FINANCIAL MANAGEMENT

Dr. Nguyen Quynh Tho

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 Teaching and learning strategies

4 hours weekly classes to impart knowledge and define the scope of coverage
for self-study.

Lectures
48%
52%
Exercises and
seminars
 Assessment

• Participation: 10%
• Mid-term test 1: 15%
• Mid-term test 2: 15%
• Final exam: 60%

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 Materials

Learning Materials
• Text book: Corporate Finance (10th Edition) by Ross,
Westerfield, Jaffe. McGraw-Hill, 2013.
ISBN: 978-0-07-803477-0
• Lecture notes and in-class materials
• Readings (if available) will be provided before each lecture.

Lecturers
Ms. Tho Nguyen (PhD): thonq@hvnh.edu.vn

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 FINANCIAL MANAGEMENT:
3 main areas of concern

Working Capital
Capital Budgeting Management
Capital Structure
What long-term How should the firm
Where will the firm manage its everyday
investments should
get the financing to financial activities?
the firm take?
pay for its
investments?

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 Content Overview

Chapter 1. Cost of Capital

Chapter 2. Capital Structure
Chapter 3. Capital Budgeting
Chapter 4. Dividend and Other Payouts
Chapter 5. Cash Management
Chapter 6. Credit and Inventory Management

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 Learning Schedule

Chapter 1 Chapter 3 Chapter 4 Chapter 6

Cost of Capital Capital Budgeting Dividends and Other Credit and Inventory
Payouts Management

Week 1 W2 W3 W4 W5 W6 W7 W8

Chapter 2 Chapter 5
Midterm Test 1 Midterm Test 2
Capital Structure Cash Management
& Revision
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 Learning Schedule
TOPIC TIMING Readings
Chapter 1. Cost of Capital Session 1 + 2 Chapter 13
Chapter 2. Capital Structure Session 3 + 4* Chapter 15, 16, 17
Chapter 3. Capital Budgeting Session 5 + 6 + 7* Chapter 18
MID-TERM TEST 1 Session 8
Chapter 4. Dividend and Other Payouts Session 9 Chapter 19
Chapter 5. Cash Management Session 10 + 11* Chapter 26, 27
Chapter 6. Credit and Inventory Management Session 12 + 13+ 14* Chapter 28
MID-TERM TEST 2 Session 15
Revision Session 16

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 Class Rules

• Questions are welcome anytime.

• Use your real fullname in Zoom and Classroom.

• Your webcam will be used as your attendance

check. No excuse!
Chapter 1
COST OF CAPITAL

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 Key Concepts and Skills

• Know how to determine a firm’s cost of equity capital

• Understand the impact of beta in determining the
firm’s cost of equity capital
• Know how to determine the firm’s overall cost of
capital
• Understand the impact of flotation costs on capital
budgeting

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 Where Do We Stand?

• Corporate Finance I on capital budgeting focused on the

appropriate size and timing of cash flows.
• This chapter discusses the appropriate discount rate
when cash flows are risky.

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 Chapter Outline
1. The Cost of Equity Capital
2. Estimation of Beta
3. Determinants of Beta
4. The Dividend Discount Model Approach
5. Cost of Fixed Income Securities
6. The Weighted Average Cost of Capital
7. Flotation costs

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 Part 1.
Cost of Equity Capital

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 1. The Cost of Equity Capital

Shareholder
Firm with invests in
Pay cash dividend
excess cash financial asset
A firm with excess cash can either pay a dividend
or make a capital investment

Shareholder’s
Invest in project Terminal Value

The discount rate of a project should be the expected return

on a financial asset of comparable risk.
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 The Cost of Equity Capital
• From the firm’s perspective, the expected return is
the Cost of Equity Capital (CAPM model):
R s  RF  (R M  RF )
• To estimate a firm’s cost of equity capital, we need to
know three things:
1. The risk-free rate, RF
2. The market risk premium, RM - RF
Cov (Ri , RM ) 
3. The company beta, i   i,M
Var(RM ) M2

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 The Risk-Free Rate

• Treasury securities are close proxies for the risk-free rate.

• The CAPM is a period model. However, projects are long-lived. So,
average period (short-term) rates need to be used.
• The historic premium of long-term (20-year) rates over short-term
rates for government securities is in the range of 1-2%.
• So, the risk-free rate to be used in the CAPM could be estimated as
2% below the prevailing rate on 20-year treasury securities.

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 Market Risk Premium

• Method 1: Use historical data

• Method 2: Use the Dividend Discount Model

Rs  D 1
g
P
– Market data and analyst forecasts can be used to implement the DDM
approach on a market-wide basis



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 Example
• Suppose the stock of Stansfield Enterprises, a publisher of
PowerPoint presentations, has a beta of 1.5. The firm is 100%
equity financed.
• Assume a risk-free rate of 3% and a market risk premium of 7%.
• What is the appropriate discount rate for an expansion of this
firm?

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 Example

Suppose Stansfield Enterprises is evaluating the following

non-mutually exclusive projects. Each costs $100 and lasts one year.

Project Project  Project’s

Estimated Cash
Flows Next Year

A 1.5 $125

B 1.5 $113.5

C 1.5 $105

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 Using the Security Market Line (SML)
SML

IRR
Project A

B
C
Firm’s risk (beta)

An all-equity firm should accept projects whose IRRs exceed the cost of
equity capital and reject projects whose IRRs fall short of the cost of
capital.
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 Part 2.
Estimation of Beta

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 2. Estimation of Beta

Beta of a security is the standardized covariance of a security's return

with the return on the market portfolio.

Market Portfolio - Portfolio of all assets in the economy. In practice, a

broad stock market index, such as the S&P 500, is used to
represent the market.

Beta - Sensitivity of a stock’s return to the return on the market

portfolio.

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 Estimation of Beta

Cov(Ri ,RM )

Var(RM )
• Problems
1. Betas may vary over time.
2. The sample size may be inadequate.
 are influenced by changing financial leverage and business risk.
3. Betas
• Solutions
– Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
– Problem 3 can be lessened by adjusting for changes in business and financial
risk.
– Look at average beta estimates of comparable firms in the industry.
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 Stability of Beta

• Most analysts argue that betas are generally stable for firms remaining in

the same industry.

• Does the beta of a firm stay the same if its industry stays the same?

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 Using an Industry Beta: Example

Imagine a financial executive at Computer Sciences estimate the firm’s

beta of 1.30. The average beta across all the firms in the software
industry is 1.08.
Assuming the risk-free rate of 1%, a risk premium of 7%, what is the
cost of equity capital?

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 Using an Industry Beta

• It is frequently argued that one can better estimate a firm’s beta by

involving the whole industry.
• If you believe that the operations of the firm are similar to the
operations of the rest of the industry, you should use the industry
beta.
• If you believe that the operations of the firm are fundamentally
different from the operations of the rest of the industry, you should
use the firm’s beta.
• Do not forget about adjustments for financial leverage.

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 Part 3.
Determinants of Beta

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 3. Determinants of Beta

• Business Risk
– Cyclicality of Revenues
– Operating Leverage
• Financial Risk
– Financial Leverage

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 Cyclicality of Revenues

• Highly cyclical stocks have higher betas.

– Empirical evidence suggests that retailers and automotive firms
fluctuate with the business cycle.
– Transportation firms and utilities are less dependent on the business
cycle.
• Note that cyclicality is not the same as variability—stocks with
high standard deviations need not have high betas.
– Movie studios have revenues that are variable, depending upon
whether they produce “hits” or “flops,” but their revenues may not be
especially dependent upon the business cycle.

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 Operating Leverage

• The degree of operating leverage measures how sensitive a firm (or

project) is to its fixed costs.
• Operating leverage increases as fixed costs rise and variable costs
fall.
• Operating leverage magnifies the effect of cyclicality on beta.
• The degree of operating leverage is given by:

DOL = D EBIT Sales

×
EBIT D Sales
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 Financial Leverage and Beta
• Operating leverage refers to the sensitivity to the firm’s fixed costs
of production.
• Financial leverage is the sensitivity to a firm’s fixed costs of
financing.
• The relationship between the betas of the firm’s debt, equity, and
assets is given by:
Debt Equity
Asset = Debt + Equity × Debt + Debt + Equity × Equity

• Financial leverage always increases the equity beta relative to

the asset beta.
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 Example

Consider Grand Sport, Inc., which is currently all-equity financed

and has a beta of 0.90.
The firm has decided to lever up to a capital structure of 1 part debt
to 1 part equity.
What is equity beta of the levered firm? Assume debt beta is zero.

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 Capital Budgeting & Project Risk

Suppose the Conglomerate Company has a breakdown of investment

projects as follows:
1/3 Automotive Retailer = 2.0
1/3 Computer Hard Drive Manufacturer  = 1.3
1/3 Electric Utility  = 0.6

Assume that the risk-free rate is 2%, the market risk premium is 7%.

When evaluating a new electrical generation investment,

which cost of capital should be used?
 Alternative: Dividend Discount Model

Rs  D 1
g
P
• The DDM is an alternative to the CAPM for calculating a
firm’s cost of equity.


• The DDM and CAPM are internally consistent, but

academics generally favor the CAPM and companies
seem to use the CAPM more consistently.
 Part 4.
Cost of Fixed Income Sercurities

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 Cost of Debt

• Interest rate required on new debt issuance (i.e., yield to maturity on

outstanding debt)
• Adjust for the tax deductibility of interest expense

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 Cost of Debt: Example

Shanken Corp. issued a 30-year, 5.9 percent semiannual bond 6 years ago. The bond
currently sells for 108 percent of its face value. The company’s tax rate is 35 percent.

a. What is the pretax cost of debt?

b. What is the aftertax cost of debt?

c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

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 Cost of Preferred Stock

• Preferred stock is a perpetuity, so its price is equal to the

coupon paid divided by the current required return.
• Rearranging, the cost of preferred stock is:
RP = C / PV
• There is no tax adjustment because dividends are not
tax deductible.

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 Cost of Preferred Stock: Example

The Saunders Investment Bank has 125,000 shares outstanding of

4 percent preferred stock with a current price of $79, and a par
value of $100.
What is the cost of preferred stock?

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 Part 5.
Weighted Average Cost of Capital

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 6. The Weighted Average Cost of Capital

• The Weighted Average Cost of Capital is given by:

RWACC = Equity × REquity + Debt × RDebt ×(1 – TC)

Equity + Debt Equity + Debt

S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B

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 WACC: Example

Consider Walt Disney Inc. whose has a market value of

$40 million and whose stock has a market value of $60
million (3 million outstanding shares of stock, each
selling for $20 per a share). The company pays a 5
percent rate of interest on its new debt and has a beta
of 1.41. The corporate tax rate is 34 percent. Assume
that market risk premium is 9.5%, current Treasury bill
rate is 1%.
What is the firm’s WACC?

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 2 Steps to determine WACC

• First, we estimate the cost of equity and the cost of debt.

– We estimate an equity beta to estimate the cost of equity.
– We can often estimate the cost of debt by observing the YTM of
the firm’s debt.
• Second, we determine the WACC by weighting these two costs
appropriately.

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 Valuation with WACC

• The value of the firm is the present value of expected

future (distributable) cash flow discounted at the WACC
• To find equity value, subtract the value of the debt from
the firm value

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 Example: International Paper Company

• The industry average beta is 0.82, the risk free rate is 2%, and the
market risk premium is 7%. The yield on the company’s debt is 5%,
and the firm has a 35% marginal tax rate. The debt to value ratio is
32%.
• What is International Paper’s cost of capital?
• Which rate should the company use to discount project’s cashflow?
 Project Evaluation: Example

Suppose International Paper is considering taking on a

warehouse renovation costing $60 million that is
expected to yield aftertax cost savings of $12 million a
year for six years. Should the firm take on the
warehouse renovation?
 Part 6.
Flotation Costs

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 Flotation Costs

• Flotation costs represent the expenses incurred upon the issue, or

float, of new bonds or stocks.
• These are incremental cash flows of the project, which typically
reduce the NPV since they increase the initial project cost (i.e., CF0).
Amount Raised = Necessary Proceeds / (1-% flotation cost)
• The % flotation cost is a weighted average based on the average
cost of issuance for each funding source and the firm’s target capital
structure:
fA = (E/V)* fE + (D/V)* fD

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 Flotation Costs: Example 1

Spatt Company, an all-equity firm, has a cost of equity of 20%. Spatt is

contemplating a large-scale $100 million expansion of its existing operations.
The expansion would be funded by selling new stock.

Based on conversations with its investment banker, Spatt believes its flotation costs
will run 10 percent of the amount issued. When flotation costs are considered,
what is the cost of the expansion?

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 Flotation Costs: Example 2

Suppose Spatt’s target capital structure is 60 percent equity, 40 percent debt. The
flotation costs associated with equity are still 10 percent, but the flotation costs for
debt are 5 percent.

Spatt is contemplating a large-scale $100 million expansion of its existing

operations. The expansion would be funded by selling new stock.

When flotation costs are considered, what is the cost of the expansion?

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 Flotation Costs and Internal Equity

• In reality, most firms rarely sell equity at all.

• Instead, their internally generated cash flow is sufficient to cover the equity
portion of their capital spending.

• Only the debt portion must be raised externally.

 We assign a value of zero to the flotation cost of equity because there is

such cost.

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 ● How do we determine the cost of equity capital?
● How can we estimate a firm or project beta?
Quick Quiz ● How does leverage affect beta?
● How do we determine the weighted average
cost of capital?
● How do flotation costs affect the capital
budgeting process?

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