expected  to  take  place  in  the  corporation’s  cash  flows  if  the  project  is  accepted,  
and  include  nothing  but  cash  flows.  
 
‘Inclusion  of  all  corporate  cash  flows  affected  by  the  investment’  sometimes  
means  that  financial  analysts  must  invoke  the  idea  of  economic  opportunity  costs.    
 
‘Inclusion  of  all  relevant  cash  flows’  means  that  analysts  must  
-­‐ Include  cash  flows  from  interactions  of  the  investment  with  other  activities  
of  the  corporation.  The  correct  cash  flows  are  the  changes  in  the  com-­
pany’s  cash  flows  if  this  project  is  accepted  
-­‐ Know  what  things  should  be  omitted  from  the  investment’s  cash  flows.  
‘Sunk  costs’  are  cash  outlays  that  have  already  been  made  
-­‐ Be  very  careful  that  the  accounting  numbers  provided  for  a  project  are  
interpreted  correctly.  Overhead  can  include  non-­‐cash  expenses,  such  as  
depreciation.  Accountants  ‘allocate’  overhead  expenses  on  the  basis  of  arbi-­‐
trary  rules  which  have  no  necessary  correspondence  to  the  additional  or  
incremental  cash  flows  that  a  project  will  require.    

Working  capital  
 
The  working  capital  consists  of  the  current  assets  and  the  current  liabilities  of  the  
company.    

Current  assets  
 
The  current  assets  of  a  company  consist  of  
-­‐ Cash  
-­‐ Marketable  securities  
-­‐ Accounts  receivable  
-­‐ Inventory  

Current  liabilities  
 
The  current  liabilities  of  a  company  consist  of  
-­‐ Accounts  payable  
-­‐ Short  term  loans  and  other  financings  
Net  working  capital  
 
From  this  the  net  working  capital  can  be  calculated:  
 
Net  working  capital  =  Total  current  assets  –  Total  current  liabilities  

Operating  cash  flow  

 
Changes  in  the  net  working  capital  can  be  used  to  determine  the  cash  flows  
concerning  working  capital:  
-­‐ Take  the  operating  profit  
-­‐ Deduct  the  change  in  the  net  working  capital  from  one  period  to  the  next  
(net  working  capital  goes  up  -­‐>  subtract  from  operating  profits)  
-­‐ Add  overhead  changes  (which  are  not  part  of  the  working  capital)  
 
The  result  is  the  operating  cash  flow.  

Taxes  
 
Check  the  income  tax  row  in  the  income  statement  of  the  project.  Taxes  will  be  
deducted  from  the  free  cash  flow  as  they  are  expenses  that  are  to  be  paid  to  the  
state.  

Fixed  assets  
 
Check  the  Fixed  assets  numbers  in  the  company’s  balance  sheet.  Take  the  
changes  to  fixed  assets  (without  depreciation!)  as  the  relevant  fixed  asset  
purchasing  cash  flows.  
 
Check  the  income  statement  for  sales  of  fixed  assets  and  use  them  is  cash  inflows.  
 
The  delta  between  fixed  assets  purchases  and  sales  are  the  fixed  asset  cash  flows.  

Free  Cash  Flow  (FCF)  

 
The  free  cash  flow  is  the  sum  of  the  following  cash  flows  that  we  have  calculated  
as  described  above:  
 
-­‐ Operating  cash  flows  
-­‐ Fixed  assets  cash  flows  
-­‐ Less  taxes  
Ungeared  free  cash  flow  (FCF*)  
 
-­‐ Take  the  free  cash  flow  from  above  
-­‐ Less  Interest  Tax  Shield  (ITS)  
 
The  result  is  the  ungeared  free  cash  flow  that  is  used  as  input  for  the  APV  and  
WACC-­‐NPV  calculations.  

Terms  and  abbreviations  used  

Cash  flows  
 
FCFt   Free  Cash  Flow  at  time  t.  The  amount  of  cash  that  the  corporation  can  
distribute  to  its  capital  suppliers  at  time  t  due  to  the  project  
It     Interest  cash  flow  at  time  t  
Tc     Corporate  income  tax  rate  
ITSt     Interest  Tax  Shield,  equal  to  It  *  Tc  
FCFt*   Unleveraged  (ungeared)  free  cash  flow.  The  amount  of  free  cash  flow  
that  the  project  is  expected  to  generate  at  time  t,  not  including  inter-­‐
est  tax  shields.  Equal  to  FCFt  -­‐  ITSt  

Market  values  
 
Et     Market  value  of  the  equity  of  the  investment  at  time  t  
Dt     Market  value  of  the  debt  of  the  investment  at  time  t  
Vt     Market  value  of  the  investment  at  time  t  

Discount  rates  
 
re     Required  return  on  equity  of  the  investment  
rd     Required  return  on  the  debt  of  the  investment  
rd*     Cost  of  debt,  adjusted  for  the  tax  rate,  i.e.  rd  *  (1  –  Tc)  
rv     Overall  weighted  average  return  on  the  capital  claims  of  the  invest  -­‐
    ment  (using  rd)  
rv*     WACC,  using  rd*  as  the  debt  required  rate  
ru     Unleveraged  (all-­‐equity)  required  return  on  the  investment  
 
 
 
6.  Applications  of  company  investment  analysis  
Payback  Period  
 
The  payback  period  method  of  investment  analysis  is  quite  straightforward.  It  is  
simply  the  number  of  periods  until  a  project’s  cash  flows  accumulate  positively  to  
equal  its  initial  outlay.  It  is  a  measure  of  the  length  of  time  expected  before  the  
investment  outlay  is  recouped.  
 
The  problems  with  payback  period  are:  
 
1. It  ignores  all  cash  flows  beyond  the  minimum  acceptable  payback  period,  
even  though  there  are  often  likely  to  be  cash  flows  of  importance  beyond  
that  time  
2. It  does  not  discount  the  cash  flows  within  the  minimum  acceptable  period,  
thereby  effectively  giving  equal  weight  to  all  cash  flows  within  those  pe-­‐
riods.  This  is  inconsistent  with  shareholder  opportunity  costs  on  the  mon-­‐
ies  invested.  
 
These  characteristics  of  the  technique  will  in  many  cases  cause  investments  to  be  
erroneously  accepted  and  rejected.  

Discounted  payback  period  

 
This  procedure  calculates  the  present  values  of  cash  flows,  and  dictates  a  
minimum  acceptable  period  until  the  discounted  cash  flows  accumulate  to  equal  
the  initial  outlay.  This  alteration  does  away  with  our  second  complaint  about  
payback  period,  but  leaves  the  fact  that  cash  flows  beyond  the  accumulation  point  
are  ignored.  

Average  (accounting)  Return  On  Investment  (AROI)  

 
This  method  calculates  a  rate  of  return  on  the  investment  in  each  period  by  
dividing  expected  accounting  profits  by  the  net  book  value  (i.e.  depreciated  value)  
of  the  investment’s  assets.    

IRR  vs.  NPV  

 
Where  there  are  sign  changes  in  the  cash  flows  across  time  multiple  IRRs  for  a  
project  can  be  produced.  If  you  are  faced  with  an  investment  project  whose  cash  
flows  contain  changes  of  sign,  it  would  be  best  to  abandon  the  IRR  technique  
and  turn  to  NPV.    

Mutually  exclusive  investment  decisions  

 
Crossover  rate  
 
The  crossover  rate  is  the  IRR  at  which  a  switch  in  preference  from  one  project  to  
another  contender  happens  (at  that  exact  point  the  NPVs  of  both  projects  are  
identical).  If  this  happens  IRR  might  give  an  incorrect  result  (compared  to  NPV).  
The  following  process  avoids  this  pitfall:  
 
Incremental  cash  flow  analysis  
 
1. Pick  any  two  projects  from  a  pool  of  mutual  exclusive  alternatives  
2. Find  the  project  with  the  highest  NPV  (discount  rate  0%  -­‐>  simply  the  sum  
of  all  cash  flows)  
This  project  becomes  the  defender;  the  other  project  is  the  challenger  
3. Subtract  the  cash  flows  of  the  challenger  from  those  of  the  defender  
The  resulting  stream  of  cash  flows  is  the  “incremental  cash  flows”  
4. Find  the  IRR  of  the  incremental  cash  flows  (defender  –  challenger)  
5. If  the  IRR  of  the  incremental  cash  flows  is  greater  than  the  hurdle  rate  keep  
the  defender  and  throw  out  the  challenger.  If  the  IRR  of  the  incremental  
cash  flows  is  less  then  the  hurdle  rate  keep  the  challenger  and  throw  out  
the  defender  
6. Return  to  the  pool  and  pick  another  project  and  repeat  from  step  2  
7. Calculate  the  IRR  of  the  “winner”.  If  the  IRR  exceeds  the  hurdle  rate  accept  
it,  other  wise  reject  the  winner  and  all  other  projects  from  the  pool.  

Cost-­‐Benefit  Ratio  
 
The  cost–benefit  ratio  (CBR)  is  defined  as  the  ratio  between  the  present  value  of  
the  cash  inflows  and  the  cash  outflows  of  an  investment.  
 
           Sum  of  the  PV  of  all  project  cash  inflows  
CBR  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
         Sum  of  the  PV  of  all  project  cash  outflows  
 
To  use  the  CBR,  an  investment  is  accepted  if  the  ratio  is  greater  than  1  and  
rejected  if  the  CBR  is  less  than  1.  
 
The  CBR  is  giving  an  incorrect  signal  as  to  which  of  the  two  investments  should  
be  preferred  if  they  are  mutually  exclusive.  The  reason  is  that  it  is  a  ratio  of  
values  rather  than  a  value  measure  itself.  Capital  claimants  are  concerned  about  
their  absolute  wealth  –  which  in  the  final  analysis  is  measured  in  value  amounts  
not  ratios.  

Profitability  Index  
 
                           Sum  of  the  PV  of  all  cash  flows  from  1  period  on  the  future  
PI  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
                   (Positive)  Value  of  the  initial  cash  outlay  to  finance  the  project  
 
A  PI  greater  than  1  signals  an  acceptable  investment.  The  PI  is  only  used  when  the  
present  cash  flow  is  a  net  outlay.  

Renewable  Investments  
 
Alternative  investments  can’t  be  expected  to  renew  at  the  same  intervals.  
Example:  Investing  in  machines  with  life  expectancies  of  5  and  7  years,  respec-­‐
tively.  
 
In  order  to  compare  those  investments  the  NPV  of  the  contenders  needs  to  be  
annualized.  Using  the  equivalent  annual  cost  (EAC)  the  NPV  of  each  investment  
is  divided  by  the  annuity  factor  (see  statistical  tables)  and  the  resultant  values  
are  compared.  

Inflation  and  company  investment  decisions  

Nominal  prices  
 
Nominal  prices  include  inflation.  Nominal  measures  are  the  only  ones  that  we  can  
have  much  confidence  in  estimating.  

Real  prices  
 
A  real  price  is  the  number  of  £s  (or  whatever  currency)  that  would  have  been  
exchanged  to  purchase  something  before  the  inflation  took  place.  
 
We  call  the  ‘inflation-­‐free’  return  the  real  rate,    
 
1  +  Nominal  return  =  (1  +  Real  return)  *  (1  +  Inflation  rate)  
 
i.e.  
  
1  +  15.5%  =  (1  +  10%)  *  (1  +  5%)  

Investment  interrelatedness  
 
When  the  acceptance  or  rejection  of  one  investment  affects  the  cash  flows  that  
can  be  expected  on  some  other  investment,  we  say  the  investments  are  economi-­
cally  interrelated.  
 

 
Depreciation  
 
Three  main  methods  mentioned  in  the  course:  
 
-­‐ Straight-­‐line  method  
-­‐ Double  declining  balance  method  
-­‐ Sum  of  digits  method  
 

Straight-­‐line  method  
 
The  straight-­‐line  method  allows  a  constant  rate  of  depreciation  each  year.  If  an  
asset  is  depreciated  over  5  years  for  example  the  depreciation  will  be  1/5th  of  the  
value  of  the  asset  per  year.  

Double  declining  balance  method  

 
The  double  declining  balance  method  means  that  depreciation  occurs  at  twice  the  
rate  of  the  straight-­‐line  method.  If  an  asset  is  depreciated  over  5  years  the  
depreciation  will  be  2/5th  of  the  remaining  value  of  the  asset.  

Sum  of  digits  method  

 
The  sum-­‐of-­‐the-­‐years’-­‐digits  method  allows  a  deduction  equal  to  the  proportion  
found  by  dividing  the  remaining  depreciable  life  of  the  asset  by  the  sum  of  the  
years  of  the  asset’s  total  life.  If  the  asset  is  depreciated  over  5  years  the  depreci-­‐
ation  will  be  5/15th  in  the  first  year  (5  years  remaining  /  1  +  2  +  3  +  4  +  5)  and  
1/15th  in  the  last  year.  
Economic  income  (EVA,  Economic  Value  Added)  
 
The  application  of  ‘economic  income’  concepts  has  become  an  increasingly  
popular  approach  to  measuring  the  economic  performance  of  management.  These  
methods  are  attempts  to  reproduce  the  benefits  of  market  valuation  meas-­
ures  as  performance  indicators,  but  at  the  same  time  make  them  useable  at  the  
middle  management  (or  individual  project)  level  of  a  company.  
 
In  concept  these  methods  are  straightforward.  All  have  the  attribute  of  charging  a  
capital  cost  against  the  net  cash  flows  of  a  company  division  in  a  given  period,  and  
seeing  if  there  is  anything  left  over.  This  cost  is  typically  calculated  by  multiply-­
ing  a  WACC  by  an  invested  amount  to  produce  a  £-­stated  capital  cost.  If  there  
is  a  positive  residual  amount  left  over,  the  division’s  revenues  have  covered  not  
only  the  costs  that  are  typical  of  those  on  its  accounting  income  statement,  but  
also  the  opportunity  costs  of  its  capital  suppliers,  leaving  a  ‘economic  profit’  for  
its  shareholders.  If  there  is  a  negative  residual,  the  division  has  not  done  as  well  
as  shareholders  could  have  done  in  a  comparable-­‐risk  investment  elsewhere.  

EVA  example  
 
A  company  has  £500m  of  assets  and  a  WACC  of  15%.  The  company  needs  to  make  
£75m  (£500m  *  15%)  just  to  break  even.  Only  profits  above  that  level  are  adding  
value  to  shareholders.  

Strength  of  economic  profit  measures  

 
Economic  profit  measures  have  the  strength  of  uncovering  company  operations  
that  are  profitable  in  an  accounting  sense,  but  not  in  an  economic  sense.  That  
economic  profit  is  tied  directly  to  shareholder  wealth  makes  it  an  excellent  
candidate  for  use  as  a  management  performance  measure.  

Problems  with  economic  profit  measures  

 
-­‐ How  should  the  differences  between  accounting  measures  of  depreciation  
and  economic  depreciation  be  dealt  with  in  determining  ‘investment?’  
-­‐ Economic  profit  performance  measure  is  applied  ‘period-­‐by-­‐  period.’  How  
can  this  be  used  to  evaluate  a  new  division  that  can  reasonably  be  expected  
to  produce  negative  cash  flows  in  its  earlier  years,  which  are  only  compen-­‐
sated  later?  Economic  income  measures  are  not  present  values  of  streams  
of  income,  as  is  NPV.  
7.  Risk  and  company  investment  decisions  
Beta  
 
The  beta  is  a  measure  of  the  systematic  or  market  risk  in  a  share.  A  security  
having  a  β  equal  to  1.0  implies  that  the  market’s  influence  on  that  security  is  such  
that  an  x  per  cent  increase  or  decrease  in  the  return  on  the  ‘market’  is  associated  
with  an  x  per  cent  increase  or  decrease  in  the  return  on  that  security.  On  the  other  
hand,  a  β  of  1.5  signals  that  an  x  per  cent  change  in  market  return  implies  a  1.5ჼA  
per  cent  change  in  the  return  on  that  security.    
 
βu     Ungeared  beta  coefficient  
βe   Beta  coefficient  of  the  equity  financed  portion  of  the  project  
βd   Beta  coefficient  of  the  debt  financed  portion  of  the  project  
 
βu  =  βe  *  Equity  proportion  +  βd  *  Debt  proportion  

Operational  gearing  
 
Operational  gearing  is  measured  by  the  level  of  fixed  costs  to  total  production  
costs.  A  company  with  high  operational  gearing  has  a  high  level  of  fixed  costs  to  
cover  before  generating  free  cash  flow  or  profits.  
 
The  β  coefficient  of  a  project  with  high  operational  gearing  (compared  to  the  
parent  company)  needs  to  be  adjusted  upwards  for  this  reason.  

Financial  gearing  
 
Financial  gearing  reflects  any  borrowing  that  the  company  may  have  undertaken.  
The  β  coefficient  of  a  company  with  debt  in  its  financing  structure  is  higher  than  if  
it  was  financed  solely  by  equity  (the  higher  the  percentage  of  debt  the  higher  the  
required  return  on  equity).  
 
The  operating  income  of  the  project  will  become  more  volatile  with  increased  
financial  gearing  (borrowing).  The  β  coefficient  of  the  project  has  to  be  adjusted  if  
the  level  of  borrowing  for  the  project  is  lower  or  higher  than  the  level  of  the  
parent  company.  
Capital  Asset  Pricing  Model  (CAPM)  
 
E(rj)  =  rf  +  [E(rm)  -­‐  rf]  *  βj  
 
E(rj)     Estimation  of  required  return  
rf     The  risk-­‐free  return  (taken  from  government  bonds)  
E(rm)  -­‐  rf   Market  risk  premium  
βj     Systematic  risk  of  asset  (debt  or  equity  rate  or  project  specific)  
 
Keep  in  mind  that  for  calculation  of  the  applicable  debt  rate  the  company  tax  rate  
has  to  be  used!  
 
Debt  cost  =  Debt  required  return  *  (1  –  Corporate  income  tax  rate)  
8.  Company  dividend  policy  
 
There  is  a  set  of  arguments  that  says  that  the  dividend  decision  of  a  company  is  
unimportant.  
 
Higher  cash  dividends  mean  lower  market  value  to  existing  shareholders,  and  
lower  cash  dividends  mean  higher  market  value  to  existing  shareholders.  
 
If  existing  shareholder  dividends  are  reduced,  their  claim  upon  future  dividends,  
and  thus  current  market  value,  is  higher  because  less  new  equity  is  raised.  If  
existing  shareholder  dividends  are  increased,  their  claim  upon  future  dividends,  
and  thus  current  market  value,  is  lower  because  more  new  shares  must  be  sold.  

Dividends  and  market  frictions  

Taxation  of  dividends  
 
When  a  company  pays  a  dividend,  the  cash  thus  distributed  must  make  its  way  
through  whatever  tax  system  exists  in  the  economy  before  the  dividend  is  useful  
to  the  shareholder.  From  the  shareholder’s  perspective,  it  is  after-­tax  (both  
company  and  personal)  dividends  that  are  of  interest.    
 
In  tax  systems  where  ‘double  taxation’  (both  the  company  and  receiver  of  the  
dividend  pay  taxes)  of  dividends  is  unavoidable,  there  is  a  strong  tax  incentive  
against  the  payment  of  dividends  for  companies  seeking  to  please  their  share-­‐
holders.    
 
In  some  countries  (such  as  the  UK),  dividends  are  not  taxed  as  heavily.  These  
‘imputation’  systems  make  some  attempt  to  alleviate  the  double  taxation  of  
dividends  by  imputing  an  amount  of  company  taxes  to  shareholders  based  upon  
the  dividends  that  companies  pay,  and  then  giving  shareholders  a  credit  on  their  
taxes  for  that  amount.  The  effect  of  such  systems  is  to  cause  less  of  a  bias  against  
dividends  than  systems  that  tax  both  company  profits  and  shareholder  divi-­‐
dends.  

Transaction  costs  of  dividend  payments  

 
From  the  perspective  of  shareholders,  if  they  can  costlessly  shift  their  portfolios  
from  shares  to  cash  and  back,  there  is  no  reason  to  prefer  one  payment  to  the  
other.  However  in  real  markets  transaction  costs  (brokerage  fees)  when  shares  
are  bought  or  sold.  
  
So  shareholders  may  prefer  one  dividend  policy  to  another  depending  upon  their  
preferences  for  consuming  wealth  across  time  and  the  costs  they  would  pay  to  
achieve  the  desired  consumption  pattern,  given  a  particular  dividend  policy  by  
the  company.  

Flotation  costs  
 
Finally,  companies  themselves  incur  costs  in  raising  money  from  capital  markets  
when  they  pay  dividends  so  high  as  to  require  new  shares  to  be  sold.  These  are  
called  flotation  costs,  and  they  can  be  significant  for  the  issuance  of  new  shares,  
depending  upon  the  mechanism  of  sale.  If  intermediaries  such  as  investment  
bankers  are  used,  the  costs  can  be  as  high  as  5  to  25  per  cent  of  the  total  value  
of  issued  shares.  

Combined  frictions  
 
Real-­‐market  considerations  of  taxes,  transaction  costs  and  flotation  costs  are  
potentially  significant  considerations  for  companies  in  their  dividend  policy  
decisions.  
 
The  resulting  optimal  dividend  policy  of  companies  would  be  as  follows:  find  all  
of  the  investments  that  have  positive  NPVs,  and  retain  as  much  cash  as  is  
necessary  to  undertake  these  investments;  if  there  is  cash  left  over,  only  then  
might  a  dividend  be  paid;  only  raise  new  equity  capital  when  internally  generated  
funds  are  insufficient  to  provide  the  cash  necessary  to  undertake  all  good  
investments.  This  is  sometimes  called  a  ‘passive  residual  dividend  policy’.  
 
If  our  discussion  of  dividends  were  complete,  we  would  expect  to  see  evidence  
that  companies  actually  pursued  such  a  policy.  What  we  see  instead  is  that  
companies’  dividends  across  time  are  much  more  stable  than  a  passive  
residual  policy  would  require.  

Other  considerations  in  dividend  policy  

Dividends  and  signalling  
 
One  of  the  empirical  findings  about  company  dividends  is  that  these  cash  payouts  
seem  to  be  more  stable  in  monetary  terms  across  time  than  any  particular  
residual  or  clientele  hypothesis  for  dividend  policy  can  explain.  
 
One  explanation  for  the  ‘smoothing’  across  time  of  company  dividends  that  seems  
more  reasonable  is  the  signalling  value  of  dividends.  
  
Real  financial  markets  have  frictions  not  only  in  the  form  of  transaction  costs,  
brokerage  fees  and  taxes,  but  also  in  the  free  flow  of  information.  This  can  take  
place  through  subtle  signals  that  the  company  gives  –  by  alterations,  for  example,  
in  its  dividend  payment.  One  reason  for  the  smoothing  of  dividends  across  time  is  
that  the  dividend  announcement  can  be  made  to  be  a  ‘surprise’  (either  good  or  
bad)  to  the  market.  

Dividends  and  share  repurchase  

 
Share  repurchases  are  nothing  more  than  a  cash  dividend  to  shareholders.  
 
One  reason  is  that  in  some  countries  the  money  received  by  shareholders  in  share  
repurchase  transactions  is  taxed  more  lightly  (or  even  not  at  all)  in  comparison  
with  cash  dividends  declared  by  the  company.  Share  repurchases  on  the  open  
market  also  show  some  signs  of  being  signalling  attempts  that  receive  a  positive  
response  from  shareholders.  
 
In  some  countries  a  company  can  undertake  a  ‘targeted’  share  repurchase.  This  
is  a  transaction  wherein  a  company  offers  to  repurchase  only  particular  shares  
(usually  held  by  an  individual  or  group  which  the  company’s  managers  are  
frightened  will  take  over  the  company  and  make  things  less  pleasant  for  existing  
management).  
 
9.  Company  capital  structure  
 
It  is  wrong  to  think  that  debt  is  cheaper  than  equity  because  interest  rates  are  
lower  than  equity  required  returns.  
 
Since  debt  has  a  claim  prior  to  equity,  whatever  risk  is  inherent  in  the  operational  
cash  flows  of  a  company  will  be  shared  unequally  by  debt  and  equity.  Debt  will  
have  less  risk  (and  thus  a  lower  required  rate),  and  equity  will  have  more  (and  
thus  a  higher  required  rate).  
 

 
 
rd     Return  required  for  the  debt  financed  part  of  the  geared  company  
Riskd     Risk  of  the  debt  part  of  the  geared  company  
ru     Return  required  for  the  ungeared  (all-­‐equity)  company  
Risku     Risk  of  the  ungeared  company  
re     Return  required  for  the  equity  financed  part  of  the  geared  company  
Riske     Risk  of  the  equity  part  of  the  geared  company  
 
The  existence  of  the  debt’s  prior  claim  has  increased  the  risk  (and  thus  the  
required  return)  to  equity.  Geared  equity  (Riske)  is  riskier  than  ungeared  
equity  (Risku).  Thus  debt  is  ‘cheaper’  in  the  sense  of  carrying  an  interest  rate  or  
required  rate  of  return  less  than  equity,  but  the  very  existence  of  debt’s  prior  
claim  serves  to  increase  the  risk  of  equity  to  be  higher  than  it  would  be  without  
debt.  This  means  that  debt  is  not  necessarily  a  ‘cheap’  capital  source  when  the  
interactions  between  debt  and  equity  financing  are  considered.  
EBIT-­‐EPS  
 
By  adding  debt  to  a  company’s  financing  EBIT  and  EPS  change.  Due  to  the  first-­‐
priority  nature  of  debt  the  remaining  profits  (as  expressed  by  EPS)  become  more  
volatile,  i.e.  more  risky.  
 

 
 

Capital  structure  and  capital  cost  (without  taxes)  

 

 
 
ru     Return  required  for  the  ungeared  (all-­‐equity)  company  
re     Return  required  for  the  equity  financed  part  of  the  geared  company  
rd     Return  required  for  the  debt  financed  part  of  the  geared  company  
rv     Return  required  for  the  geared  company  (overall  rate)  
 
As  the  percentage  of  debt  in  the  company’s  financing  increases  the  return  
required  of  debt  increase  up  to  the  level  required  of  the  ungeared  company.  
Equity  required  returns  in  turn  increase  as  well,  up  from  the  ungeared  level  of  
financing.  The  overall  rate  required  however  stays  constant  as  the  proportion  of  
debt  vs.  equity  financing  shifts  (WACC  formula!).  

Miller  &  Modigliani  

 
The  ‘M&M’  economics  of  company  capital  structure  predict  that  it  would  make  no  
difference  to  shareholder  wealth  whether  the  companies  borrowed  money  or  not.  
Financial  markets  would  ensure  that  this  is  the  final  result.  
 
They  argued  that  the  average  cost  of  capital  would  remain  the  same  whatever  the  
level  of  gearing.  Cheaper  debt  would  be  offset  by  more  expensive  equity.  

Arbitrage  
 
‘Arbitrage’  is  a  transaction  wherein  an  instantaneous  risk-­‐free  profit  is  made.    
 
Arbitrage  opportunities  cannot  be  expected  to  exist  for  any  significant  time  in  a  
market  with  well-­‐informed  investors.  Market  prices  must  adjust  to  cause  all  
equivalent  future  cash  flows,  sold  in  whatever  form  as  single  securities  or  as  
portfolios  of  holdings,  to  sell  for  the  same  price.  The  forces  of  demand  and  supply  
will  quickly  cause  prices  to  adjust  so  as  to  destroy  the  arbitrage  opportunity.  
 
Even  if  two  portfolios  have  wildly  different  securities  in  them,  if  the  portfolios’  
aggregate  future  expectations  are  identical,  the  portfolios  must  be  equally  
valuable,  and  the  individual  security  prices  within  them  will  adjust  to  accomplish  
that.  

Capital  structure  decisions  and  taxes    

 
A  company  is  taxed  by  the  government  on  the  amount  of  ‘income’  or  ‘profit’  it  
makes.  When  companies  can  report  the  payment  of  interest  for  income  tax  
purposes,  the  companies’  taxes  are  lower  by  an  amount  called  the  interest  tax  
shield.  
 
The  deductibility  of  interest  payments  by  companies  should  cause  there  to  exist  a  
bias  in  company  capital  structures  toward  the  use  of  borrowing  instead  of  equity  
capital.  

Capital  structure  and  company  value  (with  taxes)  

 

 
 
V     Value  of  the  leveraged  company  
Vu     Value  of  the  unleveraged  company  
VITS     Value  of  the  Interest  Tax  Shield  
E     Value  of  the  equity  in  the  company  
D     Value  of  the  debt  in  the  company  

Capital  structure  and  capital  cost  (with  taxes)  

 

 
 
ru     Return  required  for  the  ungeared  (all-­‐equity)  company  
re     Return  required  for  the  equity  financed  part  of  the  geared  company  
rd     Return  required  for  the  debt  financed  part  of  the  geared  company  
rv     Return  required  for  the  geared  company  (overall  rate)  
rv*     Company  cost  of  capital  (WACC)  
  
A  company’s  cost  of  capital  is  affected  by  the  amount  of  debt  in  its  capital  
structure,  and  if  interest  is  deductible  for  company  income  tax  purposes,  the  
company’s  cost  of  capital  will  be  lower  the  more  debt  it  uses.  The  reason  for  this  
is  simply  that  interest  deductibility  is  a  kind  of  tax  subsidy  for  corporate  
borrowing  that  is  not  available  for  equity  financings.  

Capital  structure  and  agency  problems  

 
‘Agency’  deals  with  situations  where  the  decision-­‐making  authority  of  a  ‘principal’  
(such  as  a  shareholder  or  bondholder)  is  delegated  to  an  ‘agent’  (such  as  the  
managers  of  a  company).  Agency  considerations  concern  themselves  with  the  
instances  where  conflicts  of  interest  may  arise  among  principals  and  agents,  and  
how  those  conflicts  of  interest  are  resolved.  
 
A  company  is  tempted  to  switch  to  a  higher  risk  project  (which  benefits  share-­‐
holders)  after  debt  financing  has  been  secured.  This  can  happen  even  if  this  
means  switching  from  a  higher  NPV  to  a  lower  NPV  project!  How  can  bondholders  
ensure  the  management  of  the  company  does  not  do  this  switch  that  has  the  
possibility  to  reduce  their  wealth?  
 
One  of  the  more  important  mechanisms  that  financial  markets  use  to  resolve  
conflicts  of  interest  is  by  the  issuance  of  complex  debt  contracts.  An  interesting  
example  of  such  a  ‘positive’  covenant  is  the  convertibility  provision  that  some  
debt  claims  carry.  ‘Convertibility’  means  simply  that  under  certain  conditions  (for  
a  specified  period  and  at  a  given  price  or  exchange  ratio)  and  at  the  option  of  the  
lender,  a  bond  can  be  exchanged  for  shares.  
 
The  company  would  no  longer  have  an  incentive  to  switch  from  the  high-­‐NPV  
project  to  the  low-­‐NPV  project  (because  the  shareholders  would  not  benefit  at  the  
expense  of  bondholders),  and  the  securities  of  the  company  would  be  priced  with  
the  market  expecting  the  company  to  undertake  the  highest  NPV  projects  rather  
than  play  games  in  switching  wealth  from  one  group  of  claimants  to  another.  

Default  and  agency  costs  

 
If  a  company  cannot  service  its  debt  payments  anymore  it  defaults  on  the  interest  
(and/or  principal)  payments  and  needs  to  declare  bankruptcy.  A  company  that  is  
wholly  equity  finances  cannot  go  bankrupt.  
 
Bankruptcy’s  essential  effect  is  merely  to  change  the  legal  ownership  of  the  
company’s  assets  from  shareholders  to  bondholders.  
  
 
 
The  true  costs  of  bankruptcy  or  financial  distress  are:  
 
1. The  costs  involved  in  pursuing  the  legal  process  of  realigning  the  claims  on  
the  assets  of  the  company  from  those  specified  in  the  original  borrowing  
contract  
2. The  implicit  and  opportunity  costs  incurred  in  this  effort  relative  to  what  
would  have  happened  had  the  company  been  financed  instead  by  equity  
capital.  
 
The  option  to  declare  company  bankruptcy  and  thereby  take  advantage  of  limited  
shareholder  liability  is  a  valuable  one.  

More  agency  considerations  

 
The  merger  and  takeover  market  is  really  the  functioning  of  the  market  for  
managers,  wherein  a  takeover  bid  is  effectively  asking  shareholders  to  replace  
one  management  group  with  another.  This  is  likely  to  be  a  more  significant  
constraint  upon  managers  to  perform  in  the  interests  of  shareholders  than  is  the  
vote  of  a  well-­‐dispersed  shareholder  group  for  the  board.  
 
Bondholders,  of  course,  have  no  such  oversight  capacity  on  the  actions  of  
managers.  So  managers  must  be  to  some  extent  concerned  about  how  sharehold-­‐
ers  view  their  performance.  
 
There  are  actions  that  managers  can  take  that  augment  their  wealth  to  the  
detriment  of  shareholders:  
-­‐ ‘Perk’  consumption  beyond  the  point  where  management  productivity  is  
efficiently  enhanced  
-­‐ Asset  operations  that  benefit  managers  instead  of  shareholders  
An  example  is  conglomeration  (the  merging  of  unrelated  firms)  to  increase  
the  size  and  reduce  the  cash-­‐flow  risk  of  the  company,  thus  making  man-­‐
agement  remuneration  higher  and  more  stable,  with  no  accompanying  ben-­‐
efits  to  shareholders  who  own  already  well  diversified  portfolios  
 
10.  Working  capital  management  
Risk,  return  and  term  
Assets  
 
Short-­term  assets  include  cash,  marketable  securities,  receivables  and  inventor-­‐
ies.  Short-­‐term  assets  are  less  risky  because  they  possess  a  much  greater  amount  
of  liquidity,  which  means  the  capacity  to  be  turned  into  cash  both  quickly  and  
without  much  loss  in  value  relative  to  that  of  their  best  use.  Short-­‐term  assets  of  
any  firm  are  more  likely  to  be  easily  used  by  a  wide  range  of  other  companies  
for  about  the  same  things  for  which  these  assets  were  originally  used.    
 
Long-­term  assets  are  in  the  form  of  plant,  equipment,  real  estate,  and  certain  
valuable  intangibles.  Long-­‐term  assets  tend  to  be  much  more  specific  to  the  line  
of  business  in  which  the  company  is  involved,  and  thus  less  easily  converted  to  
cash  and  much  more  subject  to  the  uncertainties  of  a  particular  industry  or  
market.  

Financings  
 
Short-­term  financings  exhibit  relatively  higher  expected  risk  and  return.  
 
Long-­term  financings  are  characterised  by  lower  risk  and  return.  
 
This  is  exactly  the  opposite  of  the  risk  return  characteristic  of  its  assets.  

Combining  risk  and  rates  of  return  on  assets  and  financings  
 

 
 
There  is  an  old  rule  of  thumb  in  finance,  which  goes:  ‘Finance  short-­‐term  assets  
with  short-­‐term  liabilities,  and  long-­‐term  assets  with  long-­‐term  liabilities.’  This  is  
called  maturity  matching.  
 
Mix  of  long-­‐  and  short-­‐term  assets  
 

 
Management  of  cash  balances  
 
The  optimising  of  cash  replenishment  amounts  is  solved  by  the  following:  
 
£r  =  [(2  *  £D  *  £T)  /  i]1/2  
 
£r     Optimal  amount  of  cash  replenishment  
£D     Total  annual  amount  of  cash  spent  by  firm  
£T     Transaction  costs  for  converting  interest-­‐bearing  securities  to  cash  
i     Interest  earned  on  interest-­‐bearing  securities    
General  solution  to  the  cash  management  problem  
 

 
 
£R  =  [(3  *  £T  *  s2)  /  (4  *  i)]1/3  +  £M  
 
£R     Return  point  
£U     Upper  limit  of  cash  
£M     Minimum  amount  of  cash  required  
£T     Transaction  costs  for  converting  interest-­‐bearing  securities  to  cash  
i     Interest  earned  on  interest-­‐bearing  securities    
s2   Variance  of  the  changes  in  the  cash  balance  (square  of  standard  
deviation)  

Management  of  short-­‐term  financings  

Financial  ratios  
Current  ratio  
      Current  assets  
Current  ratio  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
                     Current  liabilities  

Quick  ratio  
             Current  assets  -­‐  Inventory  
Quick  ratio  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
      Current  liabilities  
Profit  margin  
      Net  profit  after  taxes    
Profit  margin  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
        Sales  

Return  on  total  assets  

             Net  profit  after  taxes  
Return  on  total  assets  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
          Total  assets  

Return  on  specific  assets  

        Net  profit  after  taxes  
Return  on  inventory  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
          Inventory  

Return  on  owner’s  equity  

          Net  profit  after  taxes  
Return  on  owner’s  equity  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
                     Owner’s  equity  

Fixed  to  current  asset  ratio  

          Fixed  assets  
Fixed  to  current  asset  ratio  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
          Current  assets  

Debt  ratio  
           Total  debt  
Debt  ratio  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
           Total  assets  

Times  interest  earned  

             Profit  before  tax  +  Interest  charges  
Times  interest  earned  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
            Interest  charges  

Inventory  turnover  
             Sales  
Inventory  turnover  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
        Inventory  

Average  collection  period  

                 Debtors  
Average  collection  period  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
          Sales  per  day  
Fixed  assets  turnover  
                         Sales  
Fixed  assets  turnover  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
             Fixed  assets  
 
11.  International  financial  management  
Exchange  rates  and  the  law  of  one  price  
 
‘The  law  of  one  price’,  or  its  generalisation,  ‘purchasing  power  parity’  simply  
say  simply  that  the  same  thing  cannot  sell  for  different  prices  at  the  same  time.  

Spot  and  forward  exchange  rates  

 
Premium  of  a  forward  over  spot  rates:  
 
Forward  –  Spot  
-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
Spot  

Exchange  rates  and  interest  rates  

 
1  +  foreign  interest  rate     forward  foreign/domestic  exchange  rate  
-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
1    +  domestic  interest  rate          spot  foreign/domestic  exchange  rate  

Forward  exchange,  interest  rates  and  inflation  expectations  

 
If  inflation  is  expected  to  exist  during  the  period  of  the  loan,  the  real  (that  is,  
stated  in  terms  of  purchasing  power)  return  is  expected  to  be  less  than  the  
nominal  return  (Fisher  Effect).  
 
Nominal  interest  rate        =        Real  interest  rate        +          Effect  of  inflation  
 
(1  +  Nominal  rate)n                =        (1  +  Real  rate)n                *          (1  +  Inflation  rate)n  

NPV  calculations  for  international  investments  

 
There  are  two  methods  for  calculating  the  NPV  of  an  international  investment:  

Method  1:  Discount  foreign  cash  flow  

 
With  this  method  the  foreign  cash  flow  is  discounted  using  the  foreign  
interest  rate  (the  WACC  that  applies  to  the  foreign  investment).  The  resulting  
NPV  is  then  converted  to  the  domestic  currency  using  the  spot  rate.  
 
Method  2:  Convert  to  local  cash  flow  
 
In  this  method  the  cash  flows  are  converted  to  the  domestic  currency  using  
forward  rates.  The  resulting  domestic  cash  flows  are  then  discounted  using  the  
domestic  interest  rate  (domestic  WACC).  

Hedging  international  cash  flows  

 
Management  of  a  company’s  foreign  exchange  exposure  must  comprehend  the  
net  exposure  in  each  currency  based  upon  a  detailed  comprehension  of  all  
monetary  accounts.  
 
When  the  company  experiences  multiple  cash  inflows  as  well  as  outflows  only  the  
net  sum  of  these  cash  flows  need  to  be  hedged  and  not  the  individual  cash  flows  
(per  foreign  currency).  

Risk  profile  for  shareholders  

 
If  a  company’s  shareholders  are  not  well  diversified  across  international  
borders,  then  a  foreign  investment  may  well  deserve  a  lower  risk  profile  than  a  
purely  domestic  one  if  the  foreign  investment’s  cash  flows  are  not  well  corre-­
lated  with  a  comparable  domestic  one.  
 
If  shareholders  are  well  diversified  across  countries,  this  consideration  is  neutral.  
 
The  kinds  of  risks  inherent  in  experiencing  alterations  in  foreign  tax  laws,  
exchange  restrictions,  asset  confiscations  and  frictions  in  repatriation  (of  foreign  
wealth)  can  increase  the  risk  of  a  foreign  investment,  but  there  are  also  
comparable  risks  in  domestic  investment.  A  good  analysis  of  these  issues  
would  wish  to  consider  these  relative  to  comparable  domestic  risks  and  add  a  
foreign  risk  premium  only  if  truly  deserved  (there  are  doubtless  instances  in  
which  the  latter  risks  are  smaller  than  domestic  ones).  

Financial  sources  for  foreign  investment  

 
Real  assets  held  in  foreign  countries  are  not  fixed  in  foreign  currency  value;  
these  real  assets  increase  in  value  with  increases  in  foreign  inflation.  Examples  of  
such  assets  are  primarily  plant  and  equipment  and  real  estate,  but  managerial  
talent,  distribution  channels,  technological  expertise  and  other  longer-­‐term  
productive  assets  also  qualify  as  ‘real’.  
 
Monetary  assets  are  those  whose  returns  are  expected  to  be  fixed  in  nominal  or  
money  terms  in  the  future,  regardless  of  the  inflation  rate  in  the  economy.  An  
example  is  a  receivable  (debtor  account)  held  domestically,  but  denominated  in  a  
foreign  currency.  With  this  kind  of  monetary  asset,  a  change  in  the  exchange  rate  
affects  the  domestic  currency  value  of  the  asset  because  the  foreign  currency  
value  is  fixed  whilst  the  exchange  rate  varies.  
 
To  generalise  a  little,  real  assets  (e.g.  plant  and  equipment)  held  in  other  
countries  tend  to  experience  increases  in  value  as  inflation  increases,  whereas  
monetary  assets  (e.g.  accounts  receivable)  do  not.  
 
Only  the  latter  are  serious  candidates  for  the  hedging  of  exchange  risk.  
 
12.  Advanced  topics:  Options  and  agency  
Option  characteristics  
 
One  of  the  most  important  characteristics  of  an  option  is  captured  in  its  very  
name.  An  option  owner  need  not  exercise  the  option  if  the  owner  chooses  not  to  
do  so:  exercise  is  ‘optional’.  
 
If  the  price  of  the  underlying  security  falls  under  (call  option)  or  increases  above  
(put  option)  the  exercise  (strike)  price  the  holder  of  the  option  has  the  possibility  
(option)  not  to  exercise.  He  will  only  lose  the  amount  paid  for  the  option.  
 
For  every  holder  of  an  option  there  must  be  an  issuer.  That  is,  the  option  must  
have  originated  somewhere.  The  issuer  of  an  option  is  often  termed  the  option  
writer.  

Call  option  
 

 
 
A  ‘call  option’  allows  you  to  purchase  (‘call’)  another  security  or  asset  at  a  fixed  
price  for  a  fixed  period  of  time.  
  
 
Put  option  
 

 
 
A  put  option  allows  the  holder  to  sell  something  (usually  shares)  at  a  fixed  price  
for  a  fixed  period  of  time.  

Relationship  between  exercise  and  market  values  of  options  

 

 
 
The  amount  that  the  market  value  of  the  options  exceeds  the  exercise  value  of  the  
option  is  called  the  option  premium.  
 
Option  valuations  
 
Call  option  payoff  diagram  

 
 
S0     The  current  price  of  the  underlying  security  
q     The  probability  of  the  underlying  security  price  increase  
u     Upward  multiplier  for  the  underlying  security  price  
d     Downward  multiplier  for  the  underlying  security  price  
uS0     The  underlying  security  increased  price  result  
dS0     The  underlying  security  decreased  price  result  
C0     Current  market  value  of  the  option  
Cu     Option  payoff  at  expiration  if  the  underlying  security  price  is  up  
Cd     Option  payoff  at  expiration  if  the  underlying  security  price  is  down  
X     Exercise  (strike)  price  of  the  option  
 
Payoff  diagram  from  call  equivalent  portfolio  
 

 
 
rf     The  risk-­‐free  interest  rate  
Y     The  number  of  underlying  shares  to  purchase  (to  sell  if  negative)  
Z     The  amount  of  lending  (borrowing  if  negative)  at  the  risk-­‐free  rate  
 
       Cu  -­‐  Cd  
Y  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
  S0  *  (u  –  d)  
 
 
 
   u  *  Cd  –  d  *  Cu  
Z  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  
  (u  –  d)  *  (1  +  rf)t  
 
Cost  of  the  call-­‐equivalent  portfolio:  Y  *  S0  +  Z  
 
The  market  value  of  the  call  option  is  the  same  as  the  cost  of  the  call-­‐equivalent  
portfolio  (the  same  cash  flows  must  sell  for  the  same  price!),  hence:  
 
C0  =  Y  *  S0  +  Z  

Black–Scholes  option  pricing  model  

 
C0  =  S0  *  N(d1)  -­‐    X  *  e-­‐rfT  *  N(d2)  
 
  ln(S0  /  X)  +  rfT  
d1  =  -­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐-­‐  +  0.5  *  σ  *  T1/2       d2  =  d1  –  σ  *  T1/2  
             σ  *  T1/2  
 
C0     Market  value  of  the  option  
S0     Underlying  security  price  
N(d1)     ‘Cumulative  normal  unit  distribution’  at  the  point  d1  
N(d2)     ‘Cumulative  normal  unit  distribution’  at  the  point  d2  
X     Exercise  (strike)  price  
e f -­‐r T     Continuously  compounded  interest  or  discount  rate  
rf     The  risk-­‐free  interest  rate  
T     Time  until  expiration  of  the  option  
σ     Standard  deviation  of  the  price  of  the  underlying  security  
 
According  to  the  Black-­‐Scholes  model  there  are  five  variables  that  determine  the  
value  of  an  option:  
 
-­‐ S0   Underlying  security  price  
-­‐ X   Exercise  (strike)  price  
-­‐ rf   Risk-­‐free  rate  
-­‐ σ   Standard  deviation  of  the  underlying  security  price  
-­‐ T   Time  until  expiration  
Put-­‐call  parity  
 

 
   Exercise  value  of  put  and  underlying  asset              Exercise  value  of  call  and  riskless  asset  
 
The  first  thing  one  notices  about  above  figures:  the  payoffs  from  holding  a  call  
and  the  present  value  of  its  exercise  price  appear  to  be  the  same  as  those  of  
holding  a  put  and  its  underlying  asset.  
 
The  notion  of  put–call  parity  implies  that  the  following  relationship  must  hold:  
 
Put  +  Underlying  Asset  =  Call  +  Riskless  PV  of  exercise  price  
 
Or  in  a  formula  
 
P0  +  S0  =  C0  +  X  /  rft  
 
P0     Market  value  of  the  put  option  
S0     The  current  price  of  the  underlying  security  
C0     Market  value  of  the  call  option  
X     Exercise  (strike)  price  of  the  option  
rf     The  risk-­‐free  interest  rate  
t     Time  until  expiration  
 
Put–call  parity  not  only  gives  us  an  easy  way  to  value  a  put  option  (if  we  know  the  
call  value).  It  also  specifies  a  general  relationship  among  puts,  calls  and  their  
underlying  asset.  This  can  be  a  potentially  useful  piece  of  information  in  that  this  
relationship  can  be  manipulated  just  as  any  algebraic  one,  solving  for  whatever  
variable  is  of  interest.  

Applications  of  option  valuations  

 
Consider  the  equity  of  a  firm  with  debt  in  its  capital  structure.  This  equity  is  
actually  a  call  option:  if  interest  and  principal  are  paid  to  creditors,  shareholders  
own  the  underlying  assets  of  the  firm;  if  interest  and  principal  are  defaulted,  
creditors  will  end  up  with  the  assets.  
 
For  the  option  held  as  equity  by  shareholders  of  the  company,  underlying  asset  
value  is  the  total  value  of  the  company’s  assets,  and  exercise  price  is  the  
interest  and  principal  promises  to  creditors.  If  this  ratio  is  high,  the  option  is  
well  ‘in  the  money’,  which  implies  a  low  proportion  of  debt  in  the  company’s  
capital  structure.  If  the  ratio  is  low,  the  company  has  lots  of  debt.  
 
In  this  context,  though  the  absolute  (exercise)  value  of  the  equity  of  the  firm  is  
highest  when  there  is  no  debt  (a  fully  ‘in  the  money’  option),  equity  has  its  most  
advantageous  option  characteristics  when  the  company  is  very  highly  
geared  (‘at  the  money’).  
 
One  very  important  influence  upon  equity  value  as  an  option  is  given  by  the  
standard  deviation  of  underlying  asset  value  (σ).  Recall  that  option,  and  
therefore  equity,  value  increases  as  σ  increases.  The  interpretation  of  an  increase  
in  σ  is  straightforward:  it  means  that  the  operating  assets  of  the  firm  are  more  
risky.  For  example,  by  shifting  its  operations  into  a  new,  more  risky  line  of  
business,  the  firm  can  increase  the  value  of  its  shares.  
 
Other  option  value  variables  have  similar  interpretations.  For  example,  the  
longer  the  maturity  of  the  debt,  the  higher  is  equity  value,  other  things  being  
held  the  same.  

Real  options  
 
Real  options  are  options  to  alter,  abandon,  or  extend  a  project’s  cash  flows  at  
some  future  point.  Because  of  the  nature  of  real  options,  conventional  capital  
budgeting  is  not  appropriate  for  their  evaluation.  
 
The  NPV  of  the  conventional  project  would  be  calculated,  then  the  value  of  the  
real  option(s)  would  be  calculated  using  the  binomial  or  Black–Scholes  option  
pricing  model.  The  values  for  the  options  would  then  be  added  to  the  basic  NPV  of  
the  project  to  give  a  true  indication  of  the  NPV  of  the  project.  

Real  call  option  

 
Going  forward  with  a  project  sometime  enables  the  company  to  do  another  
project  later  (based  on  the  experience  gathered  or  market  share  gained,  etc.).  This  
“real  option”  to  do  the  second  project  depends  on  the  first  project  being  accepted.  
 
The  value  of  this  option  might  influence  the  decision  if  the  initial  project  is  
acceptable  or  not.  In  option  terms  the  possibility  to  do  the  second  project  is  a  call  
option  with:  
-­‐ Exercise  price  is  the  initial  outlay  of  the  second  project  
-­‐ Time  until  expiration  is  the  time  when  the  second  project  could  start  
-­‐ The  underlying  asset  is  the  cash  flow  of  the  second  project,  discounted  to  
the  start  date  of  the  project  (the  expiration  date  of  the  option)  
 
In  this  case  the  initial  project  is  said  to  contain  an  embedded  option  (to  do  the  
second  project).  

Real  put  option  

 
There  are  other  types  of  real  asset  decisions  with  embedded  options.  Consider  the  
situation  where  a  project  can  either  be  operated  or  liquidated  at  various  points  
during  its  projected  lifetime.  At  each  of  the  potential  liquidation  points  (which  
would  be  chosen  if  the  project  has  turned  out  badly)  there  is  effectively  a  put  
option  that  allows  the  company  to  sell  the  project  instead  of  operating  it  for  its  
remaining  lifetime  (or  at  least  until  the  next  liquidation  option  point).  
 
The  company  would  choose  to  liquidate  the  project  if  the  exercise  price  (the  
liquidation  value)  is  greater  than  the  present  value  of  the  remaining  project  cash  
flows  plus  the  value  of  the  additional  options  to  liquidate  further  in  the  future.  

Swaps  
Swaps  are  like  a  series  of  forward  contracts  without  the  need  to  continually  
renew  the  contract.  
 
‘Swaps’  are  derivatives  designed  to  allow  hedging  the  risks  of  interest  rate  and  
foreign  exchange-­‐rate  movements.  A  swap  is  a  conceptually  straightforward  
transaction  where  one  party  to  the  transaction  exchanges  one  stream  of  cash  flow  
with  a  ‘counterparty’,  who  provides  the  other  stream  of  cash  flow  to  be  ex-­‐
changed.  There  are  often  ‘side  payments’  of  some  type  to  or  from  one  or  the  other  
party  or  a  third-­‐party  facilitator  to  the  swap.  
 
They  are  better  for  longer-­‐term  positions,  where  it  is  difficult  to  get  coverage  with  
futures  and  forward  agreements.  These  (futures  and  forwards)  tend  to  be  used  
for  durations  of  up  to  1  year.  
 
Swaps  allow  companies  to  take  advantage  of  market  imperfections  in  that  a  
company  may  be  charged  different  rates  for  borrowing  fixed  or  floating  and  they  
can  use  their  comparative  advantage  in  one  form  of  borrowing  to  allow  everyone  
in  the  swap  transaction  to  benefit.  Swaps  are  cheaper  because  you  would  have  to  
be  renewing  futures  or  forward  contracts  continually  to  get  the  same  coverage  if  
the  coverage  was  required  for  periods  exceeding  one  year.  

Exotics  
 
‘Exotics’  are  true  derivatives,  but  ones  formulated  from  combinations  or  mixtures  
of  other  types  of  derivatives.  These  are  conceptually  important  derivatives.  They  
are  tailored  to  the  very  specific  risk  exposures  of  a  single  firm,  and  can  be  very  
complicated  –  so  complicated,  in  fact,  that  there  have  been  instances  where  there  
is  at  least  an  allegation  that  not  even  the  inventor  of  the  security  understood  the  
potential  range  of  outcomes  that  could  be  experienced  by  the  firm  entering  into  
the  transaction.  
 
 
A:  Acronyms  
 
ACT     Advance  Corporation  Tax  
APV     Adjusted  Present  Value  
AROI     Average  (accounting)  Return  On  Investment  
CAPM     Capital  Asset  Pricing  Model  
CBR     Cost  Benefit  Ratio  
DCF     Discounted  Cash  Flow  
EAC     Equivalent  Annual  Cost  
EBIT     Earnings  Before  Interest  and  Taxes  
EPS     Earnings  Per  Share  
EVA     Economic  Value  Added  
FCF     Free  Cash  Flow  
IRR     Internal  Rate  of  Return  
ITS     Interest  Tax  Shield  
NPV     Net  Present  Value  
PI     Profitability  Index  
SML     Security  Market  Line  
WACC   Weighted  Average  Cost  of  Capital  
YTM     Yield  To  Maturity