CF AfterMT Updated

Capital Budgeting – I
CORPORATE FINANCE: SESSIONS 11-12

IIM Bangalore, PGP 2020-2022, Term 2
Prof. Varun Jindal

Office: D-008
Email: varun.jindal@iimb.ac.in
Note: This slide deck should solely be used as class notes only by PGPM/PGPBA students of Sections B and F, Academic Year 2020-21, at IIM Bangalore.
Please do not post it on any online public forum.
Agenda
• Net Present Value vs. Internal Rate of Return
• Incremental Cash Flows
• Problems With Payback
Reading:
• BM Chapter 5 - Sections 5.1, 5.2, and 5.3
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Techniques for Evaluating Investment Projects
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback Period
• Book (Accounting) Rate of Return
An investment rule will lead to inferior decisions if it

• Doesn’t consider time value of money
• Gets affected by tastes of managers
• Gets influenced by choices of accounting method
• Depends on the profitability of the company’s existing business
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Techniques for Evaluating Investment Projects: A Survey of CFOs
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial
Economics 60 (2001), pp. 187-243.
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NPV: A Quick Review
• NPV recognizes the time value of money
– A dollar today is worth more than a dollar tomorrow
• NPV depends solely on the forecasted cash flows from the project and the
opportunity cost of capital
– NPV uses cash flows
– NPV uses all the cash flows of the project
– NPV discounts the cash flows properly
• A project with a positive NPV increases shareholder value and one with a
negative NPV decreases shareholder value
NPV: A Quick Review [contd.]

• NPVs can be added-up because these are all measured in today’s dollars
NPV(A + B) = NPV(A) + NPV(B)
– The package of a good and a bad project is worse than the good project on its own
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Book/Accounting Rate of Return
• Average book income divided by average book value over project life
Book Income
Book Rate of Return =
Book Assets
• Acceptance Criterion
– Accept projects that give book rate of return ≥ required rate of return (set by management)
• Advantages
– Simple to use; needs only accounting information
• Disadvantages
– Ignores time value of money
– Influenced by accounting rules and taxes
Payback Period
• How long does it take a project to “pay back” or recover its initial investment?
– Number of years before cumulative cash flow equals initial outlay
– Accept projects that have payback period ≤ specified cutoff period (set by management)
• Advantages
– Easy to understand and calculate
– Biased towards liquidity
• Disadvantages
– Ignores all cash flows after the cut-off date (biased against long-term projects)
– Gives equal weight to all cash flows before the cut-off date (ignores time value of money)
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Payback Period: An Example
Payback
Project C0 C1 C2 C3 NPV@10%
Period
A −2000 500 500 5000
B −2000 500 1800 0
C −2000 1800 500 0
Payback Period: An Example [contd.]

What do you think is the mistake we would make if we insisted on only taking
projects with a payback period of 2 years or less?
Payback
Period
3 +2624
A −2000 500 500 5000
2 −58
B −2000 500 1800 0
2 +50
C −2000 1800 500 0
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Payback Period: An Example [contd.]
projects with a payback period of 2 years or less?
Payback
Period
3 +2624
A −2000 500 500 5000
(Reject) (Accept)
2 -58
B −2000 500 1800 0
(Accept) (Reject)
2 +50
C −2000 1800 500 0
(Accept) (Accept)
– Project A, which should have been accepted (based on the NPV), is rejected
– Project B, which should have been rejected (based on NPV), is accepted
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Discounted Payback Period

• How long does it take a project to “pay back” its initial investment, taking the
time value of money into account?
– Accept projects that have discounted payback period ≤ specified cutoff period (set by
management)
• Advantages
– Will never accept a negative NPV project*
– Biased towards liquidity
• Disadvantages
– Ignores all cash flows after the cut-off date (biased against long-term projects)
* Holds for conventional investment projects that have a cash outflow followed by one or more cash inflows
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Discounted Payback Period: An Example
Discounted
Project C0 C1 C2 C3 Payback NPV@10%
Period
A −2000 500 500 5000
B −2000 500 1800 0
C −2000 1800 500 0
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Discounted Payback Period: An Example [contd.]

projects with a payback period of 2 years or less? Assume that opportunity cost of
capital is 10%.
Discounted
PV of PV of PV of PV of
Project Payback NPV@10%
C0 C1 C2 C3
Period
3 +2624
A −2000 455 413 3757
− −58
B −2000 455 1488 0
2 +50
C −2000 1636 413 0
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Discounted Payback Period: An Example [contd.]
projects with a payback period of 2 years or less? Assume that opportunity cost of
capital is 10%.
Discounted
PV of PV of PV of PV of
Project Payback NPV@10%
C0 C1 C2 C3
Period
3 +2624
A −2000 455 413 3757
(Reject) (Accept)
− −58
B −2000 455 1488 0
(Reject) (Reject)
2 +50
C −2000 1636 413 0
(Accept) (Accept)
– Project A, which should have been accepted (based on the NPV), is rejected
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Internal Rate of Return (IRR)

• IRR is defined as the discount rate that makes NPV = 0
– Accept projects for which IRR > opportunity cost of capital
• Advantages
– Considers time value of money
– Easy to understand and communicate
• Disadvantages
– Does not distinguish between investing and borrowing
– IRR may not exist, or there may be multiple IRRs
– Problems with mutually exclusive investments
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IRR: An Example
You can purchase a turbo powered machine tool gadget for $4,000. The investment
will generate $2,000 and $4,000 in cash flows at the end of one and two years from
today, respectively. What is the IRR on this investment?
NPV ($)
0 1 2 3,000
2,000
−4000 +2000 +4000
IRR = 28.08%
1,000
2,000 4,000
NPV = −4,000 + + =0 0 Discount Rate (%)
(1 + IRR) (1 + IRR)
-1,000
⇒ IRR = 28.08% -2,000
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IRR, Opportunity Cost of Capital, and NPV

NPV and IRR rules give the same answer about
IRR is a profitability measure
accepting/rejecting a project as long as the project’s NPV that depends solely on the
is a smoothly declining function of the discount rate amount and timing of the
project cash flows
• If IRR > Opportunity cost of capital ⇒ + NPV Opportunity cost of capital is

the expected return that
investors can achieve in
financial markets at the same
• If IRR = Opportunity cost of capital ⇒ 0 NPV level of risk. It depends on
the risk of the proposed
investment project
• If IRR < Opportunity cost of capital ⇒ − NPV
IRR Vs. Opportunity Cost of
Capital
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IRR Pitfall 1: Investing (Lending) Vs. Borrowing
Project C0 C1 IRR NPV@10%
D
−1,000 +1,500 +50% +364
(Investing or Lending)
E
+1,000 −1,500 +50% −364
(Borrowing)
• The IRR method cannot distinguish between investing and borrowing

– With increase in discount rate, NPV of Project D decreases and NPV of Project E increases
– When you invest in a project/lend money, you want a high rate of return
– When you borrow money, you want a low rate of return
– In the case of borrowing, you accept the project if IRR < opportunity cost of capital
• NPV of the loan is positive only if the cost of capital is > 50%.
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IRR Pitfall 2: Multiple IRRs or No IRR

Project F involves an initial investment of $30 billion and is expected to produce a
cash inflow of $10 billion at the end of each year for the next nine years. At the
end of the tenth year, it will incur $65 billion of cleanup costs.
Project C0 C1 C2 C3 C4 C5 C6 C7 C8 C9 C10
F −30 +10 +10 +10 +10 +10 +10 +10 +10 +10 −65
– There can be as many different solutions to

a polynomial as there are changes of sign
– Since there are 2 changes of sign, there

can be up to 2 IRRs for this project
– NPV is 0 when IRR is either 3.5% or

19.54%
• Take up the project if the opportunity cost
of capital is between 3.5% and 19.54%
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IRR Pitfall 2: Multiple IRRs or No IRR [contd.]
• Is it possible to get around the problem of multiple IRRs?
– Yes, by discounting the later cash flows back at the cost of capital until there remains only
one change in the sign of the cash flows
– A modified internal rate of return (MIRR) can then be calculated on this revised series
Project C0 C1 C2 C3 C4 C5 C6 C7 C8 C9 C10
F −30 +10 +10 +10 +10 +10 +10 +10 +10 +10 −65
Value at t=5 of all cash flows from year 5 to year 10 = 1.34

(discounted at 10%, the cost of capital)
Project C0 C1 C2 C3 C4 C5
F −30 +10 +10 +10 +10 +1.34
– Since there is now only one change in the sign of the cash flows, the revised series has a
unique rate of return, which is 13.7%
– Since the MIRR of 13.7% is greater than the cost of capital, the project has a positive NPV
when valued at the cost of capital
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IRR Pitfall 2: Multiple IRRs or No IRR [contd.]

• In addition to the problem of multiple IRRs, sometimes a project may not have
an IRR
Project C0 C1 C2 IRR NPV@10%

G +1,000 −3,000 +2,500 None +339
– Project G has a positive NPV at all discount rates

– No IRR exists for Project G
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IRR Pitfall 3A: Mutually Exclusive Projects – Difference in Scale of Investment
• Firms often have to choose between several alternative ways of doing the same
job or using the same facility.
– e.g. Either Project H or Project I, but not both.
NPV
Project C0 C1 IRR
@10%
H −10,000 +20,000 100% +8,182
I −20,000 +35,000 75% +11,818
• Project I has a higher NPV, but Project H has a higher IRR!
• IRR is unreliable in ranking projects that differ in the scale of investment.
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IRR Pitfall 3A: Mutually Exclusive Projects – Difference in Scale of Investment

• Can you somehow use IRR to compare projects that differ in scale of investment?
If yes, how?
– Look at the IRR on the incremental cash flows!
NPV
Project C0 C1 IRR
@10%
H −10,000 +20,000 100% +8,182
I −20,000 +35,000 75% +11,818
I−H −10,000 +15,000 50% +3,636
– IRR on the incremental investment is 50%, which is well in excess of the 10% opportunity
cost of capital
– So you should prefer Project I to Project H.
Note: Incremental cash flow trick can be used only if Projects H

and I have the same risk and hence the same cost of capital.
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IRR Pitfall 3B: Mutually Exclusive Projects – Difference in Cash Flow Pattern
Project C0 C1 C2 C3 C4 C5 Etc. IRR NPV@10%
J −9,000 +6,000 +5,000 +4,000 0 0 … 33% +3,582
K (perpetuity) −9,000 +1,800 +1,800 +1,800 +1,800 +1,800 … 20% +9,000
• Project K has a higher NPV, but project J

has a higher IRR!
• IRR is unreliable in ranking projects that

have different economic lives (or offer
Project J
different pattern of cash flows over time)
Project K
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IRR Pitfall 3B: Mutually Exclusive Projects – Difference in Cash Flow Pattern
• Can you somehow use IRR to compare projects that differ in economic life? If
yes, how?
– Look at the IRR on the incremental cash flows!
Project C0 C1 C2 C3 C4 C5 Etc. IRR NPV@10%
J −9,000 +6,000 +5,000 +4,000 0 0 … 33% +3,582
K (perpetuity) −9,000 +1,800 +1,800 +1,800 +1,800 +1,800 … 20% +9,000
K−J 0 −4,200 −3,200 −2,200 +1,800 +1,800 … 15.6% +5,408
– The IRR on the incremental cash flows from Project K is 15.6%, which is well in excess of
the 10% opportunity cost of capital.
– So you should prefer Project K to Project J.
Note: Incremental cash flow trick can be used only if Projects J

and K have the same risk and hence the same cost of capital.
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IRR Pitfall 4: When There Is More Than One Opportunity Cost of Capital
• We have so far assumed that the opportunity cost of capital is the same for all
the cash flows, C1, C2, C3, etc.
– The differences between short- and long-term discount rates can be important when the
term structure of interest rates is not “flat.”
• Remember our most general formula for calculating NPV:

𝐶 𝐶 𝐶
NPV = 𝐶0 + + + +⋯
1 + 𝑟1 (1 + 𝑟2) (1 + 𝑟3)
• The IRR rule tells us to accept a project if the IRR is greater than the
opportunity cost of capital. But what do we do when we have several
opportunity costs?
– Do we compare IRR with r1, r2, r3, . . .?
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NPV Vs. IRR

• NPV and IRR will generally give the same decision for an investment project with
an initial cash outflow followed by a series of cash inflows.
• IRR may fail under the following circumstances:

– Projects with positive initial cash flow (i.e., a positive C0)
• Workaround: Accept projects that have IRR < opportunity cost of capital
– Projects with cash flows that change sign more than once (multiple IRRs)
• Workaround: Use MIRR (Modified IRR) to overcome it (not applicable when there is no IRR)
– Mutually exclusive projects differing in their scale of investment or pattern of cash flows
• Workaround: Use incremental cash flows to overcome it (provided the projects have the
same risk)
– When the cost of capital for near-term cash flows is different from that for distant cash
flows
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Summary − Payback Rule
• Payback Period
– Length of time until initial investment is recovered
– Take the project if it pays back in some specified period
– Does not account for time value of money, and there is an arbitrary cutoff period
• Discounted Payback Period

– Length of time until initial investment is recovered on a discounted basis
– Take the project if it pays back in some specified period
– There is an arbitrary cutoff period
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Summary − Discounted Cash Flow Techniques

• NPV
– Difference between market value and cost
– Accept the project if the NPV is positive
– Has no serious problems
– Preferred decision criterion
• IRR
– Discount rate that makes NPV = 0
– Take the project if the IRR is greater than the required return
– Same decision as NPV with conventional cash flows
– IRR is unreliable with non-conventional cash flows or mutually exclusive projects
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Assigned Problems
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Assigned Problem: BM Chapter 5, Problem 8

Consider the following projects:
Cash Flows ($)
Project C0 C1 C2 C3 C4 C5
A -1000 1000 0 0 0 0
B -2000 1000 1000 4000 1000 1000
C -3000 1000 1000 0 1000 1000
a. If the opportunity cost of capital is 10%, which projects have a positive NPV?
b. Calculate the payback period for each project.
c. Which project(s) would a firm using the payback rule accept if the cutoff period
were three years?
d. Calculate the discounted payback period for each project.
e. Which project(s) would a firm using the discounted payback rule accept if the
cutoff period were three years?
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Solution to Assigned Problem: BM Chapter 5, Problem 8
Cash Flows ($)

De c i sion Bas e d on
Proj e c t C0 C1 C2 C3 C4 C5 NPV@10% Payback
Payback <=3 ye ars
A -1000 1000 0 0 0 0 -90.91 1 Accept
B -2000 1000 1000 4000 1000 1000 4044.73 2 Accept
C -3000 1000 1000 0 1000 1000 39.47 4 Reject
Year 0 1 2 3 4 5
Cash Flows ($)
PV of PV of PV of PV of PV of PV of Disc ounte d De c i sion Bas e d on
Proj e c t
C0 C1 C2 C3 C4 C5 Payback Di sc ounte d Payback <=3 ye ars
A -1000 909 0 0 0 0 - Reject
B -2000 909 826 3005 683 621 2.09 Accept
C -3000 909 826 0 683 621 4.94 Reject
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Mr. Cyrus Clops, the president of Giant Enterprises, has to make a choice between
two possible investments:
Cash Flows ($ thousands)
Project C0 C1 C2 IRR (%)
A -400 250 300 23
B -200 140 179 36
The opportunity cost of capital is 9%. Mr. Clops is tempted to take B, which has
the higher IRR.
a. Explain to Mr. Clops why this is not the correct procedure.
b. Show him how to adapt the IRR rule to choose the best project.
c. Show him that this project also has the higher NPV.
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• Recall that IRR rule is unreliable in ranking mutually exclusive projects that differ in the scale of
investment!
– Because Project A requires a larger initial investment, it is possible that Project A has both a lower IRR
and a higher NPV than Project B.
• Because the financial goal of a corporation is to maximize shareholder wealth, the application of
NPV rule gives the correct answer
• To use the IRR rule for mutually exclusive projects, calculate the IRR for the incremental cash flows
Cas h Fl ows ($ thousands)

Proje c t C0 C1 C2 IR R NPV@9%
A -400 250 300 23% 81.86
B -200 140 179 36% 79.10
A-B -200 110 121 10% 2.76
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Solution to Assigned Problem: BM Chapter 5, Problem 12 [contd.]

• Recall that IRR rule is unreliable in ranking mutually exclusive projects that differ in the scale of
investment!
– Because Project A requires a larger initial investment, it is possible that Project A has both a lower IRR
and a higher NPV than Project B.
• Because the financial goal of a corporation is to maximize shareholder wealth, the application of
NPV rule gives the correct answer
• To use the IRR rule for mutually exclusive projects, calculate the IRR for the incremental cash flows
Cas h Fl ows ($ thousands)

Proje c t C0 C1 C2 IR R NPV@9%
A -400 250 300 23% 81.86
B -200 140 179 36% 79.10
A-B -200 110 121 10% 2.76
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The Titanic Shipbuilding Company has a noncancelable contract to build a small
cargo vessel. Construction involves a cash outlay of $250,000 at the end of each
of the next two years. At the end of the third year the company will receive
payment of $650,000. The company can speed up construction by working an
extra shift. In this case there will be a cash outlay of $550,000 at the end of the
first year followed by a cash payment of $650,000 at the end of the second year.
Use the IRR rule to show the (approximate) range of opportunity costs of capital at
which the company should work the extra shift.
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Plot of
Project C0 C1 C2 C3
-6x2 + 6x - 1 = 0
A (Normal) 0 -250 -250 650
B (Extra Shift) 0 -550 650 0
B-A 0 -300 900 -650
IRR (x) of the incremental project B – A can be found by x = 0.2113 x = 0.7887
−300 900 −650

0+ + + =0
1 + 𝑥 (1 + 𝑥) (1 + 𝑥)
50(−6𝑥2 + 6𝑥 − 1)
⟹ =0
(1 + 𝑥)
⟹ 𝑥 = 0.2113, 0.7887
NPV of B – A is +ve when x > 21.13% and when x<78.87%
Extra shift makes sense if the cost of capital is between 21.13% and 78.87%
Graph drawn using www.mathpapa.com
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Note that NPV is negative for both projects A and B when the cost of capital exceeds 18.82%.
NPV @
IRR
Project 18.18% 18.82% 21.13% 25% 50% 78.87% 80%
A (Normal) 18.82% 3.3 0.0 -11.0 -27.2 -85.2 -104.3 -104.6
B (Extra Shift) 18.18% 0.0 -2.5 -11.1 -24.0 -77.8 -104.3 -104.9
B-A 21.13% & 78.87% -3.3 -2.5 0.0 3.2 7.4 0.0 -0.3
However, NPV is less negative for Project B than it is for project A when the cost of capital lies
between 21.13% and 78.87%. The incremental project B – A has a +ve NPV in this range.
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Thank You
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Capital Budgeting – II
CORPORATE FINANCE: SESSIONS 12-15
Prof. Varun Jindal

Office: D-008
Agenda
• Project Cash Flows, Tax, and Inflation
• EACs: Projects With Different Lives and Different Scales
Reading:
• BM Chapter 6
1
Applying NPV Rule Correctly: Rule 1 of 4
Rule 1: Only cash flow is relevant
• NPV depends on future net cash flow.
– Net Cash Flow = Cash Inflow – Cash Outflow
• Do not confuse cash flow with accounting income.

– Purpose of accounting income: To show how well a firm is performing
– Preparation of accounting income: Involves adjusting cash flows for capital expenses and
working capital
Preparation of Accounting Income: Adjustment for Capex

• When calculating expenditures, the accountant deducts current expenses but
does not deduct capital expenses (capex).
• Instead of deducting capex as it occurs, the accountant depreciates the outlay

over several years.
2
Preparation of Accounting Income: Adjustment for Capex [contd.]
• Example: An investment proposal costs $2,000 and is expected to provide a cash
flow of $1,500 in the first year and $500 in the second. If the capital
expenditure is depreciated equally over the two years, what is the accounting
income in the first two years?
Year 1 Year 2
Cash Inflow ($) +1,500 +500
Less Depreciation ($) −1,000 −1,000
Accounting Income ($) +500 −500
• Conversely, If you are given accounting income, you can determine cash flow by
1) Adding back depreciation*
2) Subtracting capex
* Note: Although depreciation is a non-cash expense, it affects the tax that a company pays (which is a cash expense).
Preparation of Accounting Income: Adjustment for Working Capital

• When measuring income, accountants show profit as it is earned, rather than
when the customers pay their bills
• Example: What is the accounting income for the following firm?

– Year 1: A firm spends $60 to produce goods $60 goes out $100 comes in
– Year 2: The firm sells these goods for $100 on credit

Year 3
– Year 3: Firm’s customers pay their bills Year 1 Year 2
• How will an accountant record these transactions?

– Year 1: Inventory↑ Cash↓
– Year 2: Revenue ↑ AR↑ Inventory↓ COGS ↑
– Year 3: AR↓ Cash ↑
3
Preparation of Accounting Income: Adjustment for Working Capital [contd.]
Year 1 Year 2 Year 3
Revenue ($) − 100 −
Less Cost of Goods Sold ($) − −60 −
Accounting Income ($) − 40 −
• Conversely, If you are given accounting income, you can determine cash flow by
1) Subtracting increase in inventories
2) Subtracting increase in account receivables
Year 1 Year 2 Year 3
Accounting Income 0 +40 0
Less Increase in Inventories −60 +60 −
Less Increase in Account Receivables − −100 +100
Net Cash Flow −60 0 +100
Preparation of Accounting Income: Adjustment for Working Capital [contd.]

• Similarly, changes in short-term liabilities (accounts payables, taxes payable)
also affect the cash flow.
– Increase in short-term liabilities needs to be added to the accounting income to arrive at the
cash flow
• The difference between a company’s short-term assets and short-term liabilities

is called net working capital or simply working capital.
– Most projects require an investment in working capital (i.e., working capital is a positive
figure for most projects)
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Arriving at Cash Flow from Accounting Income: Summary of Adjustments
To arrive at the net cash flow from accounting income
1) Add depreciation
2) Subtract capex (net of disposal)
3) Subtract increase in working capital
Alternatively,
Net Cash Flow = Profit After Tax + Depreciation +
Cash Flow from Capital Investment and Disposal +
Cash Flow from Changes in Working Capital
Note:
• Cash inflow will have a +ve sign and cash outflow will have a –ve sign.
A Note About Working Capital

• Working capital may change during the life of the project
– Increase in sales usually requires an additional investment in working capital (cash outflow)
• Working capital is recovered at the end of the project

– When the project comes to an end, you recover your investment in working capital (cash
inflow)
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Rule 2: Estimate cash flows on an incremental basis
The value of a project depends on all the additional cash flows that follow from
project acceptance.
• Remember to include taxes

– Taxes are an expense just like wages and raw materials.
– Therefore, cash flows should be estimated on an after-tax basis.
• Do not confuse average payoff with incremental payoffs

– A division with an outstanding past profitability record may have run out of good
opportunities (Average Payoff = Positive; Incremental Payoff = Negative)
– A division laden with losses may have turnaround opportunities in which the incremental
NPV from investing is positive (Average Payoff = Negative; Incremental Payoff = Positive)
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Applying NPV Rule Correctly: Rule 2 of 4 [contd.]

• Include all incidental effects (i.e., project’s effects on the firm’s existing business)
– A firm’s new project may cannibalize the sales of its existing business (negative incidental effect)
– A firm’s new project may help the firm’s existing business (positive incidental effect)
• Forecast sales today and recognize after-sales cash flows to come later
– Include all incremental cash flows generated by an investment
– e.g. cash flows from services and spare parts
• Forget sunk cost

– Sunk costs are past and irreversible outflows
– Decision to accept/reject the project will not affect the sunk cost, therefore it should be ignored
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• Include opportunity cost
– The cost of a resource (i.e., its opportunity cost) may be relevant to the investment decision
even when no cash changes hands
– Do not judge projects on the basis of “before versus after”
– The proper comparison is “with versus without”
– Note: The opportunity cost of a freely traded resource is simply equal to its market price
Before versus After With versus Without
– In the example above, the firm gives up $100,000 by undertaking the project
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• Beware of allocated overhead costs
– The principle of incremental cash flows says that in investment appraisal we should include only
the extra expenses (incremental increase in fixed costs) that would result from the project
– The accountant’s allocation of overheads may not represent the true extra expenses that would
be incurred
– If a project is not going to result in extra expenses, the allocated overhead costs should not be
included
• Remember salvage value

– The salvage value (net of any taxes) represents a positive cash flow to the firm
– Note: If an equipment is sold, you have to pay tax on the difference between the sale price and
the book value of the asset
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Stop and Apply: Incremental Cash Flows
Which of the following should be treated as incremental cash flows when deciding whether
to invest in a new manufacturing plant? The site is already owned by the company, but
existing buildings would need to be demolished.
a. The market value of the site and existing buildings Yes

b. Demolition costs and site clearance Yes
c. The cost of a new access road put in last year No
d. Lost earnings on other products due to executive time spent on the new facility Yes
e. A proportion of the cost of leasing the president’s jet airplane No
f. Future depreciation of the new plant No
g. The reduction in the corporation’s tax bill resulting from tax depreciation of the new
plant Yes
h. The initial investment in inventories of raw materials Yes
i. Money already spent on engineering design of the new plant No
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Rule 3: Treat inflation consistently
• Use nominal interest rates to discount nominal cash flows
• Use real interest rates to discount real cash flows
• You will get the same results, whether you use nominal or real figures
Note: Interest rates are usually quoted in nominal rather than real terms
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Applying NPV Rule Correctly: An Example of Rule 3’s Application
You invest in a project that will require a cash outlay of $100 today, and it will
produce real cash flows of $35, $50, and $30 at the end of years 1, 2, and 3,
respectively. If the nominal discount rate is 15% and the inflation rate is 10%,
what is the NPV of the project?
Two options:
• Option 1: Restate the cash flows in nominal terms and discount them at 15%
• Option 2: Restate the discount rate in real terms and use it to discount the real
cash flows
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Applying NPV Rule Correctly: An Example of Rule 3’s Application [contd.]

• Option 1: Using nominal figures
Year Nominal Cash Flow
0 -100
1 35 * 1.10 = 38.50
2 50 * 1.102 = 60.50
3 30 * 1.103 = 39.93
NPV @ 15% $5.5
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9
Applying NPV Rule Correctly: An Example of Rule 3’s Application [contd.]
• Option 2: Using real figures
(1 + Nominal Interest Rate)
Real Interest Rate = −1
(1 + Inflation Rate)
(1 + 0.15)
Real Interest Rate = − 1 = 4.5%
(1 + 0.10)
Year Real Cash Flow

0 -100
1 35
2 50
3 30
NPV @ 4.5% $5.5
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19

Rule 4: Separate investment and financing decisions
• Focus exclusively on the project cash flows, not the cash flows associated with
alternative financing scheme
– Regardless of financing, treat all cash outflows required for the project as coming from
shareholders
– Regardless of financing, treat all cash inflows from the project as going to shareholders
• This approach boils down to asking whether a project has a positive NPV
assuming all equity-financing
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10
Example: Proposal for Marketing Guano as a Garden Fertilizer
• The project requires an investment of $10,000K in plant and machinery.
• This machinery can be dismantled and sold for net proceeds estimated at $1,949K in year 7.
• The capital investment was initially depreciated using straight line method over 6 years to an
arbitrary salvage value of $500K, which is less than your forecast of salvage value.
• If the equipment is sold, you must pay tax @35% on the difference between the sale price and
the net book value of the asset.
• Refer to forecasts in the table on the next slide. All the entries are nominal amounts.
• The nominal opportunity cost of capital for projects of similar risk has been estimated as 20%.
• Is this investment worth undertaking?

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Example: Proposal for Marketing Guano as a Garden Fertilizer [contd.]

Guano project projections ($ thousands) reflecting inflation and assuming straight line depreciation
0 1 2 3 4 5 6 7
1 Capital investment 10,000 -1,949
2 Accumulated depreciation
3 Year-end book value
4 Working capital 550 1,289 3,261 4,890 3,583 2,002
5 Total book value (3 + 4)
6 Sales 523 12,887 32,610 48,901 35,834 19,717
7 Cost of goods sold 837 7,729 19,552 29,345 21,492 11,830
8 Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
9 Depreciation
10 Pretax profit (6 - 7 - 8 - 9)
11 Tax at 35%
12 Profit after tax (10 - 11)
Income Statement
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22
11
0 1 2 3 4 5 6 7
2 Accumulated depreciation 1,583 3,167 4,750 6,333 7,917 9,500

3 Year-end book value 10,000 8,417 6,833 5,250 3,667 2,083 500
4 Working capital 550 1,289 3,261 4,890 3,583 2,002
5 Total book value (3 + 4) 8,967 8,122 8,511 8,557 5,666 2,502
6 Sales 523 12,887 32,610 48,901 35,834 19,717
8 Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
9 Depreciation 1,583 1,583 1,583 1,583 1,583 1,583
10 Pretax profit (6 - 7 - 8 - 9) -4,000 -4,097 2,365 10,144 16,509 11,148 4,532 1,449
11 Tax at 35% -1,400 -1,434 828 3,550 5,778 3,902 1,586 507
12 Profit after tax (10 - 11) -2,600 -2,663 1,537 6,593 10,731 7,246 2,946 942
Note: In this example, losses from Guano project have been used to offset the firm’s taxable income from other profitable projects.
If Guano was the firm’s only project, the firm could carry forward its losses to offset its future taxable income from the Guano project.
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23

0 1 2 3 4 5 6 7

3 Year-end book value 10,000 8,417 6,833 5,250 3,667 2,083 500
4 Working capital 550 1,289 3,261 4,890 3,583 2,002
5 Total book value (3 + 4) 8,967 8,122 8,511 8,557 5,666 2,502
6 Sales 523 12,887 32,610 48,901 35,834 19,717
8 Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
9 Depreciation 1,583 1,583 1,583 1,583 1,583 1,583
10 Pretax profit (6 - 7 - 8 - 9) -4,000 -4,097 2,365 10,144 16,509 11,148 4,532 1,449
11 Tax at 35% -1,400 -1,434 828 3,550 5,778 3,902 1,586 507
12 Profit after tax (10 - 11) -2,600 -2,663 1,537 6,593 10,731 7,246 2,946 942
Had Guano been the only project with the firm, in which year would the firm have first paid its taxes?
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12
Operating Cash Flow (OCF)
• Bottom-Up Approach
– OCF = Profit After Tax + Depreciation
• Top-Down Approach
– OCF = Sales – Cash Expenses – Taxes
• Tax Shield Approach

– OCF = (Sales – Cash Expenses) * (1 – Tax Rate) + Depreciation * Tax Rate
Note:
• Depreciation and amortization, being non-cash expenses, should NOT be included in cash expenses
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Example: Computing Operating Cash Flows

Bottom-up approach for computing OCF Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
13 Profit after tax -2,600 -2,663 1,537 6,593 10,731 7,246 2,946
14 Depreciation 1,583 1,583 1,583 1,583 1,583 1,583
15 Operating cash flow (OCF) (13 + 14) -2,600 -1,080 3,120 8,177 12,314 8,829 4,529
Top-down approach for computing OCF

16 Sales 523 12,887 32,610 48,901 35,834 19,717
17 Cash expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602
18 Taxes -1,400 -1,434 828 3,550 5,778 3,902 1,586
19 Operating cash flow (OCF) (16 - 17 - 18) -2,600 -1,080 3,120 8,177 12,314 8,829 4,529
Tax shield approach for computing OCF

20 Sales 523 12,887 32,610 48,901 35,834 19,717
21 Cash expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602
22 (Sales - Cash expenses) * (1 - Tax rate) -2,600 -1,634 2,566 7,623 11,760 8,275 3,975
23 Tax shield = Depreciation * Tax rate 554 554 554 554 554 554
24 Operating cash flow (OCF) (22 + 23) -2,600 -1,080 3,120 8,177 12,314 8,829 4,529
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13
Net Cash Flow
Net Cash Flow = Operating Cash Flow +
Cash Flow from Capital Investment and Disposal +
Cash Flow from Changes in Working Capital
27
27
Example: Computing Net Cash Flow and NPV
Computing NCF Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
25 Operating cash flow (OCF) -2,600 -1,080 3,120 8,177 12,314 8,829 4,529
26 Cash flow from capital investment and disposal -10,000 1,442
27 Cash flow from change in working capital -550 -739 -1,972 -1,629 1,307 1,581 2,002
28 Net cash flow (25 + 26 + 27) -12,600 -1,630 2,381 6,205 10,685 10,136 6,110 3,444
NPV @ 20%
29 NPV 3,520
Note: The working capital of $2,002

is recovered at the end of the project.
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14
Why is Depreciation Important?
• Depreciation is a noncash expense; it is important only because it reduces
taxable income.
– It provides an annual tax shield equal to the product of the depreciation expense and the
marginal tax rate.
– Tax Shield = Depreciation Expense * Tax Rate
• What is the present value of the tax shield in the Guano project at a discount
rate of 20%?
– Tax shield for each year (for 6 years) = $1,583K * 0.35 = $554K
– PV of tax shield for 6 years = $1,842K
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Effect of Depreciation Method on Tax Shield and NPV

• What happens to the PV of tax shield and NPV of the project if we switch from
straight-line depreciation to accelerated depreciation method?
– You are now realizing the benefits of the tax shield earlier than you would have realized
under the straight-line method. Thus, now the PV of tax shield goes up.
• Example: Assume the following accelerated (MACRS) depreciation schedule for

the Guano project. What will be the value of the tax shield now (discount rate =
20%)? Will the NPV increase, decrease, or remain the same?
1 2 3 4 5 6
Depreciation (%) 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
Depreciation 2,000 3,200 1,920 1,152 1,152 576
Tax Shield 700 1,120 672 403 403 202
= Depreciation * Tax Rate
– PV of Tax shield = $2,174K ($332K) higher than under the straight-line method)
– NPV will increase on account of higher tax shield under accelerated depreciation
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15
Effect of Depreciation Method on Tax Shield and NPV [contd.]
Guano project projections ($ thousands) reflecting inflation and assuming accelerated depreciation
0 1 2 3 4 5 6 7

3 Year-end book value 10,000 8,000 4,800 2,880 1,728 576 0
4 Working capital 550 1,289 3,261 4,890 3,583 2,002
5 Total book value (3 + 4) 8,550 6,089 6,141 6,618 4,159 2,002
6 Sales 523 12,887 32,610 48,901 35,834 19,717
8 Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
9 Depreciation 2,000 3,200 1,920 1,152 1,152 576
10 Pretax profit (6 - 7 - 8 - 9) -4,000 -4,514 748 9,807 16,940 11,579 5,539 1,949
11 Tax at 35% -1,400 -1,580 262 3,432 5,929 4,053 1,939 682
12 Profit after tax (10 - 11) -2,600 -2,934 486 6,375 11,011 7,526 3,600 1,267
MACRS Depreciation Schedule 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
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Effect of Depreciation Method on Tax Shield and NPV [contd.]
Top-down approach for computing OCF Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
16 Sales 523 12,887 32,610 48,901 35,834 19,717
17 Cash expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602
18 Taxes -1,400 -1,580 262 3,432 5,929 4,053 1,939
19 Operating cash flow (OCF) (16 - 17 - 18) -2,600 -934 3,686 8,295 12,163 8,678 4,176
20 Operating cash flow (OCF) -2,600 -934 3,686 8,295 12,163 8,678 4,176
21 Cash flow from capital investment and disposal -10,000 1,267
22 Cash flow from change in working capital -550 -739 -1,972 -1,629 1,307 1,581 2,002
23 Net cash flow (20 + 21 + 22) -12,600 -1,484 2,947 6,323 10,534 9,985 5,757 3,269
NPV @ 20%
29 NPV 3,802
NPV @20% = $3,802K, which is higher than under the straight-line method
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16
Shareholder Books and Tax Books
• Firms in several countries, such as India and US, maintain two sets of books
– Shareholder books: Common to use straight-line depreciation on shareholder books
– Tax books: Common to use accelerated depreciation on the tax books
• Indian firms commonly use WDV (written down value) method on the tax books
• US firms commonly use MACRS (Modified Accelerated Cost Recovery System) on the tax books
• Japan, France and several European countries do not allow the separation of tax
accounts from shareholder accounts
– Taxes reported to shareholders must equal taxes paid to the government
• What is relevant for capital budgeting – shareholder books or tax books?

– Only the tax books are relevant in capital budgeting
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Shareholder Books and Tax Books [contd.]

In the US, firms use the Modified
Accelerated Cost Recovery System
(MACRS) for tax purposes
• Each asset is assigned a useful life
under MACRS
• Depreciation is expressed as a % of
the asset’s cost
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17
Choosing Among Competing Projects: Problem 1 of 4
Problem 1: Investment Timing Problem
• Should you invest now or wait and think about it again next year?
– Today’s investment is competing with possible future investments
• The question of optimal timing is not difficult when the cash flows are certain.
– Examine start dates (t) for investment and calculate net future value for each date
– Discount net future values back to present
Net future value at date t
NPV of investment if undertaken at time t =
(1+r)t
– Choose the alternative with the highest NPV
• The investment timing problem is much more complicated when you are unsure
about future cash flows.
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Choosing Among Competing Projects: Problem 1 of 4 [contd.]

You own a large tract of inaccessible timber. To harvest it, you have to invest a
substantial amount in access roads and other facilities. The longer you wait, the
higher the investment required. On the other hand, lumber prices will rise as you
wait, and the trees will keep growing, although at a gradually decreasing rate.
Given the following data and a 10% discount rate, when should you harvest?
0 1 2 3 4 5
Net future value ($ thousands) 50 64.4 77.5 89.4 100 109.4
% Change in value from previous year +28.8% +20.3% +15.4% +11.9% +9.4%
NPV today of harvest in year t 50 58.5 64.0 67.2 68.3 67.9
The optimal point to harvest the timber is year 4 because this is the point that maximizes NPV.
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18
Problem 2: Investments of Unequal Lives
(Choice Between Long- and Short-Lived Equipment)
• Should the company save money today by installing cheaper machinery that will
not last as long?
– Today’s decision would accelerate a later investment in machine replacement
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37

Suppose the firm is forced to choose between two machines, A and B. The two
machines are designed differently but have identical capacity and do exactly the same
job. Machine A costs $15,000 and will last three years. It costs $5,000 per year to
run. Machine B is an “economy” model, costing only $10,000, but it will last only two
years and costs $6,000 per year to run. Given a discount rate of 6%, which machine
will you choose? Assume zero inflation rate.
Costs ($ thousands)
PV @ 6%
0 1 2 3
($ thousands)
Machine A 15 5 5 5 28.37
Machine B 10 6 6 – 21.00
– Machine B offers 2 years of service for a lower total cost than 3 years of service from machine A
– But is the annual cost of using B lower than that of A?
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38
19
First Solution: Compute the Equivalent Annual Cost (EAC)
3-year annuity factor
PV of Machine A’s costs = Annuity Payment * PVIFA(6%,3)
⇒ 28.37 = EAC (A) * 2.673 Costs ($ thousands)
⇒ EAC (A) = 28.37 / 2.673 = 10.61 0 1 2 3
PV @ 6%
($ thousands)
Machine A 15 5 5 5 28.37
EAC (A) 10.61 10.61 10.61 28.37

PV of Machine B’s costs = Annuity Payment * PVIFA(6%,2)
⇒ 21.00 = EAC (B) * 1.833 Costs ($ thousands)
⇒ EAC (B) = 21.00 / 1.833 = 11.45 0 1 2
PV @ 6%
($ thousands)
Machine B 10 6 6 21.00
Machine A is better, because its EAC (B) 11.45 11.45 21.00
equivalent annual cost is less
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Second Solution: Find out the present value of the cost of using each machine for a
common time period (6 years in the following example) – Replacement Chain Method
Costs ($ thousands)
PV @ 6%
0 1 2 3 4 5 6
($ thousands)
Buy 1st Machine A in Year 0 15 5 5 5 28.37
Buy 2nd Machine A in Year 3 15 5 5 5 23.82
Machine A 15 5 5 20 5 5 5 52.18
Costs ($ thousands)
PV @ 6%
0 1 2 3 4 5 6
($ thousands)
Buy 1st Machine B in Year 0 10 6 6 21.00
Buy 2nd Machine B in Year 2 10 6 6 18.69
Buy 3rd Machine B in Year 4 10 6 6 16.63
Machine B 10 6 16 6 16 6 6 56.32
Machine A has lower cost relative to Machine B.
40
40
20
In the last example, suppose new machines cost 20% less each year in real terms to
buy and operate on account of technological improvements. How much will it cost
you now to rent each machine in each year?
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41

• Real levels of rents on new machines are going to decline each year and lessors of
old machines will be forced to match them.
• However, the lessor of a machine will set the rents so as to recover the PV of its
buying and operating costs.
Cash Flows for Lessor of Machine A
0 1 2 3 4 5
Buy Machine A in Year 0 –PV Rent1 Rent2 Rent3
Buy Machine A in Year 1 –0.8 * PV 0.8 * Rent1 0.8 * Rent2 0.8 * Rent3
Buy Machine A in Year 2 –0.82 * PV 0.82 * Rent1 0.82 * Rent2 0.82 * Rent3
• This arrangement implies the following:

– Rent2 = 0.8 * Rent1,
– Rent3 = 0.8 * Rent2 = 0.82 * Rent1
– Rentt = 0.8t-1 * Rentt-1
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21
𝑅𝑒𝑛𝑡 𝑅𝑒𝑛𝑡 𝑅𝑒𝑛𝑡
PV of Renting Machine A = + +
1.06 1.06 1.06
𝑅𝑒𝑛𝑡 0.8 ∗ 𝑅𝑒𝑛𝑡 0.8 ∗ 𝑅𝑒𝑛𝑡
⇒ 28.37 = + +
1.06 1.06 1.06
⇒ 𝑅𝑒𝑛𝑡 = $12.94
𝑅𝑒𝑛𝑡 𝑅𝑒𝑛𝑡
PV of Renting Machine B = +
1.06 1.06
𝑅𝑒𝑛𝑡 0.8 ∗ 𝑅𝑒𝑛𝑡
⇒ 21.00 = +
1.06 1.06
⇒ 𝑅𝑒𝑛𝑡 = $12.69
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43

Cash Flows for Lessor of Machine A
0 1 2 3 4 5
Buy Machine A in Year 0 –28.37 12.94 0.8 * 12.94 0.82 * 12.94 – –
Buy Machine A in Year 1 –0.8 * 28.37 0.8 * 12.94 0.82 * 12.94 0.83 * 12.94 –
Buy Machine A in Year 2 –0.82 * 28.37 0.82 * 12.94 0.83 * 12.94 0.84 * 12.94
Cash Flows for Lessor of Machine B

0 1 2 3 4
Buy Machine A in Year 0 –21 12.69 0.8 * 12.69 – –
Buy Machine A in Year 1 –0.8 * 21 0.8 * 12.69 0.82 * 12.69 –
Buy Machine A in Year 2 –0.82 * 21 0.82 * 12.69 0.83 * 12.69
Now, renting Machine B is cheaper compared to Machine A
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22
Problem 3: Replacement Problem
• When should existing machinery be replaced?
– Using it another year could delay investment in more modern equipment
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45

You are operating an elderly machine that is expected to produce a net cash
inflow of $4,000 in the coming year and $4,000 next year. After that it will give
up the ghost. You can replace it now with a new machine, which costs $15,000
but is much more efficient and will provide a cash inflow of $8,000 a year for
three years. Given a discount rate of 6%, should you replace your equipment now
or wait a year? Assume that elderly machine has no salvage value.
PV @ 6%
0 1 2 3
($ thousands)
New Machine –15 8 8 8 6.38
EAC (New Machine) 2.387 2.387 2.387 6.38
– As long as your old machine can generate a cash flow of $4,000 a year, it should not be
replaced with a new one that generates only $2,387 a year.
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23
Problem 4: Cost of Excess Capacity
• What is the cost of using equipment that is temporarily not needed?
– Increasing use of the equipment may bring forward the date at which additional capacity is
required.
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47

Suppose we have a new investment project that requires heavy use of an existing
information system. The effect of adopting the project is to bring the purchase
date of a new, more capable system forward from year 4 to year 3. This new
system has a life of five years, at a discount rate of 6%, the present value of the
cost of buying and operating it is $500,000. How much cost should be charged
against the new project?
Use by new project will result in replacement of
existing system at the end of year 3 instead of year 4
0 1 2 3 4
Firm will have to incur extra cost at the end of year 4 for
using the new system during year 4
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24
– PV of $500,000 translates to an Equivalent Annual Cost of $118,698 for each of 5 years
𝐸𝐴𝐶 1
500,000 = × 1−
0.06 1 + 0.06
– If we undertake the new project, the series of expenses begins in year 4; if we do not
undertake it, the series begins in year 5.
– The new project, therefore, results in an additional cost of $118,698 in year 4.
– Therefore, 118,698/(1.06)4 = $94,020 should be charged against the new project.
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Assigned Problems
50
50
25
Restate the net cash flows in Table 6.6 in real terms. Discount the restated cash
flows at a real discount rate. Assume a 20% nominal rate and 10% expected
inflation. NPV should be unchanged at +3,802.
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51
Using nominal figures

0 1 2 3 4 5 6 7
1 Capital investment and disposal -10,000 1,949 Nominal discount rate 20%
2 Change in working capital -550 -739 -1,972 -1,629 1,307 1,581 2,002 Rate of inflation 10%
3 Sales 523 12,887 32,610 48,901 35,834 19,717
4 Cost of goods sold 837 7,729 19,552 29,345 21,492 11,830 Real discount rate 9.09%
5 Other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
6 Tax -1,400 -1,580 262 3,432 5,929 4,053 1,939 682
7 Operating cash flow (OCF) (3-4-5-6) -2,600 -934 3,686 8,295 12,163 8,678 4,176 -682
8 Net cash flow_nominal (1+2+7) -12,600 -1,484 2,947 6,323 10,534 9,985 5,757 3,269
9 PV @ nominal discount rate of 20% -12,600 -1,237 2,047 3,659 5,080 4,013 1,928 912
10 NPV = 3,802 (sum of 9)
Using real figures

11 Inflation adjustment factor 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95
12 Net cash flow_real -12,600 -1,349 2,436 4,750 7,195 6,200 3,250 1,677
13 PV @ real discount rate of 9.09% -12,600 -1,237 2,047 3,659 5,080 4,013 1,928 912
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26
Reliable Electric is considering a proposal to manufacture a new type of industrial
electric motor that would replace most of its existing product line. A research
breakthrough has given Reliable a two-year lead on its competitors. The project
proposal is summarized in Table 6.7 on the next slide.
a. Read the notes to the table carefully. Which entries make sense? Which do
not? Why or why not?
b. What additional information would you need to construct a version of Table
6.7 that makes sense?
c. Construct such a table and recalculate NPV. Make additional assumptions as
necessary.
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Assigned Problem: BM Chapter 6, Problem 19 [contd.]

Table Notes:
1. Capital expenditure: $8 million for new machinery and $2.4 million for a
warehouse extension. The full cost of the extension has been charged to
this project, although only about half of the space is currently needed.
Since the new machinery will be housed in an existing factory building, no
charge has been made for land and building.
2. Research and development: $1.82 million spent in 2015. This figure was
corrected for 10% inflation from the time of expenditure to date. Thus
1.82 × 1.1 = $2 million.
3. Working capital: Initial investment in inventories.
4. Revenue: These figures assume sales of 2,000 motors in 2017, 4,000 in
2018, and 10,000 per year from 2019 through 2016. The initial unit
price of $4,000 is forecasted to remain constant in real terms.
5. Operating costs: These include all direct and indirect costs. Indirect costs
(heat, light, power, fringe benefits, etc.) are assumed to be 200% of
direct labor costs. Operating costs per unit are forecasted to remain
constant in real terms at $2,000.
6. Overhead: Marketing and administrative costs, assumed equal to 10% of
revenue.
7. Depreciation: Straight-line for 10 years.
8. Interest: Charged on capital expenditure and working capital at Reliable’s
current borrowing rate of 15%.
9. Income: Revenue less the sum of research and development, operating
costs, overhead, depreciation, and interest.
10. Tax: 35% of income. However, income is negative in 2016. This loss is
carried forward and deducted from taxable income in 2018.
11. Net cash flow: Assumed equal to income less tax.
12. Net present value: NPV of net cash flow at a 15% discount rate.
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27
Capital expenditure
• Given
– $8 million for new machinery and $2.4 million for a warehouse extension. The full cost of
the extension has been charged to this project, although only about half of the space is
currently needed. Since the new machinery will be housed in an existing factory building, no
charge has been made for land and building.
• Proper Treatment
– Charge needs to be made for the opportunity cost of using existing factory building (i.e., the
market value of the existing building). Remember to judge projects on the basis of “with
versus without” rather than “before versus after”.
– If the spare warehouse space is going to be used by some other project, then only a part of
the warehouse extension cost should be charged to the current project.
– The salvage value at the end of the project, if any, should be included.
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55

Research and development
• Given
– $1.82 million spent in 2015. This figure was corrected for 10% inflation from the time of
expenditure to date. Thus 1.82 × 1.1 = $2 million.
– Being a sunk cost, it should be ignored.
Working capital
• Given
– Initial investment in inventories.
– Other components of working capital (AR and AP) need to be recognized
– Growth (increasing sales) may require additional investment in working capital
– Working capital should be recovered at the end of the project
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Revenue
• Given
– These figures assume sales of 2,000 motors in 2017, 4,000 in 2018, and 10,000 per year
from 2019 through 2016. The initial unit price of $4,000 is forecasted to remain constant
in real terms.
– The entire analysis should be conducted in either real terms or nominal terms.
– The revenue forecast should consider changes in competition (Recall that Reliable has only a
two-year lead on its competitors)
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57

Operating costs
• Given
– These include all direct and indirect costs. Indirect costs (heat, light, power, fringe benefits,
etc.) are assumed to be 200% of direct labor costs. Operating costs per unit are forecasted to
remain constant in real terms at $2,000.
– The entire analysis should be conducted in either real terms or nominal terms.
Overhead
• Given
– Marketing and administrative costs, assumed equal to 10% of revenue.
– Only the extra expenses that would result from the project should be included. If the project is
not going to result in extra expenses, the allocated overhead costs should not be included.
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Depreciation
• Given
– Straight-line for 10 years.
– Depreciation is a non-cash expense, and it only affects the tax that a company pays. Therefore,
depreciation should not be included as an expense to calculate cash flows.
– Accelerated depreciation method may be used.
Interest
• Given
– Charged on capital expenditure and working capital at Reliable’s current borrowing rate of 15%.
– Ignore interest cost. Value the project as if it is all equity-financed.
59
59

Income
• Given
– Revenue less the sum of research and development, operating costs, overhead,
depreciation, and interest.
– Already discussed under various heads.
Tax
• Given
– 35% of income. However, income is negative in 2016. This loss is carried forward and
deducted from taxable income in 2018.
– If Reliable earns profits on its remaining business, the tax loss should not be carried
forward.
60
60
30
Net cash flow
• Given
– Assumed equal to income less tax.
– NCF should be computed as NCF = PAT + Depreciation – CapEx (net of disposal) – Increase
in NWC or alternatively as NCF = Sales – Cash Expenses – Taxes – CapEx (net of disposal) –
Increase in NWC
Net present value

• Given
– NPV of net cash flow at a 15% discount rate.
– The project should be discounted based on its risk rather than the company’s borrowing
rate.
61
61

Look back to the cash flows for machines A and B (in “The Choice between Long-
and Short-Lived Equipment”). The present values of purchase and operating costs
are 28.37 (over three years for A) and 21.00 (over two years for B). The real
discount rate is 6% and the inflation rate is 5%.
a. Calculate the three- and two-year level nominal annuities which have present
values of 28.37 and 21.00. Explain why these annuities are not realistic
estimates of equivalent annual costs.
b. Suppose the inflation rate increases to 25%. The real interest rate stays at 6%.
Recalculate the level nominal annuities. Note that the ranking of machines A
and B appears to change. Why?
62
62
31
Part (a): Real discount rate = 6%, Inflation rate = 5%
Nominal discount rate = (1 + real discount rate) * (1 + inflation) – 1 = 11.3%
PV of Machine A’s costs = Annuity Payment * PVIFA(11.3%,3)
⇒ 28.37 = EAC (A) * 2.4310 Machine A: Costs ($ thousands)
⇒ EAC (A) = 28.37 / 2.4310 = 11.67 0 1 2 3
PV @ 11.3%
($ thousands)
EAC (A) 11.67 11.67 11.67 28.37

PV of Machine B’s costs = Annuity Payment * PVIFA(11.3%,2)
⇒ 21.00 = EAC (B) * 1.7057
Machine B: Costs ($ thousands)
⇒ EAC (B) = 21.00 / 1.7057 = 12.31
PV @ 11.3%
Machine A appears to have less EAC compared to Machine B. 0 1 2
($ thousands)
These nominal annuities are not realistic estimates of equivalent annual EAC (B) 12.31 12.31 21.00
costs because the cost of buying and operating the machines is likely to
rise with inflation.
63
63

Part (b): Real discount rate = 6%, Inflation rate = 25%
Nominal discount rate = (1 + real discount rate) * (1 + inflation) – 1 = 32.5%
PV of Machine A’s costs = Annuity Payment * PVIFA(32.5%,3)
⇒ 28.37 = EAC (A) * 1.7542 Machine A: Costs ($ thousands)
⇒ EAC (A) = 28.37 / 1.7542 = 16.17 0 1 2 3
PV @ 32.5%
($ thousands)
EAC (A) 16.17 16.17 16.17 28.37

PV of Machine B’s costs = Annuity Payment * PVIFA(32.5%,2)
⇒ 21.00 = EAC (B) * 1.3243
Machine B: Costs ($ thousands)
⇒ EAC (B) = 21.00 / 1.3243 = 15.86
PV @ 32.5%
Now, Machine B appears to have less EAC compared to Machine A. 0 1 2
($ thousands)
Inflation has a significant impact on the calculation of EAC. The rankings EAC (B) 15.86 15.86 21.00
change because, at higher inflation rate, Machine A with the longer life is
affected more. So, it makes sense to do EAC calculations in real terms.
64
64
32
Thank You
65
65
33
Risk and Return – I
CORPORATE FINANCE: SESSION 16
Prof. Varun Jindal

Office: D-008
Agenda
• Security Risk
• Portfolio Risk
• Diversification
• Capital Asset Pricing Model (CAPM)
Note: The coverage of this session, which is based on parts of Sections 7.1, 7.2, 7.3, 7.4, and 8.2,
is not formally a part of the course outline. However, it is absolutely essential to have a fair
knowledge of this material before moving to Chapter 9.
1
Introduction
• This is what you already know about risk
– The opportunity cost of capital depends on the risk of the project
• This is what you are going to know very soon!

– How is risk measured?
– What is the relationship between risk and the opportunity cost of capital?
Measures of Risk (Variability or Spread)

• There is no universally agreed-upon definition of risk.
– The returns on most assets vary unpredictably over time – they are risky
• The measures of risk that we start our discussion with are variance and
standard deviation.
• When variance is estimated from a sample of observed returns, we add the

squared deviations and divide by N – 1, where N is the number of observations.
1
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝑀𝑒𝑎𝑛 𝑅𝑒𝑡𝑢𝑟𝑛
𝑁−1
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒
2
Computing Portfolio/Security Risk: An Example
Year Actual Mean Deviation from Squared Deviation

Return (%) Return (%) the Mean (%)
1 15 10.5 4.5 20.25
2 9 10.5 –1.5 2.25
3 6 10.5 –4.5 20.25
4 12 10.5 1.5 2.25
Total 0 45
45
Variance = 4 –1 = 15 Standard Deviation = 3.873%
3 Types of Portfolios
I
• Portfolio of US Treasury Bills (T-Bills) N
– No risk of default C
R
– Short maturity and relatively stable prices E
A
S
• Portfolio of US Treasury Bonds (T-Bonds) E
– No risk of default I
– Prices fluctuates as interest rates vary [Interest ↑ ⇒ ↓ Price] N
R
I
• Portfolio of US Common Stocks S
K
– Prices fluctuate with ups and downs of the issuing companies
Let’s see if investment performance coincides with intuitive risk taking!
3
The Value of an Investment of $1 Made at the End of 1899 (Nominal)
US Common Stocks
US T-Bonds
US T-Bills
Annual Standard Deviations and Variances: 1900 – 2014

Annual Standard Deviations and Variances
Standard Deviation (σ) Variance (σ2)
US Treasury Bills (T-Bills) 2.9% 8.2
US Government Bonds (T-Bonds) 9.1% 83.3
US Common Stocks 19.9% 395.6
As expected, T-Bills were the least variable security, and common stocks were the
most variable. T-Bonds held the middle ground.
4
Common Stocks: Profitable But Variable Investment!
Average Annual Return and Risk Premium: 1900 – 2014

Average Annual Rate of Return
Return (Nominal) Average Risk Premium
US Treasury Bills (T-Bills) 3.8% 0
US Treasury Bonds (T-Bonds) 5.4% 1.6%
US Common Stocks 11.5% 7.7%
• Investment in T-Bills is the safest investment, and therefore it also earns the
lowest return
• By taking on the risk of investment in a risky security, investors demand a risk

premium over the return on T-Bills.
– Risk-premium for government bonds = 5.4 – 3.8 = 1.6%
– Risk-premium for common stocks = 11.5 – 3.8 = 7.7%
Return = Risk-free Rate + Risk Premium
10
5
Security Risk and Expected Return: An Example
Probability of State Return on Return on

State
Occurring Security A Security B
Boom .25 28% 10%
Normal .50 15% 13%
Recession .25 -2% 10%
Expected Return 14.0% 11.5%
Std. Deviation 10.65% 1.50%
• Expected Return (Security A) = 0.25 * 28% + 0.50 * 15% + 0.25 * -2% = 14%
• Expected Return (Security B) = 0.25 * 10% + 0.50 * 13% + 0.25 * 10% = 11.5%
• Std Dev (Security A) = [0.25 * (28 – 14)2 + 0.50 * (15 – 14)2 + 0.25 * (–2 – 14)2]1/2 = 10.65%
• Std Dev (Security B) = [0.25 * (10 – 11.5)2 + 0.50 * (13 – 11.5)2 + 0.25 * (10 – 11.5)2]1/2 = 1.50%
11
Portfolio Expected Return

• Expected return on a portfolio is a weighted average of the expected returns on
the individual securities making that portfolio
• For a portfolio of two or more securities, the expected (or mean) return is
𝑟 = 𝑥 ×𝑟
– 𝑥 is the proportion of total funds invested in security 𝑖

– 𝑟 is the expected return on security 𝑖
– 𝑚 is the total no. of securities in the portfolio
12
6
Portfolio Risk and Expected Return: An Example
Let’s make a portfolio consisting of equal investments in Securities A and B
Probability of State Return on Return on
State Portfolio
Occurring Security A Security B
Boom .25 28% 10% 19%
Normal .50 15% 13% 14%
Recession .25 -2% 10% 4%
Expected Return 14% 11.5% 12.75%
Std. Deviation 10.65% 1.50% 5.45%
• Portfolio Expected Return = 0.25 * 19% + 0.50 * 14% + 0.25 * 4% = 12.75%
• Portfolio Std Dev = [0.25 * (19 – 12.75)2 + 0.50 * (14 – 12.75)2 + 0.25 * (4 – 12.75)2]1/2 = 5.45%
The portfolio standard deviation is less than the weighted average of individual SD which is 6.08%.
This is due to the relationship or covariance between the returns of the two securities
13
Portfolio Risk for 2-Stock Portfolio

• Portfolio risk depends on riskiness of the securities and also the relationship
among those securities
Portfolio Variance
Stock 1 Stock 2
x1x2s12 = 𝑥 σ + 𝑥 σ + 2𝑥 𝑥 σ
Stock 1 x12s12
= x1x2ρ12s1s2
= 𝑥 σ + 𝑥 σ + 2𝑥 𝑥 ρ σ σ
x1x2s12
Stock 2 x22s22 𝑵𝒐𝒕𝒆:
= x1x2ρ12s1s2
𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = σ =ρ σ σ
Variance of two-stock portfolio is sum of the above four boxes 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 = ρ
14
7
Portfolio Risk for 2-Stock Portfolio: An Example
Suppose you invest $55 in Stock 1 and $45 in Stock 2. The expected return on
Stock 1 is 10% and that on Stock 2 is 20%. Assume a correlation coefficient of 0.65
between the two stocks and that the standard deviation of returns on Stock 1 is
17.1% and that on Stock 2 is 20.8%. What is the risk and the expected return on
your portfolio?
Stock 1 Stock 2
x12s12 x1x2s12
Stock 1
= 0.552 * 17.12 = 0.55 * 0.45 * 0.65 * 17.1 * 20.8
x1x2s12 x22s22
Stock 2
= 0.55 * 0.45 * 0.65 * 17.1 * 20.8 = 0.452 * 20.82
Portfolio Variance = 290.50 Portfolio Standard Deviation = 17.04%

Portfolio Return = x1r1+x2*r2 = 0.55 * 10% + 0.45 * 20% = 14.5%
15
Portfolio Risk for 2-Stock Portfolio: An Example [contd.]

How will the risk of your portfolio change if the correlation between the two stocks in
your portfolio becomes 1, 0.8, 0.5, 0, and -1?
Stock 1 Stock 2
Return 10% 20%
Standard Deviation 17.1% 20.8%
Weight 0.55 0.45
Correlation 1 0.8 0.5 0 -1

Portfolio s 18.77% 17.80% 16.25% 13.27% 0.04%
Weighted Avg. s 18.77%

• The weighted average s is equal to the portfolio s when correlation coefficient is = 1
• Portfolio s declines as the correlation between the two securities comes down
• Portfolio s is minimum when the correlation between the two securities is -1
16
8
Benefit of Diversification
Assume that you have already made an investment in Stock 1 and Stock 2 (as
given in the previous example). Now, you invest $100 in Stock 3 whose expected
return is 25% with an annualized standard deviation of 22%. Assume a
correlation coefficient of 0.50 between the existing portfolio (made up of Stock 1
and Stock 2) and Stock 3. What will be the portfolio return and risk now?
Existing Portfolio
Stock 3
(Stocks 1 & 2) New Portfolio Expected Return = 20%
Return 15% 25%
Standard Deviation 17.04% 22.00% New Portfolio Std Dev = 16.95%
Weight 0.50 0.50
Lower risk and yet higher return
Correlation 0.5 through diversification!
Portfolio s 16.95%
17
Benefit of Diversification [contd.]

Portfolio standard deviation (%)
• Even a little diversification can provide

a substantial reduction in variability
– You can get most of this benefit with
relatively few stocks
• Diversification works because prices of

different stocks do not move exactly
together (i.e., stock price changes are
less than perfectly correlated) 0
5 10 15
Number of Stocks in the Portfolio
18
9
Specific (Unsystematic) and Market (Systematic) Risk
• Specific / Unsystematic Risk
– Risk that can be eliminated by diversification
– Stems from the fact that many of the perils that
surround an individual firm are peculiar to it
– Also called diversifiable risk
• Market / Systematic Risk

– Risk that cannot be eliminated by diversification
– Stems from the fact that there are economywide
perils that threaten all businesses
– Also called non-diversifiable risk
For a reasonably well-diversified portfolio, only market risk matters
19
Measuring Market Risk

• What is the contribution of an individual stock to the risk of a well-diversified
portfolio?
– It depends on the market risk of the individual stock
• How do we measure the market risk of an individual stock?

– It boils down to measuring how sensitive the stock is to market movements
• This sensitivity of the stock’s return to the return on the market portfolio is called beta (β)
• You can find β by regressing the individual stock returns on market portfolio returns
• What is a market portfolio?

– It’s a portfolio of all assets in the economy
– In practice, a broad stock market index, such as BSE SENSEX or NSE NIFTY 50, is used to
represent the market
20
10
Measuring β: An Example
• Regression line that fits Ford’s returns on
market returns has a slope of 1.44.
• This means Ford has a β of 1.44.

– When the market rises by extra 1%, Ford’s
stock price will rise by extra 1.44% on average
• Note that Ford’s returns will also be

subject to specific risk. So, the actual
returns will be scattered about the fitted
regression line (not shown in figure).
21
Calculating β
• The ratio of covariance to variance measures a stock’s beta.
β =
σ is covariance between the returns of stock i and market returns
σ is variance of the market returns
• The covariance of the market with itself is the same as the variance of the market.
Thus, the beta of the market is always 1.
• The covariance between the returns of risk-free asset and market returns is 0.
Thus, the beta of the risk-free asset is always 0.
• The risk of a well-diversified portfolio is proportional to the portfolio beta, which

equals the weighted average beta of the securities included in the portfolio.
22
11
Capital Asset Pricing Model (CAPM)
• What we know so far

– The difference between a security’s expected return and the return on Treasury bills (𝑟 ) is
known as the security’s risk premium
– For a well-diversified portfolio, the appropriate measure of risk is β
– Treasury bills (risk-free security) have a β of 0 and a risk premium of 0
– The market portfolio with expected return 𝑟 has a β of 1 and a risk premium of (𝑟 − 𝑟 )
• What we do not know

– What is the expected risk premium when beta is not 0 or 1?
• CAPM, given by William Sharpe, John Lintner, and Jack Treynor, provides the
answer to the above question
23
Capital Asset Pricing Model [contd.]

• In a competitive market, the expected risk premium varies in direct proportion
to beta
– An investment with a β of .5 has half the expected risk premium than that on the market
– An investment with a β of 2 has twice the expected risk premium than that on the market
• Expected risk premium on stock = beta × expected risk premium on market

𝑟 − 𝑟 = 𝛽(𝑟 − 𝑟 )
• Alternatively, the expected return on a security is positively related to its beta

𝑟 = 𝑟 + 𝛽(𝑟 − 𝑟 )
• CAPM can be used to find the discount rate for a capital investment
24
12
Capital Asset Pricing Model [contd.]
Expected Return
Security Market Line (SML)
Market Return (𝑟 ) .
Market portfolio
Risk-Free Return (𝑟 )
Beta
0 1
25
Thank You
26
13
Risk and Return – II
Prof. Varun Jindal

Office: D-008
Agenda
• Cost of Equity
• Cost of Debt
• Weighted Average Cost of Capital
Readings:
• BM Chapter 9 – Sections 9.1, 9.2, and 9.3 (exclude fudge factors)
1
Company Cost of Capital
• Expected return on a portfolio of all the company’s outstanding debt and equity
securities
– Expected rate of return on the firm’s stock for an all-equity firm (e.g., Infosys)
• Opportunity cost of capital for investment in all of the firm’s assets
• Appropriate discount rate for the firm’s average-risk projects

– Applicable for expansion of a firm’s existing business
– Not applicable for new projects that are more or less risky than a firm’s existing business
Company and Project Costs of Capital

• We measure the risk of each project by its beta
– High beta ⇒ High risk
– Low beta ⇒ Low risk
SML
Required Return
• High risk-projects require high rate of return

(as indicated by SML)
rf
• Which projects should a firm accept or reject?
– The firm should accept projects lying above the SML
0
– The firm should reject projects lying below the SML Beta
2
Company and Project Costs of Capital [contd.]
What will happen if a firm uses the company
cost of capital rule to accept/reject projects?
SML
Company Cost of Capital Rule: Accept any project Accepting
regardless of its risk as long as it offers a higher poor high-risk
rA projects
return than the company’s cost of capital Rejecting good Company Cost
Required Return
low-risk of Capital
projects
Consequences of Using Company Cost of Capital
rf
Rule:
• Any project regardless of its risk gets accepted
as long as it offers a higher return than the 0
Avg. β of firm’s Project Beta
company’s cost of capital assets
• Any project regardless of its risk gets rejected if
it offers a lower return than the company’s cost
of capital
Company and Project Costs of Capital [contd.]

• The discount rate for a project depends on the project risk, and not on the
company undertaking the project
– The opportunity cost of capital depends on the use to which that capital is put
• Then why is so much time spent estimating the company cost of capital?
– Many projects are expansions of a firm’s existing business. For these average-risk projects,
the company cost of capital is the right discount rate.
– Businesspeople have good intuition about relative risks, but not about absolute risk.
Company cost of capital is a useful starting point for setting discount rates.
• Easier to add to/subtract from the company cost of capital than to start from scratch
3
Back to Company Cost of Capital
• Company cost of capital is the expected return on a portfolio of all the company’s
assets, or alternatively debt (D) plus equity (E)
– The values of debt and equity add up to overall firm value (D + E = V) and firm value V equals
asset value. These figures are all market values, not book (accounting) values.
Debt D
Assets
Equity E
• Company cost of capital 𝑟 (also called WACC) is, therefore, estimated as a weighted
average of the cost of debt (𝑟 ) and the cost of equity (𝑟 )
𝐷 𝐸
Company Cost of Capital, 𝑟 = 𝑟 +𝑟
𝑉 𝑉
Back to Company Cost of Capital [contd.]

• In the presence of corporate taxes
– Since interest on debt is a tax-deductible expense for firms, the after-tax cost of debt is (1 –
𝑇 ) * 𝑟 where 𝑇 is the marginal corporate tax rate
𝐷 𝐸
After−tax WACC = 1 − 𝑇 𝑟 +𝑟
𝑉 𝑉
4
• What do you think should be the relation between rD, rE, and rA, intuitively?
• The cost of debt (rD) is less than the cost of equity (rE)
– Equity is a residual claim on the firm’s assets, and it stands behind debt
• The company cost of capital (rA), a weighted average of the two, lies in-between
rD and rE
𝑟 ≥𝑟 ≥𝑟
Note: The WACC formula doesn’t tell you the complete story. As the debt ratio D/V increases, the cost of the
remaining equity also increases, offsetting the apparent advantage of more cheap debt. Debt does have a tax
advantage, however, because interest is a tax-deductible expense.

Measuring the Cost of Debt
• Interest rate required on new debt issuance or YTM on outstanding debt
– Don’t forget to adjust for the tax deductibility of interest expense
Measuring the Cost of Equity

• CAPM is commonly used to estimate the cost of equity, which is the expected
rate of return on the firm’s common stock
𝑟 = 𝑟 + 𝛽 (𝑟 − 𝑟 )
10
10
5
Estimating Equity β
• Recall that beta of a stock is the slope of the fitted line obtained by regressing the
stock returns on the market returns
– Do not make a mistake of regressing the stock price on the market index
– Before computing stock returns, stock price should be adjusted for corporate actions such as
stock splits, stock dividends, cash dividends, etc. because they affect the stock price (i.e., total
return data should be used instead of simple price return data for both stock and index)
– Total Returns Index (TRI)
• TRI for NSE: https://www1.nseindia.com/products/content/equities/indices/historical_total_return.htm
• Although we are interested in the future β of a firm’s stock, we turn to historical

evidence to get its estimate
11
11
Estimating Equity β [contd.]

• Regression line that fits Ford’s returns on
market returns has a slope of 1.44.
• This means Ford has a β of 1.44.

– When the market rises by extra 1%, Ford’s
stock price will rise by extra 1.44% on average
12
12
6
• Market Risk: A part of each stock’s total risk comes from movements in the
market
– R2 measures the proportion of the total variance in the stock’s returns that can be explained
by market movements
• Specific Risk: The rest is firm-specific, diversifiable risk, which shows up in the
scatter of points around the fitted line
– (1 – R2) measures the proportion of the total variance in the stock’s returns that is specific
to the stock
13
13

• Noise in the returns (due to an event such as financial crisis) can obscure the true
beta
– Possible Solution: Give less weight to the extreme observations or even omit them entirely
– Standard error of the estimated β gives the extent of possible mismeasurement
– There is a 95% chance that true β will lie within the confidence interval of “mean ± 2 * std
errors” (for normally distributed data)
Market Risk = 44%

Specific Risk = 56%
There is a 95% chance

that true β will lie within
2.34 ± 2 * 0.34 (i.e.,
between 1.66 and 3.02)
14
14
7
Industry β
• There is always a large margin for error when estimating the beta for individual
stocks
• Estimation errors tend to cancel out when beta is estimated for a portfolio (such
as for a group of firms in the same industry)
• The estimate of industry beta is therefore more reliable
• When to use industry beta

– If the operations of the firm are similar to the operations of the rest of the industry, use the
industry beta
– If the operations of the firm are substantially different from the operations of the rest of the
industry, use the firm’s beta
– Don’t forget about adjustments for financial leverage
15
15
Determinants of β
• Cyclicality of revenues
• Operating leverage
• Financial leverage
16
16
8
Determinants of β: Cyclicality of Revenues
• Cyclical firms — firms whose revenues and earnings are strongly dependent on
the state of the business cycle — tend to be high-beta firms
– Cyclical Businesses: Luxury resorts and restaurants, automotives, construction, and steel
– Less-Cyclical Businesses: Food and tobacco products, FMCG products, and pharma products
• Cyclicality is not the same as variability — stocks with high standard deviations
need not have high betas
– Much of this variability could reflect diversifiable risk
17
17
Determinants of β: Operating Leverage

• Firms with high fixed costs relative to variable costs in their cost structure have
high operating leverage
• Operating leverage magnifies the effect of cyclicality on beta
• High operating leverage translates to a high beta
• Thumb rule for judging the relative risks of alternative technologies for
producing the same product
– Other things being equal, the alternative with the higher ratio of fixed costs to project value
will have the higher project beta
18
18
9
Determinants of β: Financial Leverage
• While operating leverage refers to the firm’s fixed costs of production, financial
leverage refers to the firm’s fixed costs of finance
– This is because a levered firm must make interest payments regardless of the firm’s sales
• Just as an increase in operating leverage increases beta, an increase in financial

leverage (i.e., an increase in debt) also increases beta
• The beta of a portfolio/asset is a weighted average of the betas of the individual

items in the portfolio/asset
𝐷 𝐸
• The asset beta of a firm is therefore given by: 𝛽 = 𝛽 𝐷+𝐸
+𝛽
𝐷+𝐸
19
19
Determinants of β: Financial Leverage [contd.]

• The beta of debt is very low in practice. It is not uncommon to assume that 𝛽 ≈
0. In that case:
𝐸
𝛽 =𝛽
𝐷+𝐸
𝐷
⇒𝛽 =𝛽 1+
𝐸
• The equity beta of a levered firm will always be greater than the equity beta of an
otherwise identical all-equity firm, i.e., 𝛽 > 𝛽
• Which beta does regression analysis estimate, the asset beta or the equity beta?
– Regression provides us with 𝛽 because the technique uses stock returns as inputs
20
20
10
A Note on Debt β
• Even though debt beta is generally low, it is still a positive number
– Debt investors worry about the risk of default, which is partly a macroeconomic and market
risk
– All bonds are exposed to uncertainty about interest rates and inflation
21
21
20
rE
Expected rA
Return (%)
rD
0
0 0.2
βD β0.8
A βE1.2
Beta
22
22
11
Stability of β
• β may change over time due to:
– Changes in business mix
– Change in technology / operating leverage
– Changes in financial leverage
23
23
Analysing Project Risk

• A project’s value is equal to the expected cash flows discounted at an
appropriate discount rate
• Step 1: Prepare unbiased forecasts of a project’s cash flows that give due
weight to all possible outcomes (both favorable and unfavorable). Unbiased
forecasts incorporate all risks, including diversifiable risks as well as market
risks.
• Step 2: Consider whether diversified investors would regard the project as more
or less risky than the average project. Only market risks are relevant here.
Diversifiable risk can affect project cash flows, but it does not increase the cost of capital
24
24
12
Assigned Problems
25
25

The total market value of the common stock of the Okefenokee Real Estate
Company is $6 million, and the total value of its debt is $4 million. The treasurer
estimates that the beta of the stock is currently 1.5 and that the expected risk
premium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity
that Okefenokee debt is risk-free and the company does not pay tax.
a. What is the required return on Okefenokee stock?
b. Estimate the company cost of capital.
c. What is the discount rate for an expansion of the company’s present business?
d. Suppose the company wants to diversify into the manufacture of rose-colored
spectacles. The beta of unleveraged optical manufacturers is 1.2. Estimate the
required return on Okefenokee’s new venture.
26
26
13
D = $4 million, E = $6 million (Note: Both D and E are expressed in market values)
𝛽 =1.5,
𝑟 − 𝑟 = 6%, 𝑟 = 4%
𝑟 = 4% (because the company’s debt is risk-free)
Part (a)
• 𝑟 = 𝑟 + 𝛽 (𝑟 − 𝑟 )
• 𝑟 = 4% + 1.5 * 6% = 13%
Part (b)
• 𝑟 =𝑟 +𝑟 (in the absence of taxes)
• 𝑟 = 4% * 0.4 + 13% * 0.6 = 9.4%
27
27

Part (c)
• The discount rate for a project depends on the project risk
• The expansion of the company’s present business carries the same risk as the
other assets of the company
• The company cost of capital, 9.4%, is therefore the appropriate discount rate
Part (d)
• 𝑟 = 𝑟 + 𝛽 (𝑟 − 𝑟 )
• 𝑟 = 4% + 1.2 * 6% = 11.2%
28
28
14
The McGregor Whisky Company is proposing to market diet scotch. The product
will first be test-marketed for two years in southern California at an initial cost of
$500,000. This test launch is not expected to produce any profits but should
reveal consumer preferences. There is a 60% chance that demand will be
satisfactory. In this case McGregor will spend $5 million to launch the scotch
nationwide and will receive an expected annual profit of $700,000 in perpetuity. If
demand is not satisfactory, diet scotch will be withdrawn.
Once consumer preferences are known, the product will be subject to an average
degree of risk, and, therefore, McGregor requires a return of 12% on its
investment. However, the initial test-market phase is viewed as much riskier, and
McGregor demands a return of 20% on this initial expenditure.
What is the NPV of the diet scotch project?
29
29

-5,000,000 700,000 700,000 700,000
2 3 4 5
-500,000 700,000
𝑁𝑃𝑉 (𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑜𝑛 𝑠𝑢𝑐𝑐𝑒𝑠𝑠𝑓𝑢𝑙 𝑡𝑒𝑠𝑡) = −5,000,000 + = $833,333
0.12
0
2
High-Risk Phase Low-Risk Phase
Discount Rate = 20% Discount Rate = 12%
833,333
2
-500,000 0.6 × 833,333 + (0.4 × 0)

𝑁𝑃𝑉 = −500,000 + = −$152,778
(1 + 0.20)
0
2
0
30
30
15
Thank You
31
31
16
Capital Structure – I
Prof. Varun Jindal

Office: D-008
Agenda
• Leverage and firm value
• Miller-Modigliani propositions I and II with no taxes
Reading:
• BM Chapter 17
1
Introduction
• Capital Structure
– The use of debt and equity financing by a firm
• Financial Leverage / Gearing

– The use of debt in a firm’s capital structure
• Flavours of Debt
– Long-term vs. Short-term
– Secured vs. Unsecured
– Senior vs. Subordinated
– Convertible vs. Nonconvertible
• Flavours of Equity
– Common
– Preferred
MM Proposition I
• What combination of securities maximizes the value of a firm?
• Modigliani & Miller (MM)’s Proposition I: In a perfect market, the market value of
a firm is unaffected by its choice of capital structure
Value of the levered firm (VL) = Value of the unlevered firm (VU)
– Assumptions:
• No taxes
• No transaction/bankruptcy costs
• Individuals and firms can borrow or lend at the same risk-free rate of interest
• No other imperfections
• As long as investors can borrow or lend on their own account on the same
terms as the firm, they can “undo” the effect of any changes in the firm’s capital
structure
2
MM Proposition I: An Example
Macbeth Spot Removers is reviewing its capital structure. The company has no leverage
and all the operating income is paid as dividends to the common stockholders (assume no
taxes and no imperfections). The expected earnings are $1,500 in perpetuity (earnings are
not certain). The company has 1,000 shares outstanding and the price per share is $10.
Ms. Macbeth, the firm’s president, believes that shareholders would be better off if the
firm had equal proportions of debt and equity. She therefore proposes to issue $5,000 of
debt at an interest rate of 10% and use the proceeds to repurchase 500 shares. Will it
increase value of Macbeth’s shares?
Macbeth Spot Removers - Unlevered
Data
Number of shares 1,000
Price per share $10
Market value of shares $10,000
Outcomes
EBIT ($) 500 1,000 1,500 2,000
EPS ($) 0.50 1.00 1.50 2.00
Return on shares 5% 10% 15% 20%
Expected
outcome
MM Proposition I: An Example [contd.]

Macbeth Spot Removers - Unlevered
Data
Number of shares 1,000
Price per share $10
Outcomes
EBIT ($) 500 1,000 1,500 2,000
EPS ($) 0.50 1.00 1.50 2.00
Expected
outcome
Macbeth Spot Removers - Levered
Data
Number of shares 500
Price per share $10
Market value of debt $5,000
Interest @ 10% $500
Outcomes
EBIT ($) 500 1,000 1,500 2,000
Interest ($) 500 500 500 500
Equity earnings ($) 0 500 1,000 1,500
EPS ($) 0 1 2 3
Expected
outcome
6
3
“The effect of leverage depends on the company’s income.
• If income > $1,000, the return to the equityholder is
increased by leverage.
• If income < $1,000, the return is reduced by leverage.
• If income = $1,000, the return is unaffected.
Our capital structure decision, therefore, boils down to

what we think about income prospects. Since we expect
operating income to be above the $1,000 break-even
point, I believe we can best help our shareholders by
going ahead with the $5,000 debt issue.”
Ms. Macbeth’s Reasoning
Do you agree with Macbeth’s reasoning?
EBIT ($)

• If shareholders can replicate the same set of payoffs on their own, would they
pay a premium on Macbeth’s levered shares?
– No. Therefore, a share of levered Macbeth must sell for $10.
• An investor with $10 of his money can borrow $10 @10% and invest $20 in
two unlevered Macbeth shares to replicate the same pattern of returns
Individual Investor
Outcomes
Firm EBIT ($) 500 1,000 1,500 2,000
Firm EPS ($) 0.50 1.00 1.50 2.00
Individual earnings on 2 shares ($) 1 2 3 4
Individual interest@10% ($) 1 1 1 1
Individual net earnings on investment ($) 0 1 2 3
Individual return on $10 investment 0% 10% 20% 30%
Expected
outcome
8
4
Current Structure: Proposed Structure:
All Equity Equal Debt & Equity
Expected EPS ($) 1.50 2
Price per share ($) 10 10
Expected return on share 15% 20%
Leverage increases the expected stream of EPS but not the share price. Why?
– Increase in the expected earnings stream is exactly offset by an increase in the rate at which
the earnings are discounted
MM Proposition II: Financial Risk and Expected Returns

• Expected return on a firm’s assets (𝑟 )
Expected Operating Income (EBIT)
𝑟 =
Market Value of All Securities
• In perfect capital markets, a firm’s borrowing decision does not affect either its
operating income (EBIT) or the total market value of its securities.
– The return on assets remains the same (i.e., 𝑟 ) for the levered firm
• If an investor holds all of a firm’s debt and equity, (s)he is entitled to all the
firm’s operating income (EBIT).
– The expected return on the portfolio is just 𝑟
10
10
5
MM Proposition II: Financial Risk and Expected Returns [contd.]
Expected Return on a Portfolio = Weighted Average
• But, 𝑟 = ×𝑟 + ×𝑟 of the Expected Returns on the Individual Holdings
• Alternatively, 𝑟 = 𝑟 + 𝑟 − 𝑟
• MM Proposition II: The expected return on the common stock of a levered firm
increases in proportion to the debt–equity ratio (D/E)
– Note 1: D and E are market values (NOT book values)
– Note 2: 𝑟 = 𝑟 if the firm has no debt
,
• For unlevered Macbeth: 𝑟 = 𝑟 = = 15%
,
• For levered Macbeth: 𝑟 = 𝑟 + 𝑟 − 𝑟 = 15% + 15% − 10% ∗ 1 = 20%
11
11
MM Proposition II: Financial Risk and Expected Returns [contd.]

• When the firm is unlevered, shareholders demand a return of 𝑟
• When the firm is levered, shareholders require a premium of 𝑟 − 𝑟 to

compensate for the extra financial risk
12
12
6
Implications of MM Propositions
• At low levels of debt
– The firm’s debt is risk-free
– 𝑟 is independent of D/E
– 𝑟 increases linearly as D/E increases (Proposition II)
• Beyond moderate levels of debt

– Risk of default on debt increases
– 𝑟 goes up
– Rate of increase in 𝑟 slows down (Proposition II)
• Why does 𝑟 increases at a lower rate as D/E increases

(intuitively)?
– Holders of risky debt bear some of the firm’s
business risk. As the firm borrows more, more of
that risk is transferred from stockholders to
bondholders.
13
13
MM Propositions: An Example (BM Chapter 17, Problem 3)

The common stock and debt of Northern Sludge are valued at $50 million and $30 million,
respectively. Investors currently require a 16% return on the common stock and an 8%
return on the debt. If Northern Sludge issues an additional $10 million of common stock and
uses this money to retire debt, what happens to the expected return on the stock? Assume
that the change in capital structure does not affect the risk of the debt and that there are no
taxes.
Initial: E = $50 million D = $30 million 𝑟 =16% 𝑟 =8%

Later: E = $60 million D = $20 million 𝑟 =? 𝑟 =8%
Expected Return on Assets OR Cost of Equity for Unlevered Northern Sludge

𝐷 𝐸 30 50
𝑟 = ×𝑟 + ×𝑟 = × 8% + × 16% = 13%
𝐷+𝐸 𝐷+𝐸 80 80
Expected Return on Stock OR Cost of Equity for Levered Northern Sludge After Refinancing
𝐷 20
𝑟 =𝑟 + 𝑟 −𝑟 = 13% + 13% − 8% × = 14.67%
𝐸 60
14
14
7
Stop and Apply: MM Propositions
What’s wrong with the following arguments? Assume no taxes and other
imperfections.
• “Shareholders demand—and deserve—higher expected rates of return than

bondholders do. Therefore debt is the cheaper capital source. We can reduce
the WACC by borrowing more.”
– The argument will hold as long as the extra borrowing does not lead shareholders to
demand a still higher expected rate of return. However, the cost of equity capital 𝑟
increases by just enough to keep the WACC (𝑟 ) constant (MM II).
15
15
Stop and Apply: MM Propositions [contd.]

• “As the firm borrows more and debt becomes risky, both shareholders and
bondholders demand higher rates of return. Thus by reducing the debt ratio we
can reduce both the cost of debt and the cost of equity, making everybody
better off.”
– As the firm borrows more and debt becomes risky, some of the business risk gets
transferred to bondholders which increases 𝑟 but decreases 𝑟 . However, the WACC (𝑟 )
remains constant even then.
• “Moderate borrowing doesn’t significantly affect the probability of financial

distress or bankruptcy. Consequently, moderate borrowing won’t increase the
expected rate of return demanded by stockholders.”
– Even in the absence of financial distress or bankruptcy, the financial risk to shareholders
increases with increase in leverage in line with MM II (i.e., leverage increases the variability
of EPS)
16
16
8
How Changing Capital Structure Affects Beta: Levering and Unlevering
• A firm’s asset beta is equal to the beta of a portfolio of all the firm’s debt and its
equity. Why?
– If you own a portfolio of all the firm’s securities, you get all the cash flows as well as bear all
the associated risks.
• Also, the beta of a portfolio is a weighted average of the debt and equity betas
𝐷 𝐸 [Unlevered Beta]
𝛽 =𝛽 =𝛽 +𝛽
𝑉 𝑉
• After increasing leverage, the risk of the total portfolio remains unaffected, but
equity is now riskier due to increased financial risk (debt could also be riskier)
• The changed equity beta due to change in capital structure can be obtained as:
𝐷
𝛽 =𝛽 + 𝛽 −𝛽 [Levered Beta]
𝐸
17
17
How Changing Capital Structure Affects Beta: Levering and Unlevering [contd.]
• Debtholders usually bear much less risk than stockholders. Debt betas are often
close to 0, i.e., 𝛽 ≈ 0. In that case:
𝐷
𝛽 =𝛽 1+
𝐸
18
18
9
After-Tax WACC
• Interest paid on debt is tax-deductible
• After-tax cost of debt is 𝑟 (1 − 𝑇 ) where 𝑇 is the marginal corporate tax rate
• After-tax 𝑊𝐴𝐶𝐶 = 𝑟 × 1 − 𝑇 × +𝑟 ×
Note: MM II states that in the absence of taxes the company cost of capital stays the same
regardless of the amount of leverage. But if companies receive a tax shield on their interest
payments, then the after-tax WACC declines as debt increases.
19
19
After-Tax WACC: An Example (BM Chapter 17, Problem 21)

Omega Corporation has 10 million shares outstanding, now trading at $55 per share. The
firm has estimated the expected rate of return to shareholders at about 12%. It has also
issued $200 million of long-term bonds at an interest rate of 7%. It pays tax at a
marginal rate of 35%.
a. What is Omega’s after-tax WACC?
b. How much higher would WACC be if Omega used no debt at all?
Here, E = $550 million, D = $200 million, 𝑟 =12%, 𝑟 =7%, 𝑇 =35%
After-tax 𝑊𝐴𝐶𝐶 = 𝑟 1 − 𝑇 +𝑟 = 7% ∗ 1 − 0.35 ∗ + 12% ∗ = 10.01%
WACC (w/o debt) , 𝑟 = 𝑟 +𝑟 = 7% ∗ + 12% ∗ = 10.67%
20
20
10
After-Tax WACC: An Example (BM Chapter 17, Problem 21) [contd.]
10.67%
7%
21
21
Assigned Problems
22
22
11
Archimedes Levers is financed by a mixture of debt and equity. You have the
following information about its cost of capital:
Can you fill in the blanks?
23
23

Cost of Equity (𝑟 )
• 𝑟 = 𝑟 + 𝛽 (𝑟 − 𝑟 )
• 𝑟 = 10% + 1.5*(18% – 10%)
• 𝑟 = 22%
Cost of Capital (𝑟 )
• 𝑟 =𝑟 +𝑟
• 𝑟 = 12% * 0.5 + 22% * 0.5
• 𝑟 = 17%
24
24
12
Beta of Debt (𝛽 )
• 𝑟 = 𝑟 + 𝛽 (𝑟 − 𝑟 )
• 𝛽 = 22% 17%
0.25 0.875
• 𝛽 = =0.25
Beta of Assets (𝛽 )
• 𝛽 =𝛽 +𝛽
• 𝛽 = 0.25 * 0.5 + 1.5 * 0.5
• 𝛽 = 0.875
25
25
Assigned Problem: Supplementary Problem (SP) 2

Two firms, U and L, are identical except for their capital structure. Both will earn
$150 in a boom and $50 in a slump. There is a 50% chance of each event. U is
entirely equity-financed, and therefore shareholders receive the entire income. Its
shares are valued at $500. L has issued $400 of risk-free debt at an interest rate
of 10%, and therefore $40 of L’s income is paid out as interest. There are no
taxes and other market imperfections. Investors can borrow and lend at the risk-
free rate of interest.
a. What is the value of L’s stock?
b. Suppose that you invest $20 in U’s stock. Is there an alternative investment in
L that would give identical payoffs in boom and slump? What is the expected
payoff from such a strategy?
c. Now suppose that you invest $20 in L’s stock. Design an alternative strategy
with identical payoffs.
d. Now show that MM’s proposition II holds.
26
26
13
Part (a)
• Since U and L are identical except for their capital structure, their market
values must be the same in perfect capital markets (MM I).
• Market value of firm L (VL)= Market value of firm U (VU) = $500
• But, VL = DL + EL ⇒ 500 = 400 + EL ⇒ EL = $100
27
27
Assigned Problem: Supplementary Problem (SP) 2 [contd.]

Part (b)
• Investment in U’s stock = $20 or 4% of U’s stock (20/500)
0.04 ∗ $150 = $6 𝑖𝑛 𝑏𝑜𝑜𝑚

• Earnings for owing 4% ($20) of U’s stock =
0.04 ∗ $50 = $2 𝑖𝑛 𝑠𝑙𝑢𝑚𝑝
0.04 ∗ $(150 − 40) = $4.4 𝑖𝑛 𝑏𝑜𝑜𝑚

• Earnings for owing 4% ($4) of L’s stock =
0.04 ∗ $(50 − 40) = $0.4 𝑖𝑛 𝑠𝑙𝑢𝑚𝑝
• Earnings for lending $16 ($20 – $4) at risk-free rate = 0.10 * $16 = $1.6
• Thus, investment of $20 in U’s Stock = Investment of $4 in L’s Stock +

Lending $16 at the risk-free rate
28
28
14
Part (c)
• Investment in L’s stock = $20 or 20% of L’s stock (20/100)
0.20 ∗ $(150 − 40) = $22 𝑖𝑛 𝑏𝑜𝑜𝑚

• Earnings for owing 20% ($20) of L’s stock =
0.20 ∗ $(50 − 40) = $2 𝑖𝑛 𝑠𝑙𝑢𝑚𝑝
0.20 ∗ $150 = $30 𝑖𝑛 𝑏𝑜𝑜𝑚

• Earnings for owing 20% ($100) of U’s stock =
0.20 ∗ $50 = $10 𝑖𝑛 𝑠𝑙𝑢𝑚𝑝
• Payment for borrowing $80 ($20 – $100) at risk-free rate = 0.10 * $80 = $8
• Thus, investment of $20 in L’s Stock = Investment of $100 in U’s Stock +

Borrowing $80 at the risk-free rate
29
29

Part (d)
• MM II: 𝑟 = 𝑟 + 𝑟 − 𝑟
. ∗ . ∗
• Return on assets or equity for U = = = 20%
• Return on assets for L, 𝑟 = Return on assets or equity for U = 20%
. ∗ . ∗
• Return on equity for L, 𝑟 = = = 60%
• LHS = 𝑟 = 60%
• RHS = 𝑟 + 𝑟 − 𝑟 = 20 + (20 − 10) = 60%
• LHS = RHS
30
30
15
Thank You
31
31
16
Capital Structure – II
Prof. Varun Jindal

Office: D-008
Agenda
• Leverage and Firm-Value With Taxes
Reading:
• BM Chapter 18 – Sections 18.1 and 18.3
1
Introduction
• What we know so far?
– Debt policy doesn’t matter in a well-functioning capital market with no frictions or imperfections
India (2017)
Industry Median Book Debt Ratio United States (2013)
Online Marketplaces 0.01 Industry Median Book Debt Ratio
ITES 0.10 Internet information providers 0.02
Education 0.13 Communications equipment 0.10
Computer Software 0.17 Integrated oil and gas 0.12
Tourism 0.18 Software 0.18
Trading 0.26 Semiconductors 0.18
Tobacco Products 0.27 Appliances 0.23
Beverages 0.28 Railroads 0.38
Hotels and Restaurants 0.35 Biotechnology 0.39
Healthcare 0.42 Aerospace 0.40
Minerals 0.46 Chemicals 0.42
Conventional Electricity 0.47 Gas utilities 0.45
Cement 0.61 Airlines 0.62
Road Transport Services 0.61 Hotels 0.74
Steel 0.64
Fertilizers 0.66
• Do financial managers worry about debt policy in practice? Yes

3
Corporate Taxes
• The interest on debt paid by a firm is a tax-deductible expense
• The tax deductibility of interest increases the total income that can be paid out
to bondholders and shareholders
2
Corporate Taxes [contd.]
Example: Firm U has no debt. Firm L has borrowed $1,000 at 8%. The marginal
corporate tax rate for both firms is 35%.
Income Statement (in USD)

Firm U Firm L
EBIT 1,000 1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax @ 35% 350 322
Net income to shareholders 650 598
Total income to both bondholders and shareholders 0 + 650 = 650 80 + 598 = 678
Interest tax shield (.35 x interest) 0 28
L’s tax bill is $28 less than U’s. This is the tax shield provided by the debt of L.
Total income that L pays out to its bondholders and shareholders increases by $28.
5
Corporate Taxes [contd.]

• If the debt of L is fixed and permanent, it has a permanent stream of cash flows
of $28 per year.
• The risk of the tax shields can be assumed to be the same as that of the interest
payments generating them.
– Note that the expected rate of return demanded by investors who are holding L’s debt is 8%
28
• PV (Tax Shield) = = $350
.08
𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡
• In general, 𝑃𝑉 (𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐷𝑒𝑏𝑡
𝑇 ×𝑟 ×𝐷
𝑃𝑉 (𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) = =𝑇 ×𝐷
𝑟
6
3
MM I With Taxes
• Value of a firm in the presence of taxes:
Value of the Levered Firm (𝑉 ) = Value of the Unlevered Firm (𝑉 )+ PV(Tax Shield)
• In the special case of fixed, permanent debt:

𝑉 = 𝑉 +𝑇 ×𝐷
• What does the above formula imply about the optimal capital structure?
– All firms should be 100% debt-financed
MM I With Taxes [contd.]

• Do you think firms should be 100% debt-financed?
– Firms that borrow incur other costs (costs of financial distress and bankruptcy)
– The perpetual debt assumption overstates the PV of tax shield
• How could perpetual debt assumption overstate the PV of tax shield?

– Interest tax shields can’t be used unless there will be future profits to shield
4
Costs of Financial Distress
• When does financial distress occur?
– Financial distress occurs when promises to creditors are broken or honored with difficulty
• Does financial distress always lead to bankruptcy?

– Financial distress may or may not lead to bankruptcy
• Investors anticipate the possibility of levered firms falling into financial distress.
This concern is reflected in the current market value of the levered firm’s securities.
• Thus, the value of the levered firm can be broken down into three parts:
𝑉 = 𝑉 + 𝑃𝑉 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 − 𝑃𝑉(𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠)
• The costs of financial distress depend on:

– Probability of distress
– Magnitude of costs encountered if distress occurs
9
MM I With Taxes and Financial Distress Costs
Maximum Value of Firm

The trade-off between the
benefits of tax shield and the PV of Costs of
Market Value of the Firm
Financial Distress
costs of distress determines
optimal capital structure.
PV of Interest
Tax Shields
Value of Levered Firm (VL)
This is called the trade-off

theory of capital structure. Value of
Unlevered
Firm (VU)
Optimal debt ratio
Debt Ratio
10
10
5
Different Forms of Financial Distress Costs
Form 1: Bankruptcy Costs
• What is Bankruptcy? When does it occur?

– Shareholders have limited liability that allows them to walk away from the firm when it gets into
trouble
– Former creditors become new shareholders of the firm; Old shareholders are left with nothing
– Note: Not every firm that gets into trouble goes bankrupt.
• Bankruptcy costs: Legal, accounting, and other professional fees

– Lawyers and other professionals are involved throughout during bankruptcy
11
11
Different Forms of Financial Distress Costs

Form 1: Bankruptcy Costs [contd.]
• Who bears the bankruptcy costs?

– The costs of bankruptcy come out of shareholders’ pockets.
– Creditors foresee the costs and foresee that they will pay them if default occurs.
– For this they demand a higher promised interest rate in advance.
– This reduces the possible payoffs to shareholders and reduces the present market value of their
shares.
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12
6
Different Forms of Financial Distress Costs [contd.]
Form 2: Costs of Financial Distress Short of Bankruptcy
• Impaired ability to conduct business

– Customers may stop buying products due to concern about resale value and the availability
of service/replacement parts
– Suppliers may stop giving trade credit
– Existing employees keep slipping away from their desks for job interviews
– Potential employees are unwilling to sign on
• Agency costs of debt: Conflicts of interest between bondholders and

shareholders leading to poor operating and investment decisions
– Excessive risk-taking
– Underinvestment (Refusing to contribute equity capital)
– Cash in and run (Milking the property)
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13
Agency Costs of Debt: Example of a Firm in Financial Distress
Assets BV MV Equity & Liabilities BV MV

Fixed Assets $400 $0 Equity $300 $0
Cash $200 $200 Long-Term Debt $300 $200
Total $600 $200 Total $600 $200
• What will bondholders and shareholders get if the distressed firm is liquidated
today?
– Bondholders get $200
– Shareholders get nothing
• Let’s now analyze how the agency costs of debt/borrowing!
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14
7
Agency Costs of Debt Possibility 1: Excessive Risk-Taking
• What happens if the following investment opportunity comes up? The cost of the
investment is $200 (all the firm’s cash), and the required return is 50%.
Payoff = $1,000
1
Invest $200
0
1
Payoff = 0
• Expected payoff from the Gamble = $1000 × 0.10 + $0 = $100
. × , ( . × )
• 𝑁𝑃𝑉 = −200 + = −$133
.
• Should this project be accepted or rejected?

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Agency Costs of Debt Possibility 1: Excessive Risk-Taking [contd.]

PV of Bonds PV of shares
Without Risky Project Without Risky Project

• PV of bonds = $200 • PV of shares = 0
With Risky Project With Risky Project

• Expected payoff to bondholders after 1 period • Expected payoff to shareholders after 1 period
= $300 × 0.10 + $0 = $30 = ($1,000 – $300) × 0.10 + $0 = $70
$ $
• PV of bonds = = $20 • PV of shares = = $46.67
. .
Managers, acting on behalf of shareholders, accept this risky –ve NPV project.
16
16
8
Agency Costs of Debt Possibility 2: Underinvestment
Consider a government–sponsored project that guarantees $350 in one period.
The cost of investment is $300 (the firm only has $200 now), so the shareholders
will have to supply an additional $100 to finance the project. The required return
is 10%.
$350
NPV = –$300 +
(1.10)
NPV = $18.18
Should this project be accepted or rejected?
17
17
Agency Costs of Debt Possibility 2: Underinvestment [contd.]

PV of Bonds PV of Shares
Without Project (Underinvestment) Without Project (Unerinvestment)

• PV of bonds = $200 • PV of shares = 0
With Project With Project

• Expected payoff to bondholders after 1 period • Expected payoff to shareholders after 1 period
= $300 = ($350 – $300) = $50
$ $
• PV of bonds = = $272.73 • PV of shares = −$100 + = −$54.54
. .
Managers, acting on behalf of shareholders, reject this +ve NPV project.

18
18
9
Agency Costs of Debt Possibility 3: Cash In and Run
Shareholders may be reluctant to put money into a firm in financial distress
(underinvestment), but they are happy to take the money out in various forms:
• Paying liquidating dividends

– Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm
insolvent, with nothing for the bondholders, but plenty for the former shareholders.
– Note: Such tactics often violate bond indentures
• Increasing perquisites to shareholders and/or management
19
19
Reducing Agency Costs of Debt: Limit Borrowing

• The more the firm borrows, the higher are the agency costs of debt.
• The increased odds of poor decisions in the future prompt investors to mark
down the present market value of the firm.
• The fall in value comes out of the shareholders’ pockets. Therefore, it is

ultimately in their interest to avoid temptation.
• The easiest way to do this is to limit borrowing to levels at which the firm’s
debt is safe.
20
20
10
A Question
Why debt ratios are low for firms with a higher proportion of intangible assets?
• Because the costs of distress vary with type of asset
• The values of intangible assets (technology, human capital, brand image etc.) are
considerably diminished when passing through bankruptcy
• That is why debt ratios are low in the pharmaceutical industry, where value
depends on continued success in R&D, and in many service industries where
value depends on human capital.
21
21
Assigned Problems
22
22
11
The Salad Oil Storage (SOS) Company has financed a large part of its facilities with
long-term debt. There is a significant risk of default, but the company is not on the
ropes yet. Explain:
a. Why SOS stockholders could lose by investing in a positive-NPV project
financed by an equity issue.
b. Why SOS stockholders could gain by investing in a negative-NPV project
financed by cash.
c. Why SOS stockholders could gain from paying out a large cash dividend.
23
23

a. SOS stockholders could lose if they invest in the +ve NPV project and then
SOS becomes bankrupt. Under these conditions, the benefits of the project
accrue to the bondholders.
b. If the new project is sufficiently risky, then, even though it has a –ve NPV, it
might increase stockholder wealth by more than the money invested. This is a
result of the fact that, for a very risky investment, undertaken by a firm with a
significant risk of default, stockholders benefit if a more favorable outcome is
actually realized, while the cost of unfavorable outcomes is borne by
bondholders.
c. If SOS pays out all of its assets as one lump-sum dividend, stockholders get all
of the assets, and the bondholders are left with nothing.
24
24
12
Amalgamated Products has three operating divisions:
Division Percentage of Firm Value
Food 50
Electronics 30
Chemicals 20
To estimate the cost of capital for each division, Amalgamated has identified the
following three principal competitors:
Estimated Debt
Competitor
Equity Beta Debt + Equity
United Foods 0.8 0.3
General Electronics 1.6 0.2
Associated Chemicals 1.2 0.4
Assume these betas are accurate estimates and that the CAPM is correct. Assume
further that the Amalgamated is exempt from corporate income tax.
25
25

a. Assuming that the debt of these firms is risk-free, estimate the asset beta for
each of Amalgamated’s divisions.
b. Amalgamated’s ratio of debt to debt plus equity is 0.4. If your estimates of
divisional betas are right, what is Amalgamated’s equity beta?
c. Assume that the risk-free interest rate is 7 percent and that the expected
return on the market index is 15 percent. Estimate the cost of capital for each
of the Amalgamated’s divisions.
d. How much would your estimates of each division’s cost of capital change if you
assumed that debt has a beta of 0.2?
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26
13
Solution to Assigned Problem: Supplementary Problem (SP) 3
Part A: Finding asset (unlevered) betas for individual divisions of Amalgamated
(Asset beta of a division = Asset beta of a comparable firm or competitor)
𝐷 𝐸 𝐷 𝐷 𝐸
Division/Firm 𝛽 =1− 𝛽 𝛽 =𝛽 +𝛽
𝑉 𝑉 𝑉 𝑉 𝑉
Food 0.3 0 0.7 0.8 0.56
Electronics 0.2 0 0.8 1.6 1.28
Chemicals 0.4 0 0.6 1.2 0.72
Part B.1: Finding asset (unlevered) beta of Amalgamated

(Asset beta of a portfolio = Weighted average of asset betas of portfolio constituents)
𝛽 𝐴𝑚𝑎𝑙𝑔𝑎𝑚𝑎𝑡𝑒𝑑 = 0.50 × 𝛽 𝐹𝑜𝑜𝑑 + 0.30 × 𝛽 𝐸𝑙𝑒𝑐𝑡𝑟𝑜𝑛𝑖𝑐𝑠 + 0.20 × 𝛽 𝐶ℎ𝑒𝑚𝑖𝑐𝑎𝑙𝑠
⇒ 𝛽 𝐴𝑚𝑎𝑙𝑔𝑎𝑚𝑎𝑡𝑒𝑑 = 0.50 × 0.56 + 0.30 × 1.28 + 0.20 × 0.72 = 0.808
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27
Solution to Assigned Problem: SP 3 [contd.]

Part B.2: Finding equity (levered) beta of Amalgamated
𝐷
𝛽 =𝛽 + 𝛽 −𝛽
𝐸
0.4
⇒ 𝛽 (𝐴𝑚𝑎𝑙𝑔𝑎𝑚𝑎𝑡𝑒𝑑) = 0.808 + 0.808 − 0
0.6
⇒ 𝛽 (𝐴𝑚𝑎𝑙𝑔𝑎𝑚𝑎𝑡𝑒𝑑) = 1.35
Part C: Finding cost of capital for divisions of Amalgamated using CAPM

𝑟 =𝑟 +𝛽 𝑟 −𝑟
⇒𝑟 𝐹𝑜𝑜𝑑 = 7% + 0.56 15% − 7% = 11.48%
⇒𝑟 𝐸𝑙𝑒𝑐𝑡𝑟𝑜𝑛𝑖𝑐𝑠 = 7% + 1.28 15% − 7% = 17.24%
⇒𝑟 𝐶ℎ𝑒𝑚𝑖𝑐𝑎𝑙𝑠 = 7% + 0.72 15% − 7% = 12.76%

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14
Solution to Assigned Problem: SP 3 [contd.]
Asset Betas of Different Divisions of Amalgamated Products
Asset Beta Asset Beta
Division
(When Debt Beta = 0) (When Debt Beta = 0.2)
Food 0.56 0.62
Electronics 1.28 1.32
Chemicals 0.72 0.80
Equity Beta of Amalgamated Products

When Debt Beta = 0 When Debt Beta = 0.2
Asset Beta of Firm 0.808 0.866
Debt Ratio (D/V) 0.40
Equity Beta of Firm 1.35 1.31
Cost of Capital for Different Divisions of Amalgamated Products

Risk-Free Rate 7%
Expected Return on Market 15%
Cost of Capital Cost of Capital

Division
(When Debt Beta = 0) (When Debt Beta = 0.2)
Food 11.48% 11.96%
Electronics 17.24% 17.56%
Chemicals 12.76% 13.40%
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29

Milton Industries expects free cash flow of $5 million each year. Milton’s corporate
tax rate is 35% and its unlevered cost of capital is 15%. The firm also has
outstanding debt of $19.05 million, and it expects to maintain this level of debt
permanently.
a. What is the value of Milton Industries without leverage?
b. What is the value of Milton Industries with leverage?
30
30
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Solution to Assigned Problem: Supplementary Problem (SP) 4
a. Value of unlevered Milton Industries
5
𝑉 = = $33.33 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
0.15
b. Value of levered Milton Industries
𝑉 = 𝑉 + 𝑇 × 𝐷 = 33.33 + 0.35 × 19.05 = $40 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
31
31
Thank You
32
32
16

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Capital Budgeting – I

CORPORATE FINANCE: SESSIONS 11-12

Prof. Varun Jindal

• Internal Rate of Return (IRR)

• Book (Accounting) Rate of Return

An investment rule will lead to inferior decisions if it

Techniques for Evaluating Investment Projects: A Survey of CFOs

NPV: A Quick Review [contd.]

A −2000 500 500 5000

B −2000 500 1800 0

C −2000 1800 500 0

Payback Period: An Example [contd.]

Discounted Payback Period

A −2000 500 500 5000

B −2000 500 1800 0

C −2000 1800 500 0

Discounted Payback Period: An Example [contd.]

Internal Rate of Return (IRR)

⇒ IRR = 28.08% -2,000

IRR, Opportunity Cost of Capital, and NPV

• If IRR > Opportunity cost of capital ⇒ + NPV Opportunity cost of capital is

Project C0 C1 IRR NPV@10%

• The IRR method cannot distinguish between investing and borrowing

IRR Pitfall 2: Multiple IRRs or No IRR

– There can be as many different solutions to

– Since there are 2 changes of sign, there

– NPV is 0 when IRR is either 3.5% or

Value at t=5 of all cash flows from year 5 to year 10 = 1.34

IRR Pitfall 2: Multiple IRRs or No IRR [contd.]

Project C0 C1 C2 IRR NPV@10%

– Project G has a positive NPV at all discount rates

• Project I has a higher NPV, but Project H has a higher IRR!

• IRR is unreliable in ranking projects that differ in the scale of investment.

IRR Pitfall 3A: Mutually Exclusive Projects – Difference in Scale of Investment

Note: Incremental cash flow trick can be used only if Projects H

• Project K has a higher NPV, but project J

• IRR is unreliable in ranking projects that

Note: Incremental cash flow trick can be used only if Projects J

• Remember our most general formula for calculating NPV:

NPV Vs. IRR

• IRR may fail under the following circumstances:

• Discounted Payback Period

Summary − Discounted Cash Flow Techniques

Assigned Problem: BM Chapter 5, Problem 8

Cash Flows ($)

Assigned Problem: BM Chapter 5, Problem 12

Cas h Fl ows ($ thousands)

Solution to Assigned Problem: BM Chapter 5, Problem 12 [contd.]

Cas h Fl ows ($ thousands)

Solution to Assigned Problem: BM Chapter 5, Problem 13

IRR (x) of the incremental project B – A can be found by x = 0.2113 x = 0.7887

−300 900 −650

Prof. Varun Jindal

• Do not confuse cash flow with accounting income.

Preparation of Accounting Income: Adjustment for Capex

• Instead of deducting capex as it occurs, the accountant depreciates the outlay

Preparation of Accounting Income: Adjustment for Working Capital

• Example: What is the accounting income for the following firm?

– Year 2: The firm sells these goods for $100 on credit

• How will an accountant record these transactions?

Preparation of Accounting Income: Adjustment for Working Capital [contd.]

• The difference between a company’s short-term assets and short-term liabilities