Finance I

By: Andrew Iu

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Table of Contents
Reminders
Chapter Chapter Chapter Chapter Chapter 4 5 6 10 & 11 7

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Questions to Review
Chapter 9 Chapter 22 Chapter 11 1.1 1.2 1.3 1.4 1.5 1.6 4.1 4.2 4.3 4.4 4.5 4.6 4.7

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4 4 4 4 4 5 5 5 6 6 6 8 8 8

Week 1, Class 1
What is Corporate Finance? Corporate Securities as Contingent Claims on Total Firm Value The Corporate Firm Goals of the Corporate Firm Financial Institutions, Financial Markets and the Corporation Trends in Financial Markets and Management The Financial Market Economy Making Consumption Choices Over Time The Competitive Market The Basic Principle Practicing the Principle Illustrating the Principle Corporate Investment Decision Making

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Week 1, Class 2

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10 10 10 11 11 11 11 13 13 13 13 14 15 15 16 16 16 17 17 17 18 18

Week 2, Class 1

Week 3, Class 1 Week 3, Class 2

5.1 The One-Period Case 5.2 The Multiperiod Case 5.3 Compounding Periods 5.4 Simplifications 5.5. What is a Firm Worth? 6.2 How to Value Bonds 6.3 Bond Concepts The Term Structure of Interest Rates The Expectations Hypothesis The Liquidity Preference Theory 6.4 6.5 6.6 6.7 6.7 The Present Value of Common Stocks Estimates of Parameters in the Dividend Discount Model Growth Opportunities The Dividend Growth Model and the NPVGO Model (Advanced) Price-Earnings Ratio

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15 16

Week 4, Class 2

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Week 5, Class 1
15.1 15.2 15.3 15.4 15.5

Week 6, Class 1

Common Stock Corporate Long-Term Debt: The Basics Preferred Shares Income Trusts Pattens of Long-Term Financing

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19 19 20 21 21 22 22 22 22 22 22 23 23 23 23 24 25 26 27 28 30 30 30 30 31 31 31 32 32 32 33 33 34 34 34 36 36 36 36 37 37 37 37 37 38 40

Week 6, Class 2
11.1 11.2 11.3 11.4 11.5 11.6

10.1 Returns 10.2 Holding Period Returns 10.3 Return Statistics 10.4 Average Stock Returns and Risk-Free Returns 10.5 Risk Statistics 10.6 More on Average Returns Individual Securities Expected Return, Variance, and Covariance Risk and Return for Portfolios The Efficient Set for Two Assets The Efficient Set for Many Securities Diversification: an Example

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Week 8, Class 1

Week 8, Class 1 (cont’d)
12.1 12.2 12.3 12.4 12.5 12.6 12.7 13.1 13.2 13.3 13.4 13.6

11.7 Riskless Borrowing and Lending 11.8 Market Equilibrium 11.9 Relationship between Risk and Expected Return (CAPM) Factor Models: Announcements, Surprises and Expected Returns Risk: Systematic and Unsystematic Systematic Risk and Betas Portfolios and Factor Models Betas and Expected Returns The Capital Asset Pricing Model and the Arbitrage Pricing Theory Parametric Approaches to Asset Pricing The Cost of Equity Capital Estimation of Beta Determinants of Beta Extensions of the Basic Model Reducing the Cost of Capital

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Week 8, Class 1

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Week 8, Class 2

Week 9, Class 1
7.1 7.2 7.3 7.4 7.5 7.6 7.7

14.1 Can Financing Decision Create Value? 14.2 A Description of Efficient Capital Markets 14.3 & 14.4 The Different Types of Efficiency and the Evidence for Each 14.5 The Behavioural Challenge to Market Efficiency 14.6 Empirical Challenges to Market Efficiency 14.7 Reviewing the Differences 14.8 Implications for Corporate Finance Why Use NPV? The Payback Period Rule The Discounted Payback Period Rule The Average Accounting Return The Internal Rate of Return Problems with the IRR Approach Profitability Index (PI)

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W9,C2 - W10,C2

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Week 11, Class 1

8.1 Incremental Cash Flows 41 8.2 The Majestic Mulch and Compost Company: An Example 41 8.3 Inflation and Capital Budgeting 41 8.4 Alternative Definitions of Operating Cash Flow 41 8.5 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 42 8.6 Investments of Unequal Lives: The Equivalent Annual cost method 42 Appendix 8A - Capital Cost Allowance 43 22.1 Types of Leases 22.2 Accounting and Leasing 22.3 Taxes and Leases 22.4 The Cash Flows of Financial Leasing 22.4 A Detour on Discounting and Debt Capacity with Corporate Taxes 22.5 NPV Analysis of the Lease-Versus-Buy Decision 22.8 Does Leasing Ever Pay? The Base Case 22.9 Reasons for Leasing 22.9 Some Unanswered Questions 9.1 Decision Trees 9.2 Sensitivity Analysis, Scenario Analysis and Break-Even Analysis 9.3 Monte Carlo Simulation

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44 44 44 44 45 45 45 45 45 46 46 46

Week 11, Class 2

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• YTM = APR • When applying spot rates (to bond pricing) apply the one-year spot rate to the first coupon payment.12 . • (6A. remember to grow the first dividend of the perpetuity by the correct amount Chapter 10 & 11 • Variance is the sum of the squared residuals divided by N . • Read the question carefully • The expected return on a portfolio is the weighted expected return on the securities • The formula for the variance of a portfolio is (Xa)²(Var(a)) + 2(Xa)(Xb)Cov(a. • In a dividend pricing question. but is compounded semi-annually or to match the payment increments.average)..liquidity premiums apply only to the given time horizon). REMEMBER TO SQUARE ROOT THE VARIANCE • When calculating covariance. Do NOT discount without converting to EAR.observation).1 NOT SIMPLY N • WHEN CALCULATING THE VALUE OF THE SD FOR A PORTFOLIO. • Remember that spot rates are cumulative and future rates are not cumulative. • The YTM is always given at an annual rate. where the signs are irrelevant. It is not like variance. The formula is (observation . remember that the SIGNS MATTER. not (average . and so on. where this is a finite growing annuity and a terminal perpetuity. the value of the denominator is the average book value • This implies that you actually need to add up each year’s book value and divide by the number of years! • Do not simply take the average of the first and last years’ book values 4 . the two-year spot rate to the second.b). • To calculate the value of a share in x periods. The change in Y is NPV(1+r) Chapter 5 Chapter 6 • LOOK FOR ANNUITY’S IN ADVANCE/ARREARS. compound the growth of the dividend forward to that period and apply the perpetuity formula.. Do not simply perform a future value calculation (this does not account for the growth rate).Reminders Chapter 4 • The change in x resulting from an investment project is the NPV. It is NOT the change in Y. • NOT -2(Xa)(Xb)Cov(a.b) • The portfolio with the least risk is called the minimum variance portfolio • Get the variance on a portfolio calculation right! MULTIPLY the weights by the SDs. Chapter 7 • In the AAR calculation.

7 .Remember to when calculating the weighted expected returns to calculate the % weight correctly • 11.remember to multiply by 1-t when performing break-even sales questions • 9.remember to look carefully at the time periods.When calculating a portfolio variance/SD under varying probabilities. part 2 . • 9.Questions to Review Chapter 9 • 9.7.12 . remember that you must first determine the portfolio return under each scenario and then calculate the portfolio’s variance from there 5 .3 . use the before-tax interest rate as the discount rate Chapter 11 • 11.1 .1 .remember to add depreciation to fixed costs for the numerator in the breakeven formula Chapter 22 • 22.Read the question carefully • 11.11 • lease payments are after tax • if a company receives no tax shield.

Retained cash flows. 1. • Value creation depends upon cash flows. analyzing capital expenditures. • The value of the firm is equal to the debt plus the equity. 1. in excess of the cash flows paid to creditors (debt holders) and shareholders. • Shareholders’ equity equals the asset value of the firm less debt. and information systems. these securities are said to be contingent claims on the total firm value.3 The Corporate Firm Finance I Notes 6 . How can the firm raise the cash for these investments? (capital structure) C. • Finance answers three questions: A. If this is the case. the capital mixture generating the most value must be chosen. which includes taxes.Current Liabilities. the mixture of capital can alter the value of the firm. • The treasurer is responsible for handling cash flows.1 What is Corporate Finance? • The firm is financed with debt and equity. and making financing plans. How should short-term operating cash flows be managed? (net working capital) • Net Working Capital = Current Assets .2 Corporate Securities as Contingent Claims on Total Firm Value • Since debt and equity securities depend on the value of the firm. The controller handles the accounting function. In what long-term assets should the firm be invested? (capital budgeting) B. Class 1 1.Week 1. costs and financial accounting. increase the value of the firm.

Partnership income is taxed. Limited life. Liability Unlimited liability. Limited partners are not liable. Complexity of Set-Up No formal charter required (and therefore the cheapest). shareholders elect a board of directors who. Complete control by owner. Perpetual life. Partnerships are generally prohibited from reinvesting partnership cash flow. limited liability was extended to trust holders later as the structure grew in importance. in turn. select senior management.Sole Proprietorship Definition Business owned by one person. distributions are taxed only in the hands of the unitholders. Partnership Business owned by two or more people. Incorporators must prepare articles of incorporation and a set of bylaws. however. Units subject to restrictions on transferability.each partner agrees to share some management work and liability. depending of partnership complexity. There is no market for trading units. • Since it is not a corporation. Corporation Business entity created a distinct ‘legal person’ composed of one or more actual individuals or legal entities. • For the same reason. Broad latitude on reinvestment and dividend payout. No distinction is made between personal and business assets. general partners manage firm. Shareholders are not personally liable for obligations of the corporation. Equity investment is limited to sole proprietor’s personal wealth. Limited life. There are two types: 1) general partnership . Liquidity and Marketability Voting Rights Each share typically has one vote. general partners may have unlimited liability. Common stock can be listed on exchange. Some voting control by limited partners. 2) limited partnership . Some written documents required.one partner is a general partner and the limited partners do not participate in managing the business. unitholders originally did not enjoy limited liability. Continuity of Existence • Income trusts hold the debt and equity of an underlying business and distribute income to unitholders. Both corporate profits and dividends are taxed (though a dividend tax credit exists). Reinvestment and Dividend Payout Broad latitude on reinvestment and dividend payout. All net cash flow is distributed to partners. Finance I Notes 7 . Taxation All business income is taxed at personal income tax rate.

• Placements of new issues can be either: • Private . an auction market) are said to be listed. 1. and • The dropping of share price leaves a company vulnerable to takeovers (by other firms.sold to buy-side financial institutions like pension funds and mutual funds. • The foreign exchange market is the world’s largest over-the-counter (dealer) market. • Contracts with management and compensation arrangements (such as stock option plans). these are often called money-market instruments.buyers and sellers interact directly to exchange securities. • Shareholders (the principals) hire managers (the agents) to act on their behalf. • Stocks that trade on an organized exchange (i. • Short term debt securities trade in money markets. limited transferability of issues and unlimited liability for owners. • Public .) • Donaldson argued that the basic financial objective of managers is the maximization of corporate wealth. for instance).). • In this case. • Capital markets are forums for raising long-term debt or equity. suppliers and the public. • The costs of aligning managers’ goals with shareholders’ goals are called agency costs.6 Trends in Financial Markets and Management Finance I Notes 8 . • The diffusion of ownerships generates an ownership-control dichotomy. • Primary markets are those markets where securities are initially issued. • Stakeholders include shareholders. 1. These include: • Monitoring costs. • It is assumed that these two groups will behave in a self-interested manner. governments. Because sole proprietorships and partnerships have limited lives. • Secondary markets are markets where securities are traded after they are issued.sold to retail investors. The spread on the interest rates rendered to each party is the intermediary’s profit-making mechanism. etc.. as opposed to an auction market (where buyers and sellers trade directly with one another). • There are three distinct sets of corporate interests: shareholders. etc. • Williamson proposes the notion of expense preference: that managers prefer certain types of expenses (office furniture. Financial Markets and the Corporation • Financial institutions serve as intermediaries between fund suppliers (investors) and fund raisers (corporations. 1.4 Goals of the Corporate Firm • Set-of-Contracts Viewpoint: view of the corporation as a set of contracting relationships among individuals who have conflicting objectives. This process involves the bankers purchasing the issue and reselling it. • Indirect finance refers to the use of an intermediary to match lenders and borrowers of funds. • There are two kinds of secondary markets • Auction markets .e. which is the amount of wealth over which management has control. raising capital is very difficult for these forms of business organization.5 Financial Institutions. directors and executives. • Shareholders align managerial interests with their own through several mediums: • They control the election of the board of directors. employees. • Dealer markets . • The money market is a dealer market (dealers buy and sell securities are their own risk). and • Incentive costs. profit is made on the spread between the purchase price and the sale price. This view point suggests that the corporate firm will attempt to maximize the shareholders’ wealth by taking actions that increase the current value per share of existing stock in the firm.• The corporation is a company form used to solve the problem of raising large amounts of cash. management. customers. This is not the same as shareholder wealth. underwriting is often conducted by a banker or group of bankers (called a syndicate). • Residual losses are the lost wealth to shareholders due to divergent behaviour of managers. such as shareholders and mangers.a collection of dealers buy and sell securities (called over-the-counter market). company cars. • Direct finance refers to the circumventing to the intermediary by the lender and borrower.

• Financial engineering involves the designing of new securities and new financial processes. Successful financial engineering: • Controls risk. and • Reduces tax Finance I Notes 9 .

The red line represents the result of a shift in the interest rate. • It is the intersection between the supply and demand curves for fund where the ‘price’ of the funds is the interest rate. funds can be rationed. Class 2 4.Week 1. if supply exceeds demand (because the interest rate is unreasonably high). and • There are many traders and no single trader can influence the market. This results from three conditions: • Trading is costless. Maximum possible consumption in one year **the line is straight because we assume the individual does not influence the market rate of interest (r). • Financial intermediaries match borrowers (issuers of financial instruments) and lenders (buyers of financial instruments). 10 . • Bearer instruments are a type of financial instrument which convey interest payments.3 The Competitive Market X A X + Y/(1+r) Consumption Now • We assume perfectly competitive financial markets in which all agents are price takers. • The interest rate where the funds demanded equals the funds supplied is called the equilibrium rate of interest. Y + X(1+r) B slope = -(1+r) Point of zero borrowing Y C Maximum possible consumption now 4. • In market disequilibrium.2 Making Consumption Choices Over Time Consumption in One Year *the interest rate is considered risk-free since we assume default cannot occur. 4. • Financial markets permit varying inter-temporal consumption preferences • Financial instruments are byproducts of financing arrangements between those who require funds and those who are willing to invest funds. This condition. the amount lenders can provide may be restricted by the intermediary. market access is free.1 The Financial Market Economy • Financial markets develop to facilitate borrowing and lending between individuals. • Information on borrowing and lending is readily available. This is a condition of a perfectively competitive financial market. For instance. • Market clearing refers to a condition where the supply of funds (generated by lenders) exactly equals the demand for funds (generated by borrowers). will not last long as transactions beyond the intermediary place downward pressure on the interest rate. however.

7 Corporate Investment Decision Making Consumption Now 11 . 4. Consumption in One Year Y + X(1+r) + ∆Y slope = -(1+r) • Assume investment instrument 1 has a return (r1) greater than the market rate (r). • ∆Y = ∆X • (1+r) Y + X(1+r) B ∆Y = investment cost • (r1 .• If the possibility exists of borrowing and lending at different interest rates (assuming the same level of risk). regardless of the size of the investment).r) Y C ∆X = investment cost • (r1 . • NPV is a measure of the amount of cash an investor would require today to substitute for the investment. 4. It shifts the budget line up by ∆Y. 4. • The separation theorem states that the regardless of consumption preference. • If NPV > 0. if an investment instrument has a positive NPV. arbitrage will occur to close the interest rate spread. the consumption mix curve shifts outward and the investment should be undertaken.4 The Basic Principle • The financial markets provide a benchmark for testing investments. • ∆X is called the NPV of the investment. the investment should not be undertaken. This is called the first principle of investment decision making. It is equal to ∆Y divided by (1+r). The value of an investment to an individual does not depend on consumption preferences. • An investment project is only desirable if it expands the range of consumption choices (shifts the consumption mix curve out). if NPV < 0.r) / (1+r) X A X + Y/(1+r) 4. the consumption mix curve is shifted outward (the individual does not necessarily have to sacrifice current consumption.6 Illustrating the Principle • Net present value = present value of the cash flow [ CF / (1+r) ] less the outlay (cost of the investment). This is called the NPV rule. it should be purchased. • Note that as long as an investment project has a positive NPV. they are also mechanisms for enabling investments.5 Practicing the Principle • Not only are financial markets a benchmark.

his shares will increase by his ownership portion of the NPV. • One difference between the firm and the individual is that the firm has no consumption endowment. • If an individual investor wishes to consume today. they will be acting in the best interest of shareholders. • As long as managers follow the NPV rule.• Shareholders in a firm will be unanimous in accepting positive NPV projects (since they will always increase the value of the firm). positive NPV will always be accepted. his shares will increase by his ownership portion of the NPV times (1+r). if an investor wishes to consume in one year. • Regardless of the consumption preferences (patient or impatient) of individual shareholders. Consumption in One Year NPV Quantity Starting point: consumption now = 0. consumption in one year = 0 Consumption Now 12 .

present and future value analyses will always lead to the same decision. continuous compounding generates the highest FV of any compounding period. • Net present value is the present value of the cash flows minus the present value of the cost of the investment.4 Simplifications • There are four types of cash flow series: • Perpetuity. then the future value calculation is: • FV = PV • e^(r•t) • Because interest accrues continually upon interest. convert r to an effective annual rate figure. • r^2 represents the compound interest (interest upon interest). • It is important to apply the correct discount rate to calculate the present value of each. • T represents the number of periods • r represents the interest in a single period • When analyzing investment alternatives. • The conversion formula (to determine EAR) is (1 + r/m)^m -1. and • Growing Annuity. • The present value of each of the above has a finite value (including the perpetual cash flow streams). • In the case of mortgages. and 13 . determine the monthly rate which. 5. • The effective annual rate (EAR) is the annual rate when a consideration is made for compounding. • The present value of a set of cash flows is simply the sum of the present values of the individual cash flows. • 2r represents the simple interest (without accruing interest).3 Compounding Periods • The stated annual interest rate is the annual interest rate without consideration for compounding (also called annual percentage rate). • Annuity. • Therefore. the future value = $1 • (1 + r) • (1 + r) = 1 + 2r + r^2. • The discount rate will vary depending upon the risk associated with the investment. • Second.1 The One-Period Case • The relationship between present and future value is: • FV = PV(1+r)^t. the stated annual interest rate is always compounded semi-annually. m is the number of compounding periods per year. 5. • In a two-period case where the principal is $1. • The present value factor is the element multiplied by the future cash flow to determine its present value.Week 2. • The process of calculating the present value of a future cash flow is called discounting. • The NPV is equal to the sum of the present values of all the future cash less the outlay 5. yields the effective annual rate. to determine the monthly payment on a mortgage with r stated rate and a value of PV: • First. the future value calculation changes to: • FV = PV(1+r/m)^(m•n) • If interest is compounded continuously (that is.2 The Multiperiod Case • Compounding is the process of interest accruing upon interest. m is infinite in the above equation). • Therefore. when compounded. • Growing perpetuity. Class 1 5.

then to calculate the PV of this annuity: • Calculate the annuity’s PV with the above formula but with payments t-1. to determine the present value of the annuity: • Calculate the PV of the annuity at the end of period x-1 (normal calculation). Delay annuity • If an annuity begins more than one period from the present (at the end of period x). with t payments in total. What is a Firm Worth? • A firm is akin to any investment project: it is worth the sum of the present values of all its future cash flows.5. Equating Present Value of Two Annuities • In the case of two separate annuities (typically where one is a cash inflow and one is an outflow). II.• Last.1/(1+r)^t ]. Growing Cash Flow Perpetual Growing Perpetuity PV = C / (r-g) Finite Growing Annuity PV = (C/(r-g)) [1 . to determine the coupon (payment amount) on the outflow annuity. then to determine the PV of this annuity: • Adjust the discount rate by compounding the EAR x times. Infrequent annuity • If an annuity has payments less frequently than every year (every x years). • If the annuity begins payment immediately (annuity in advance). 5.1/(r(1+r)^t) ] Note that the element [ 1/r 1/(r(1+r)^t) ] is called the annuity factor Annuity Tricks I. III. and • Using this discount rate. IV. or PV = (C) [ 1/r . and • Discount the above quantity to the present (PV / (1+r)^(x-1)). equate the present value of this annuity with the present value of the inflow annuity and solve for C.(1+g)^t/(1+r)^t ] Stagnant Cash Flow Perpetuity PV = C / r Annuity PV = (C/R) [ 1 . Annuity in advance • The above annuity formula assumes the annuity begins payment in one period (called an annuity in arrears). 14 . apply the annuity formula (below) where the discount rate is the monthly rate (determined in the second step) and the number of compounding periods is the total number of months the mortgage will exist for. and • Add the first payment to this quantity. apply the above formula.

the holder receives no cash payment until maturity. • A fixed-rate preferred stock that provides the holder with a fixed dividend is a perpetuity.3 Bond Concepts • A bond will trade: • At face value if the coupon rate equals the market rate of interest • At a discount if the coupon rate is less than the market rate of interest • At a premium if the coupon rate is greater than the market rate of interest • The yield to maturity (called the yield for short) is the discount rate (r) required to equate the bond’s trading price (clean price) with the present value of its future cash flows.000 face values.beginning price + FV of interest payment)/(beginning price) 15 . • The date when the issuer makes the last payment is called the maturity date or simply maturity. • The principal is sometimes called the face value or the denomination. The bond expires on this date. Present value of a bond = present value of an annuity (where C is the coupon payment) + the present value of the principal • The stated price (clean price) is calculated by removing the effect of accrued interest.2 How to Value Bonds • In a pure discount bond. • Level coupon bonds make regular payments to the holder (coupons) as well as the principal in the final period. Class 1 6.Week 3. the dirty price is the sum which is actually paid • Clauses which allow the issuer to repurchase bonds are called call provisions. 6. or a zero-coupon bond. • Holding period return = (ending price . • Bonds issued in Canada typically have $1.

• Hence. The question becomes how do we determine r. 16 . where F = the face value and r is the spot rate for one year. and there are two investment instruments available: • Invest in a one-year instrument. The Liquidity Preference Theory • If an investor has a one-year time horizon. The Expectations Hypothesis • The expectations hypothesis states that the forward rate (f2) is equal to the one-year spot rate. The market prices the two-year instrument with a lower forward rate than the expected spot-rate in year two to compensate for risk. • r1 (spot rate 1) over period 1 • r2 (spot rate 2) over period 1 and period 2 (cumulative element) • The yield to maturity on a multi-period bond yields an average (of sorts) on the spot rates over the bond’s periods. • The forward rate over period 1 is equal to the spot rate over period 1. f2 > spot rate expected over year 2 is true most of the time. f2 > spot rate expected over year 2 • If an investor has a two-year time horizon. and there are two investment instruments available: • Invest in a two-year instrument. risk is involved. where f2 = forward rate in period 2. beginning at the end of period 1. • Hence. • This is called the liquidity premium.Week 3. • Hence. • A flat yield curve implies stable or declining future spot rates (since the liquidity premium is offset by falling spot rates). • However. • Since the investor cannot sell the second instrument at the end year one with certainty. • The forward rate is the expected rate over a given interval (past period 1). The true pricing of f2 depends on time-horizon sought by most investors. this hypothesis assumes that investors are risk neutral (not risk averse). f2 < spot rate expected over year 2 • These conclusions are contradictory. • The value of a zero-coupon bond after period 1 is given by F / (1+r)^2. risk is involved. It is a non-cumulative rate. Class 2 The Term Structure of Interest Rates • A spot rate is the cumulative rate of interest over a given period. beginning at the end of period 1. • Invest in a two-year instrument and sell at the end of year one. • Since the investor cannot sell the second instrument at end of year one with certainty. The market therefore sets the forward rate on instrument two (for year two) higher than the expected spot rate for year two to compensate for risk. • (1+r2)^2 = (1+r1)•(1+f2). Economists have concluded that this time horizon is typically shorter rather than longer. • Invest in a one-year instrument and then purchase another one-year instrument.

The present value of a finite stream of dividends plus the present value of the future share sale price. 6. Share price = DIV / r B. • G cannot exceed r.5 Estimates of Parameters in the Dividend Discount Model • Net investment equals gross investment less depreciation • Net investment can only be positive if some earnings are retained (and not paid out as dividends). Compute the share price manually (calculate present values over different interest rate intervals and discount and sum all of these in the present). Zero growth 1. Constant growth 1. the company is called cash cow. • There are three growth rate adjustments A. or B.6 Growth Opportunities • When a company pays out all its earnings (DPS = EPS). Growth rate changes over time 2.Week 4.4 The Present Value of Common Stocks • There are two ways to value a stock: A. Differential growth 1. P = EPS/r = DIV/r • NPVGO stands for the net present value (per share) of growth opportunities • P = EPS/r + NPVGO • Two conditions must be met: • Earnings must be retained so that the projects can be funded • The projects must have a positive NPV • A policy of investing in projects with negative NPVs rather than paying out earnings as dividends will lead to growth in dividends and earnings. Class 2 6. • The second method is actually identical to the first since the future share price is a function of the present value of the dividends received after the sale of the shares. Share price = DIV / (r-g) C. • When a firm is a cash cow. but will reduce value • Firms with no dividends have positive share prices because: • Investors believe they will receive dividends eventually • The firm will be acquired in a merger 17 . but not ad infinitum 6. The present value of all future dividends. r = dividend yield + growth rate r = dividend yield + retention rate • ROE • Note that the growth is derived under the assumption that future return on retained earnings and the retention rate are equal to their past values. the analyst has likely made projections for the next few years. if it does. Deriving the Growth Rate Earnings next year = earnings this year + retained earnings • return on retained earnings Dividing each side by earnings this year: 1 + g = 1 + retention rate • return on retained earnings g = retention rate • return on retained earnings Return on equity serves as a proxy for return on retained earnings. Deriving the Discount Rate r = DIV / Po + g Therefore.

the lower the multiple. we calculate the value of the share as a cash cow (EPS / r). for example). • Under the dividend discount model. we calculate the value of a stock in three parts: • First. it is worthwhile to compare the dividend growth model with the NPVGO model when growth occurs through continual investing. Hence. 18 . • Accounting convention: Accounting convention also influences the P/E ratio (when revenue and depreciation are recognized. the higher the risk.6. we calculate the present value of the NPVs of each year’s investment • Since each year’s NPV grows by a constant rate (the growth rate) and each year’s NPV is discounted at the discount rate (to the power of the year number). • The numerator is the NPV in year 1 • The denominator is the difference between the discount rate and the growth rate • Second. three variables influence the P/E: • Growth opportunities: two companies have the same EPS. not just an investment in a single opportunity.7 The Dividend Growth Model and the NPVGO Model (Advanced) • A steady growth in dividends results from a continual investment in growth opportunities. • Risk: Also. we sum these two quantities together • These approaches will yield the same current share prices 6. Therefore. • Last.7 Price-Earnings Ratio • Under the NPVGO model: Price per share = EPS/r + NPVGO • The price-to-earnings multiple implies: P/EPS = 1/r + NPVGO / EPS. we divide the dividend by the discount rate less the growth (which is calculated as the retention rate times the return on retained earnings) • Under the NPVGO model. the company with the higher NPVGO (access to superior growth opportunities) will trade a higher multiple. Hence. the P/E ratio is negatively related to r. the NPVGO is simply a perpetuity where.

in turn. book value and replacement value are all equal when a firm purchases an asset The following ratios measure the performance of the firm’s asset purchases • Market-to-book value ratio of common stock • Tobin’s Q ratio (market value of assets to replacement value of assets) • Shareholders elect directors who. then 1/(N+1) percent of the stock will guarantee election • Permits participation of minority shareholders • Straight Voting: each shareholder may cast his number of votes for each candidate • Excludes participation of minority shareholders • To elect a director. it is not a liability • Dividends are not tax-deductible • Dividends received by individual shareholders are partially sheltered.2 Corporate Long-Term Debt: The Basics • Securities issued by firms can be classified as equity or debt 19 .Week 5. appoint management • Shareholders have the following rights • The right to vote • The right to share proportionally in dividends paid • The right to share proportionally in assets remaining after liabilities have been paid in a liquidation • The right to vote on matters of great importance to shareholders (ex: merger) • The right to share proportionally in any new sock when approved by the board of directors • Voting can occur in two ways • Cumulative Voting: each shareholder is given a number of votes (typically. These most votes may distributing to one or more candidate • If there are N directors up for election. Class 1 15. Canadian corporations that own shares in other companies are 100% tax protected • Classes of Shares • Share classes often have different voting rights • Nonvoting shares must receive dividends no lower than dividends on voting shares • Nonvoting shares allow management to retain control • US stocks with superior voting rights typically trade at 5% higher than their nonvoting counterparts • Coattail provisions give nonvoting shareholders the right to vote or to convert their shares into voting shares in the case of a takeover bid 15.1 Common Stock • Common stock (or common shares) stock has no special preference either in dividends or in bankruptcy • Some stock have a stated value called the par value • Common shareholders are protected by limited liability • Authorized shares specify the maximum number of shares a corporation can issue • • • • • Book value of equity = retained earnings + contributed surplus + share capital + adjustments to equity The market value of shares is typically higher than book-value per share Replacement value refers to the current cost of replacing the assets of the firm Market value. 50% of shares + one are required • Staggering involves permitting a fraction of the board to be elected at any one time. It has two effects: • Makes it more difficult for a minority to elect a director when there is cumulative voting • Makes successful takeover attempts less likely • A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares • An outside group of shareholders can attempt to obtain as many votes as possible via proxy • Dividends • Unless a dividend is declared by the board of directors. the number of shares held times the number of directors to be elected).

• Corporations can legally default at any time on its liability (this can be a valuable option) • The main differences between debt and equity include: • Debt is not an ownership interest • The device used by creditors to protect themselves is the loan contract (indenture) • The payment of interest is a cost of doing business and is therefore tax deductible • The government effectively a tax-subsidy on the use of debt • Unpaid debt is a liability. • Sinking funds reduce the risk of the company repaying the principal and also enhance liquidity • Call provisions give the firm the right to pay a specific amount (call price) to retire (extinguish) the debt before the stated maturity date • Canada plus calls have a dynamic call price which are designed such that the call premium compensates investors for the difference in interest between the original bond and new debt issued to replace it. creditors can claim the firm’s assets. Some debt is subordinated. setting forth maturity date. they are trying to obtain the tax benefits of debt while eliminating its bankruptcy costs Types of debt • Debenture: unsecured corporate debt • Bond: secured by a mortgage on the corporate property • Note: short-term obligation (less than 7 years) • Long-term debt is any debt longer than one-year from the date is originally issued and is sometimes called funded debt • A sinking fund is an account managed on behalf of the issuer by a bond trustee for the purpose of retiring all or part of the bond prior to the stated maturity. • Restrictive covenants: • Restrictions on further indebtedness • A maximum on the amount of dividends that can be paid • A minimum level of working capital 15. • A mortgage is used for security on tangible property • Holders of such debt have prior claim on mortgaged assets • An indenture is the written agreement between the corporate debt issuer and the lender. • If not paid. • Seniority indicates preference in position over other lenders. it provides that the property can be sold in the event of default to satisfy the debt for which security is given.3 Preferred Shares • Preferred shares have preference over commons share holders in the payment of dividends and the case of liquidation • Preference means preferred shareholders must receive a dividend before common shareholders • Failure to pay a dividend on preferred shares cannot result in bankruptcy • Dividends paid on preferred shares are either cumulative or noncumulative • Cumulative shares require that missed dividends be carried forward in arrearage • Preferred shareholders must be paid their dividends (cumulative and current) before common shareholders receive dividends • Dividends in arrears: • Prevent common shareholders from receiving dividends • Grant preferred shareholders voting rights if the dividends are not paid within a given amount of time • Preferred shares can be: • Convertible into common shares • Callable by the issuer • Bestowed with the right to sell back to the issuer a given price (redeemable) • Some preferreds are floating rate • Yields on preferreds are generally lower than bond yields (since they are more tax efficient for companies to hold) 20 . • Debt cannot be subordinated to equity • Security is a form of attachment to property. interest rate and all other terms. This may result in liquidation or bankruptcy • When corporations try to create a debt security that is really equity.

This means that he operating entity does not have to pay tax • The income trust receiving the payments is not taxed since it is not a corporation (but a partnership).since yields are lower) • Other reasons for issuing preferreds (for heavily taxed companies) include: • Regulated public utilities companies can pass the tax advantage of issuing preferred shares on to their customers because of the way pricing formulas are built • Preferreds do not involve the same bankruptcy threats as debt • Issuance of preferreds does not influence firm control 15. Therefore. or lease payments. until its operating income is zero. most preferreds are held by corporate investors • Lightly taxed companies (or those protected by tax shelters) benefit from issuing preferreds over debt (since they do no benefit from the tax shield created by the debt but enjoy lowering financing costs on preferred . payments are taxed only in the hands of unitholders.• Hence. which are typically tax-deductible. followed by debt and equity last 21 .dividends • Sale of marketable securities • External financing • Debt (used first) • Equity (used as a last resort) • There is a financing pecking order with internally generated cash flow used first.4 Income Trusts • The operating entity pays the income trust interest. 15.5 Pattens of Long-Term Financing • Cash flow to finance capital expenditure and net working capital is derived from three sources: • Internal financing (cash flows generated in the business) represents about two thirds • Internal financing is defined as net income + depreciation . royalties.

Price (today) ] / Price (today) • Return (percentage) = dividend yield + capital gains yield 10.Week 6. long bonds.16% • Value at risk (VaR) represents the maximum possible loss at a certain confidence level • In the above example. Class 1 10. and Canadian treasury bills) are pretax. symmetric distribution which any actual distribution will approach as the number of observations approaches infinity • The standard deviation measures the spread of the normal distribution • 68.90% to 43.5 Risk Statistics • The risk of returns is measured by the dispersion of a frequency distribution • The greater the dispersion (and the wider the distribution).1 Returns • Total earnings = dividend income + capital gain (.74% of observations will fall within three standard deviations of the mean • Therefore.03%.1% and the SD is 16. • Therefore.2 Holding Period Returns • The holding period returns on the textbook indices (Canadian common stock. it must included in returns • Dividend yield = Dividend (in one period) / Price (today) • Capital gains yield = [ Price (in one period) .90%). nominal returns • Calculating cumulative returns on these indices assumes the reinvestment of dividends 10. the standard deviation. the VaR on a 200 million investment is 41. are the most common measures of variability or dispersion • The normal distribution is the bell-shaped.1 • Arithmetic average answers the question What was your return in an average year over a particular period? • The geometric average return is approximately equal to the arithmetic average less half the variance (the geometric average will always be smaller) • In predicting a return over the next T periods (and with historical data of N periods available) apply the following: R(T) = (T-1)/(N-1)•geometric average + (N-T)/(N-1)•arithmetic average • Notice.28%. • This results from the fact that the standard deviation on T-Bills is much lower than common stocks 10.28% chance that the return is lower 10.3 Return Statistics • A frequency distribution depicts the distribution of returns • Average return is the mean of the distribution 10.90% is 2.capital loss) • Total cash if stock is sold = initial investment + total dollar earnings = proceeds from sale + dividends • Regardless of whether a gain is realized. there is less than a 5% chance that an observation (a year’s return) will outside the range -20. the probability of an observation falling below -20.4 Average Stock Returns and Risk-Free Returns • The yield on a T-bill is called the risk-free return over a short time • The difference between risky returns and risk-free returns is often called the excess return on the risky asset. small stocks.6 More on Average Returns • Geometric average answers the question What was your average compound return per year over a particular period? • Geometric average return = [(1+r1) • (1+r2) • (1+rt)]^(1/t) . provided we are willing accept that there is a 2.26% of observations will fall within one standard deviation of the mean • 95. geometric averages are less relevant over short time periods and arithmetic average are less relevant over long time period 22 . It represents a risk premium.8 million (200 • -20. for instance. the greater the uncertainty of returns • The variance and its square root.44% of observations will fall within two standard deviations of the mean • 99. US common stock. if the mean is 11.

b) = COV(Ra.Avg.4 The Efficient Set for Two Assets 23 . 11. Variance.. the lower the portfolio variance • This is called a hedge A A B (Xa)²(Var(Ra)) (Xa)(Xb)(COV(a.Avg.b)) (Xb)²(Var(Rb)) • The variance of the portfolio equals the sum of the elements in the above matrix • The SD of a portfolio will always be less than the weighted average SD of the individual securities when the correlation between the securities is less than 1 (this applies to discussions of two or more securities) • This is attributable to the affects of diversification • This explains why the standard deviation of most stocks are lower than the index 11.Rb) / [SDa • SDb] • Correlations will vary between -1 (for perfectively negatively correlated) and 1 (for perfectively positively correlated) • This standardization makes correlation a more useful variable 11. Rb) ] / (n-1) • Covariance will be negative if observations move in different direction and positive if they move in the same direction • Covariance is not useful because it gives us an absolute magnitude (instead of a relative magnitude) • ρ(a. + Xi(Ri) • Xi is the proportion of the portfolio allotted to security i and Ri is the expected return on security i • The expected return is simply the historical arithmetic average • The expected return on a portfolio is simply a weighted average of the expected returns on the individual securities • portfolio variance (two-security model) = (Xa)²(Var(Ra)) + 2(Xa)(Xb)(COV(a. Ra)(Rb .1 Individual Securities • Covariance is a statistic measuring the interrelationship between two securities.. • Alternatively.2 Expected Return. Rb) = [ ∑(Ra .Avg.Week 6.5 • COV(Ra. R)^2 ] / (n-1) • SD(R) = [Var(R)]^0.3 Risk and Return for Portfolios • expected portfolio returns = Xa(Ra) + Xb(Rb) + Xc(Rc) + .b)) + (Xb)²(Var(Rb)) • The variance of a portfolio depends on both the variances of the individual securities and the covariance between the two securities • The lower the covariance between the securities. this relationship can be stated in the correlation between two securities. Class 2 11.b)) B (Xa)(Xb)(COV(a. and Covariance • Var(R) = [ ∑(R .

the more bent the curve. The smaller ρ. Mixing these portfolios together creates a more efficient set (since the correlation coefficient between the two portfolios is less than 1) • One caution regarding this analysis is that expected returns (as calculated by historical averages) can be unrealistic if they are based upon periods in history which are atypical (ex: during crises or unusual bull markets) 11. Simply make A a domestic portfolio and B an international portfolio. B The straight line represents the feasible set under a correlation of 1 between A & B. We say that portfolios along this portion of the set are dominated. • We can apply the same logic to international and domestic exposure. Any point below this line implies a lower expected return with the same risk. 1 A A rational investor will never choose a portfolio on the backward bending portion of the feasible set.Expected return on portfolio It is impossible for an investor to choose any point off the curved lined (the curved line assume the correlation coefficient is below 1). F E D MV C B A Standard deviation on portfolio 24 . feasible set or efficient set. but no beyond it can. A rational investor will choose a point on this line. This is called the minimum variance portfolio. Any point within this region can be chosen. This is called the opportunity set. Standard deviation on portfolio This is the point of minimal risk (the lowest possible standard deviation and variance).5 The Efficient Set for Many Securities Expected return on portfolio Any point between MV and F lies on the efficient set. All portfolios where the securities have ρ <= 0 and even some where ρ >= 0 have backward bending portions.

.....n)) . (Xb)(Xn)(COV(b...covariance) Variance of portfolio’s return Average VAR Diverisfiable risk. unique risk Average COV Portfolio risk. market risk.. (Xn)²(Var(Rn)) • Again. • Notice that the number of terms containing covariance increases as the matrix grows.n) B (Xa)(Xb)(COV(a. ... (Xa)(Xn)(COV(a. .. • The number of terms whose value depends upon individual-security variance (unsystemic risk) is N • The number of terms whose value depends on covariance is N²-N or N(N-1) • Hence... ..b)) (Xb)²(Var(Rb)) .A A B .n)) .. N (Xa)²(Var(Ra)) (Xa)(Xb)(COV(a.. systematic risk Number of securities 25 . .n)) (Xb)(Xn)(COV(b. covariance becomes increasingly important as N grows 11.. unique or unsystematic risk is that risk can can be diversified away • Total risk of an individual security (variance) = portfolio risk (covariance) + unsystematic or diversible risk (variance . the variance of the portfolio is the sum of the elements in this matrix.b)) . • In general. N (Xa)(Xn)(COV(a.6 Diversification: an Example • Variance of a portfolio = (1/N)(average variance) + (1-(1/N))(average covariance) • Variance of a portfolio = average covariance as N approaches infinity • Hence the floor on portfolio is covariance (or systematic risk or market risk) • Diversifiable. nonsystematic risk..

• This will also amplify the standard deviation • This assumes the investor can borrow at the risk-free rate (which is impossible). investing $1. borrowing at the risk-free rate will amplify returns (since the marginal expected return on the risky security will exceed the cost of borrowing). Expected portfolio return Purely risky security portfolio Levered returns under a risk-free borrowing rate Higher cost of borrowing drives down return/risk ratio. or in the region below the efficient set is feasible • Choosing any feasible point and then connecting this with the risk-free rate forms a line upon which some mixture of the risky-asset mix (the mix which went into creating the feasible point) and risk-free investments can be used to achieve a given point on the line • The capital market line is the line which lies tangent to the efficient frontier and is constructed by mixing risk-free assets with the asset-mix which was used to create the point of tangency. highest return security).000 and borrowing $200 at the risk-less rate will cause the weight to be 120%). it will cause the weight of the risky security to exceed 100% (for example.7 Riskless Borrowing and Lending • The standard deviation of portfolio (risk) which includes a risky security and a risk-less security is equal to the weight of the risky security times the standard deviation of the security. This results from the fact that: • The variance on a risk-less security is zero (since it never deviates from the expected return) • The covariance between the two securities is zero (since every residual of the risk-less security is zero) • Alternatively. Mixture of risk-less and risky security Levered returns under a borrowing rate above the risk-free rate Risk-free rate Standard deviation of portfolio • The optimal portfolio: • Any point on the efficient set (from the minimum variance portfolio to a portfolio composed entirely of the highest risk. The borrowing rate is higher than the risk-less rate.Week 8. Class 1 11. • However. 26 . which implies that the marginal standard deviation (SD added via leverage) will exceed the marginal gain in expected return.

• A rational investor will only choose portfolios along the capital market line • The separation principle argues that investors make two separate decisions: • 1) The investor first: • Estimates the expected returns on risky assets • Estimates the variances and covariances of the risky assets • Calculates the efficient frontier (from MV to T to F in the below) • Determines the point of tangency (T in the below) • 2) The investor. every investor will calculate the same efficient set and therefore tangency portfolio (and hence. It is a market-value weighted portfolio. • Under this assumption. • Beta measures the responsiveness of a security to movements in the market portfolio. At this point. determines how to mix the risky portfolio T with risk-free assets (representing movement along the capital market line from the risk-free level to above the tangency point) Expected return on portfolio Capital market line F T D MV Risk-Free Rate B A Any point on this line is attainable by mixing the portfolio at point x with risk-free assets.8 Market Equilibrium • Homogenous expectations assumes that all investors have the same expectations for returns. Standard deviation on portfolio 11. depending on their risk aversion. x C E Any point on the capital market line can be achieved by combining the tangency point portfolio (100% risky assets) with risk-free assets (either borrowing or lending). meaning that each security is weighted by security market capitalization divided by total market capitalization. variances and covariances. one that represents the market portfolio well). State I II III Bull Bull Bear Type of Economy 15 15 -5 Return on Market (%) Return on Security (%) 25 15 -5 27 . the portfolio’s risk level falls. Tangency point is the ideal mixture of risky assets. the portfolio contains no borrowing or lending of risk-free assets. when added to a diversified portfolio (ideally. every investor will create a portfolio along the capital market line depending on the individual’s risk tolerance) • This portfolio every investor chooses (before risk-free borrowing/investing) is called the market portfolio. • A negative beta security.

• Beta = COV(Ri.State IV Bear Type of Economy -5 Return on Market (%) Return on Security (%) -15 Expected security return I II Expected market return III IV Slope of the line of best fit equals beta. all investors hold the market portfolio. While most investors do not hold the market portfolio exactly. A beta above 1 implies a security which is riskier than the market. 11. • The formula for beta is the covariance of market portfolio’s return to the security return divided by the market portfolio’s variance. Rm) / VAR(Rm) • The average beta above all securities in the market is equal to 1 • The variance of an individual security is only important if the investor is looking to hold a portfolio of only one security • The beta of an individual security is important for decision making when the investor’s portfolio is well diversified (representative of the market portfolio) Single-security portfolio Security variance Partially diversified portfolio Security’s variance and covariances with portfolio holdings Diversified portfolio Security beta • Under the homogenous expectations hypothesis. below 1 is the opposite. they do hold portfolios diversified enough to allow beta to serve as a good risk measure.9 Relationship between Risk and Expected Return (CAPM) • Expected market return = risk-free rate + risk premium • Capital Asset Pricing Model (CAPM): Expected return on security = risk-free rate + beta • (expected market return .risk-free rate) 28 .

Note that the slope of the line equals to the difference between the market return and the risk-free rate. The SML determines the expected return of a single security based upon its beta. a market portfolio) with risk-free borrowing or lending. A portfolio can be positioned on the line by taking its beta (weighting the securities’ betas) and multiplying by the risk premium. 2) if a security lies above the line. the return on the security equals the risk-free return • If beta = 1. its price will fall (since no rational investor will purchase it when they can capture a higher return/risk ratio by mixing a market portfolio and risk-free investments). the CML determines the expected return on the optimal portfolio (market portfolio) based upon standard deviation (not the same as beta). 2) Portfolios as well as securities: the SML applies to securities as well as portfolios. investors will push the price of the security higher (because it offers a greater return/risk ratio) and therefore the expected returns lower until the security is positioned on the SML. Therefore: 1) if a security is below the line. This follows from the fact that we can artificially create an point on the SML line by mixing a beta 1 security (ie. 29 . the return on the security equals the expected market return Expected security return Positive NPV Project Security market line (SML) Expected market return Risk-free rate Negative NPV Project Direct relationship between beta (risk) and expected return. 3) Potential confusion: the SML (Security Market Line) and the CML (Capital Market Line) are not the same. Beta Beta = 1 Three additional important points: 1) Linearity: the SML is a straight line.• Beta (since it is a good measure of risk for most investors (since most investors something akin to the market portfolio)) is positively related to return • Under this model: • If beta = 0. A falling price will drive expected returns higher until the security lies on the SML.

+ βkFk + ε • Where ε is uncorrelated to every other securities’ ε • In practice.1 Factor Models: Announcements. we can define m = βiFi + βGNPFGNP + βrFr • Where. Unsystematic risk: is a risk that specifically affects a single asset or a small group of assets 1. εy) = 0.+Xnεn • The third element in the equation actually zero as diversification approaches the market portfolio (because all the correlations are zero) 30 .. Systematic risk: is any risk that affects a large number of assets.. and the actual figure is 1. • The expected component drives expected returns • The surprise component drives the uncertain return • News refers to the surprise component of an announcement.Week 8. the expected component will have no influence on share price since it will already be discounted 12.. • Therefore. each to a greater or lesser degree 1. returnm) + ε • Where Rm is the return on the market portfolio 12.2 Risk: Systematic and Unsystematic • The uncertain return component of actual return is the true risk associated with a security • The surprises (drivers of uncertain return) can be divided into two categories: A.4 Portfolios and Factor Models • The return on a entire portfolio is given by the sum of: • Weighted average of expected returns: X1R1 + X2R2 + X3R3 + X4R4 +.+ Xnβn)F • Weighted average of unsystematic risks: X1ε1 + X2ε2 + X3ε3 + X4ε4 + ..5% increase in GNP. Also called idiosyncratic risk • The distinction between these two types of risk is never precise. researchers use a one-factor model: • Actual return = expected return + β(Rm . where εx is the idiosyncratic risk associated with security x and εy is the same risk of some other security • If a risk is truly unsystematic. Class 1 (cont’d) 12. • Therefore. a company’s earnings release will often not have a significant influence on the market since the market discounted this news item (included the news when it calculated expected return) • An announcement = expected + surprise • If the market anticipates a 0. Surprises and Expected Returns • Actual return = expected return + uncertain (risky) return • The uncertain return component results from any news which the market could not anticipate (ex: earnings surprises.3 Systematic Risk and Betas • The beta coefficient captures the influence of systematic risk • It tells us the response of the stock’s return to a systematic risk • We previously defined beta to be the relationship between a security and one systematic risk . the surprise (or innovation) is 1%.) • Events which the market anticipates are said to be discounted • For instance. sudden drop in interest rates. etc. key executives leaving. Uncertainty regarding general economic conditions B. and the systematic sources of risk.exp. are called the factors. even a seemingly isolated occurrence will affect the broader economy in a minor way..+ XnRn • (Weighted average of Betas)F: (X1β1 + X2β2 + X3β3 +.5%.. designated F. actual return = expected return + β1F1 + β2F2 + β3F3 +. it will be uncorrelated with the risk of other securities in the market 12.. actual return = expected return + systematic risk (m) + unsystematic risk (ε) • CORR(εx.the market portfolio’s return • We can generalize beta to any type of systematic risk • For instance.. βi is the beta coefficient for the inflation rate and Fi is surprise for the inflation rate • Likewise for GNP and the interest rate (r) • This model is called the factor model.

and these parameters are derived through an analysis of actual data • Consider another model: expected return is related to P/E. the arguments are analogous 12. systematic risk was argued to be the result of positive covariances. • When the factor is the market portfolio itself.5 Betas and Expected Returns • In CAPM.6 The Capital Asset Pricing Model and the Arbitrage Pricing Theory Pedagogy Capital Asset Pricing Model • The treatment . • In the one-factor model of the arbitrage pricing theory. moving to the many risky assets. this risk is the result of a factor. • Hence. Instead of arguing that an inverse relationship exists for valuation reasons. the beta of a security measure the security’s responsiveness to movements in the market portfolio. Hence. • Style portfolios are often defined by stock attributes • High P/Es correspond to growth portfolios • Low P/Es correspond to value portfolios • Fund managers are compared against benchmarks (appropriate indices) and peer groups 31 . one might argue that the P/E is simply a better measure of systematic risk. after scaling properly. in this chapter. the beta for the market portfolio is one. the beta of a security measures its responsiveness to the factor. we can treat the market portfolio as the factor itself. the APT and CAPM are fundamentally equivalent 12. its expected returns are perfectly related to the factor through the portfolio’s beta.• Unsystematic risk can be diversified away (third component of the equation) • Systematic risk cannot (second term in the equation) • In the previous chapter.7 Parametric Approaches to Asset Pricing • APT and CAPM are parametric or empirical models in that an overarching theory is constructed where certain attributes are related to expected returns through parameters (betas in APT). and finishing when a risk-free asset is added to the many risky ones . • Since market portfolio contains no unsystematic risk (since it has perfect diversification).beginning with the case of two risky assets. Since a single factor drives the positive covariances.is of great intuitive value • The model adds factors until the unsystematic risk of any security is uncorrelated with the unsystematic risk of every other security • The model can handle multiple factors while CAPM cannot Application Arbitrage Pricing Theory 12.

This is because of the error which arises from unsystematic returns 13. in Sales • Operating leverage magnifies the affects of the business cycle • Operating leverage refers to the fixed costs of production • Financial leverage: financial leverage refers to the fixed cost of financing • These fixed costs result from the interest expense which does not vary with the quantity sold Project’s IRR Positive NPV Projects SML Risk-free rate Negative NPV Projects Beta Dollars TC High operating leverage FC Quantity Dollars TC Low operating leverage FC Quantity 32 .Rf) 13. the IRR on the project must exceed the expected return for the firm overall • The expected return is the cost of equity: • E(R) = Rf + B (E(Rm) . in EBIT / % chg.3 Determinants of Beta • Cyclicality of revenue: different industries have different sensitivities to the business cycle • Operating leverage: lower variable costs and higher fixed costs imply higher operating leverage • The steeper the slope of the TC line. Class 1 13.2 Estimation of Beta • Beta = COV(Ri.Week 8. the lower contribution margin and operating leverage are • Operating leverage can be measured by: % chg.1 The Cost of Equity Capital • Firms can pursue two courses of action if they have extra cash: • Distribute it to shareholders via dividends • Reinvest in a project • Firms should pursue the latter if the expected return is superior (assuming the risk is the same on the project as it is on the firm) on the available project than what investors could achieve elsewhere in the market • In other words. RM) / VAR (RM) • Beta is also the slope of the line of best between the returns on the firm when plotted as a function of the market returns • This line is called the characteristic line of the firm • The error in beta-estimation on a single stock is much higher than the error for a portfolio of securities.

There are broadly three costs: • Brokerage fees . bonds and preferreds • The cost of debt is (1-t)YTM • The use the after-tax cost of the debt because this is the true cost of the debt to the firm • RWACC = (S/V)• Rs + (B/V) • (1-t) • YTM + (P/V) • Rp • This is the discount rate we would use to evaluate projects with essentially the same risk level as the entire firm 13. expected returns are positively related to both beta and trading costs • The spread a specialist charges (bid-ask spread) is positively related to the ratio of informed investors to uninformed investors (this is called adverse selection) • This is because the more informed investors there are.6 Reducing the Cost of Capital • The Expected return and therefore cost of capital are negatively related to liquidity • Liquidity is the cost of buying and selling stock. it is apparent that leverage increases Beta 13. etc. dividend reinvestment programs. bonds and preferreds are therefore: S/V.it is the beta which would exist if the firm was financed by purely equity • The Bequity will always be greater than or equal to the BAsset • From the above formula.costs paid to the broker to execute a trade • Market impact costs . for instance. the higher the cost • Since trading costs (liquidity) are deduced from return. more informed investors raise the cost of capital (by increasing the bid-ask spread) • Firms can improve the cost of capital • By lowering the ratio (through.the price drop associated with the sale of a large issue • Bid-ask spread . thereby upsetting the optimal debt-to-equity ratio • A firm’s total capitalization (enterprise value) = long-term debt and equity • V=S+B+P • The weights for common stock.) • Supplying more information to many everyone informed • Greater financial data on corporate segments and management forecasts • Encouraging analysts to follow the company • These actions will reduce information asymmetry 33 .the wider the bid-ask spread the specialist offers. stock splits. the higher the likelihood the specialist will the exploited (since informed investors have information which enables them to determine the true worth of a share) • Hence. • rp = the required rate of return on the preferred • D = dividend • P = the market price of the preferred • The weighted average cost of capital: • Firms may issue debt or equity a single time. investors will demand greater returns on securities with higher trading costs • Hence.4 Extensions of the Basic Model • Choosing the same discount rate for all projects is incorrect unless they all have the same risk level (betas) • To value a portion of a business (or a project): • Unlever the beta of the pure play • Relever the beta based upon the business’s capital structure • The cost of debt: return that the firm’s long-term creditors demand on new borrowing • The YTM is this required rate of return • The Coupon rate of the firm’s outstanding debt is irrelevant • The cost of preferred stock: a share of preferred is essentially a perpetuity • rp = D / P. B/V and P/V • We use the market values for stocks.• BAsset (1 + (1-t)(D/E)) = BEquity • BAsset represents the unlevered beta of the security .

4 The Different Types of Efficiency and the Evidence for Each • There are three forms of market efficiency which depend upon classifications of information. • Because the form of efficiency depends upon the availability of information: • Strong form implies semi-strong form efficiency • Semi-strong form implies weak-form efficiency 34 . lawyers. issuing stocks and warrants) • By the efficient market hypothesis. • This allows firms to issue securities at higher costs (and hence raise capital more cheaply) 14. accountants. or • Reduce the cost of underwriting/issuance (investment bankers.Week 8. this should be impossible • Reduce cost or increase subsidies: packaging securities with a strategy to: • Minimize overall tax. it is achieved by simultaneously purchasing and selling substitute securities 14.) • Create a new security: conducting financial innovation to offer risk/reward trade-offs which are not easily replicable. Class 2 14. security prices adjust immediately and correctly to new information • The efficient market hypothesis (EMH) has implications for investors and firms: • Prices will adjust before investors have time to exploit any new information • Firms should not expect to be able issue securities at greater than the present value of their cash flows Foundations of Market Efficiency 1) Rationality: all investors are rational (price will rise immediately to reflect new information because no rational investor would wait) 2) Independent Deviations from Rationality: the number and influences of overly-optimistic and overlypessimistic irrational investors will cancel one another out. the majority of investors are swept away in either over-optimism of over-pessimism.3 & 14.1 Can Financing Decision Create Value? • There are three ways to create value from financing opportunities (earn positive NPVs): • Fool investors: complex securities can sometimes be sold for more than their fair value (for instance. hence making the market collectively rational 1) Opponents of the EMH argue that irrationalities do not perfectly cancel at that. etc.2 A Description of Efficient Capital Markets • In an efficient market. 3) Arbitrage: Arbitrage is risk-less profit. at times.

Support / Evidence • It is cheap to access information and identify trends (anyone with a computer and some knowledge of programming and statistics can design such an information system) • Serial correlation serial correlations near 0 imply there is no correlations between returns historically (shares follow a random walk) • Event studies: the release of information in time t should be reflected in the abnormal period at time t. insiders are able to consistently earn excess returns Weak form efficiency (price information) Semi-strong form efficiency (publicly available information) Strong form efficiency (all information . There should be no carry-over from past events • Mutual-fund performance: mutual funds are consistently unable to outperform the market (implying that analyzing all publicly available information is futile) • Growth in ETFs confirms investors agree it is impossible to regularly outperform the market SemiStrong Form Publicly available information • A market is semi-strong efficient if it incorporates all publicly available information including published accounting statements as well as historical price information Strong Form Private & Public information • Any information pertinent to the value of a security is fully incorporated (this includes even private information) • This implies corporate insiders should not be able to profit for private information • Little supporting evidence. • Weak-form efficiency can be expressed mathematically by: Pt = Pt-1 + expected return + random error. • The random error is due to new information on the stock. This random error creates a “random walk”.public and private) Degree of information availability 35 .Form Weak Form Information Type Past price data Description • A capital market is weak-form efficient if it fully incorporates past information in past stock prices. • Historical price information is the easiest type of information to acquire. • Seasonal share-price trends should not exist under this form of efficiency.

6 Empirical Challenges to Market Efficiency • Limits to arbitrage: engaging in arbitrage can result in large short-term losses if the market remains irrational.5 The Behavioural Challenge to Market Efficiency • Rationality: many investors are irrational (investors are likely to sell winners and hold losers ) • Independent Deviations from Rationality: psychologists argue that investors deviate from rationality in accordance with a set of principles (and therefore do not do so randomly.this is incorrect because many more investors are following a share on a given day than are trading on that day.share prices are constantly reacting to new information • Shareholder disinterest: because only a portion of outstanding shares are traded each day.8 Implications for Corporate Finance • Accounting: Changes in accounting will not be fool an efficient market (since accounting changes do not affect the cash flows from a security) • Timing decisions: managers will attempt to issue equity when it is overvalued to earn a positive NPV on the issuance • Under efficient capital markets.securities sometimes move wildly above their true values).7 Reviewing the Differences • Representativeness creates overreaction to stock returns which generate bubbles • Conservatism implies investors adjust their beliefs slowly which creates under-reactions 14. • The same holds for acquisitions • Managers should only buy other companies if synergies can be generated (not because the company is undervalued) • Information on market prices: • The shares of the acquirer in a deal often fall.representativeness: the belief that positive returns in the past on a security imply a higher probability of positive returns in the future • Leads to bubbles • Second principle . it implies markets are inefficient . • Studies report that prices seem to be adjust slowly to information contained in earnings announcements • Investors are slow to adjust their perceptions of a company • Arbitrage: arbitrage only functions correctly if the influence amateurs does not exceed the influence of professionals (if amateurs underprice McDonalds in the past. managers should not waste time attempting to determine the direction of currencies or interest rates. they may continue to do this in the future). it is not and evidence suggests that bankers are indeed successful in this activity • This may be because bankers are corporate insiders (have access to private information) • Share prices return less than the market after IPOs and SEOs • Speculation and efficient markets: if markets are efficient. • First principle . 14. “Markets can say irrational longer that you can stay solvent”. hence allowing deviations to cancel).conservatism: people are too slow to adjust their belief system to new information. 14. implying that deals often hurt the acquirer • There is a strong negative correlation between managerial turnover and prior share prices • Stocks tend to fall far before the forced departure of an executive 36 .Efficient Markets Misconceptions • The Efficacy of Dart Throwing: all the EMH says is that manager will not be able to outperform the market for a sustained period of time (or at least that it is highly improbable). • Price fluctuations: price fluctuations to imply randomness . 14. • Earnings surprise: prices adjust slowly to earnings announcement surprises (conservatism evidence) • Size: the return on stocks with small market capitalizations tend to have higher returns (beyond the compensation for extra risk) • Value versus growth: value stocks (low valuation multiples) tend to outperform growth stocks • Crashes and bubbles: stock market crashes on no significant news indicate market inefficiency (bubble theory . this should be impossible • In reality.

4 The Average Accounting Return • The AAR = the average project earnings (after tax and depreciation) / average book value • Problems • AAR uses accounting numbers (earnings & book value) which are somewhat arbitrary • AAR does not take into account timing (no present value calculations involved) • AAR requires an arbitrary cut-off • Advantage: easy to calculate from numbers already in the accounting system 7.the principle that the value of the firm rises by the NPV of the project • Three key attributes of NPV are: • NPV uses cash flows .Week 9.5 The Internal Rate of Return • The IRR is the discount rate which yields a NPV of zero • Accept if IRR > discount rate • Reject if IRR < discount rate • Indifferent if IRR = discount rate • The IRR does not depend upon anything external (hence the word internal) • A bond’s IRR is its YTM 37 .2 The Payback Period Rule • The payback period is the amount of the time it takes to recoup the initial investment outlay • The payback period rule requires a project to repay the outlay within a given amount of time • Problems with the payback period • Timing of the cash flows within the payback period • The temporal distribution of cash flows is irrelevant • The payback period therefore fails to consider the time value of money • Payments After the Payback Period • Payback period fails to consider cash flows after the payback date (Despite the fact that these cash flows could be enormous) • Arbitrary standard for payback period • Payback period benchmarks are chosen arbitrarily • This is unlike the NPV rule. NPV is the overriding method 7. where the discount rate is not arbitrary but is commensurate with risk • Managerial perspective (advantages) • The payback period is simple • The recapturing of cash is often important • Standard academic criticisms are often exaggerated • With small projects.3 The Discounted Payback Period Rule • We discount the cash flows and then ask how long it will take these cash flows to equal the initial investment • The discounted payback period will always be longer than the normal payback period • Like the normal payback rule. why not simply calculate NPV? 7. the payback period rule may be useful. Class 1 7. for large projects. this rule requires us to make some arbitrary choice for the cut-off date • This rule is a poor comprise between NPV and the payback period rule • If we are going to discount the cash flows and compare them with the initial outlay.earnings are an artificial construct • NPV uses all the cash flows of the project • NPV discounts the cash flows properly (at the appropriate discount rate) 7.1 Why Use NPV? • Increases firm value for shareholders (simple decision rule) • Value-additivity .

there will be N IRRs (hence if there are negative and then positive and then negative cash flows. accept (cheaper financing) NPV Positive NPV Projects IRR Negative NPV Projects Discount rate • 2 . so why borrow at a higher IRR?) • If the IRR < discount rate. the decision rule is reversed: • If the IRR > the discount rate. then the project is a financing one • if this is the case. • No one IRR is superior to another so it illogical to choose one IRR as the correct one 38 .6 Problems with the IRR Approach • An independent project is one whose acceptance or rejection is independent of the acceptance or rejection of all other projects • Mutually exclusive investments implies can accept A or B but not both. Two Problems for both independent and mutually exclusive investments • 1 .we can borrow at the discount rate.NPV Positive NPV Projects IRR Negative NPV Projects Discount rate 7. there will be 2 IRRs).Investment or financing? • if the initial cash flow is in and the terminal cash flow is out.Multiple Rates of Return • If cash flows changes signs N times. reject (expensive financing .

because two different projects will have different temporal cash flow distributions. • Timing problem . it is possible for one project to a higher NPV while the other has a higher IRR • Solution: calculate the IRR on the incremental cash flows.• Modified IRR (MIRR) handles this problem by combining cash flows into only two cash flows by shifting cash flows along the time line • By discounting and summing cash flows. second is negative (financing) Multiple cash flows with different signs 1 Number of IRRS IRR Criterion Accept: IRR > r Reject: IRR < r 1 Accept: IRR < r Reject: IRR > r Many No valid IRR Problems with Mutually Exclusive Projects • Scale problem . If this is above the discount rate. MIRR employs an discount rate )and this implies the project’s evaluation is not strictly internal) Flows First cash flow is negative. second is positive (investing) First cash flow is positive. purchase the investment with earlier cash flows NPV Incremental IRR IRR IRR A B Discount rate 39 . they will have different sensitivities to changes in the discount rate • The investment with more cash flow distributed in a later time-period will be more sensitive to changes in the discount rate (the slope of the NPV line below is steeper) • To solve this problem: • Calculate the incremental IRR • If the discount rate is below this incremental IRR. accept the larger project. purchase the investment with heavier cash flows later • If the discount rate is above. hence. there will be only one sign change and hence only one IRR • However.IRR does not consider the size of the project.

7 Profitability Index (PI) • Profitability index = PV of CFs subsequent to initial investment / initial investment Three considerations: • Independent projects • Accept if PI > 1 • Reject if PI < 1 • Mutually exclusive projects • Accept if incremental PI > 1 • Capital rationing • If we do not have enough financing to fund all positive NPV projects: • Choose the projects with the highest PIs • PI therefore helps to ration capital 40 .• Redeeming qualities: • No discount rate is required • The project’s benefits are summarized in one number 7.

by taking the project. real interest rate ≈ nominal interest rate .C2 . Accounts receivable not received in cash 2.2 The Majestic Mulch and Compost Company: An Example • Net working capital is defined as the difference between current assets and current liabilities • An investment in net working capital represents a cash outflow since it represents 1. • Hence an increase in working capital for one year represents an outflow for that year • Project cash flow: • Operating CF = revenue . these costs do not enter out analysis • Lost revenues can be viewed as costs. the firm forgoes other opportunities for using the assets.taxes • Investment CF = changes in working capital + investment outlays (+ investment returns like salvage value) • Which set of books? • There are two sets of books: • Tax books . Incremental cash flows are the changes in the firm’s cash flows that occur as a direct consequence of accepting the project. • Depreciation is always a nominal quantity (because the straight-line method makes no consideration for inflation) 8.where GAAP rules are applied • Interest expenses are not considered in calculating cash flows since we assume financing is purely equity-based 8. Or a cash a balance (which ties up cash and is hence a cash outflow from the firm) 4.W10. Free up cash by deferring payment through accounts payable • **Note that the consideration for net working capital is the same reconciliation process used in the operating section of the cash flow statement to reconcile net income to operating CF • Net working capital ultimately goes to zero as the project is closed out • The change in working capital each year is a cash outflow.inflation rate • This approximation fails as the rates get larger • A cash flow is expressed in nominal terms if the actual dollars to be received are given • Discounting? Which rate do I use? • Nominal cash flows must be discounted at the nominal rate • Real cash flows must be discounted at the real rate • The NPVs will be same regardless of whether real or nominal rates are used as long as the discount rate and the cash flow terms are consistent. They are called opportunity costs because.operating costs (which exclude deprecation) . only cash flows that are incremental to the project should be used.3 Inflation and Capital Budgeting • The real interest rate is the inflation-adjusted rate (it deducts the influence of inflation) while the nominal interest rate does not • 1 + nominal interest rate = (1 + real interest rate) ( 1 + inflation rate) • Therefore. • Side effects are classified as either • Erosions .W9. Inventory (which ties up cash and is hence a cash outflow from the firm) 3.1 Incremental Cash Flows • In calculating the NPV of a project.where the size of taxes are calculated according CRA rules • Shareholders’ books .C2 8.reduction in sales as a result of a project • Synergy .increase in cash flows (more inflows or less outflows) resulting from existing projects by accepting a new project • Allocated costs should be viewed as a cash outflow of a project only if it is an incremental cost to the project 8. • A sunk cost is a cost which has been incurred in the past.4 Alternative Definitions of Operating Cash Flow • Operating cash flow can be calculated in three ways: 41 .

determine the PV of the costs for each machine • Third. determine the equivalent annual cost of the new machine (the replacement) • Second.6 Investments of Unequal Lives: The Equivalent Annual cost method • When two investments have unequal lives (and therefore unequal costs).• Net income + depreciation (bottom-up approach) • Sales . convert all terms to real terms • Second. • The four cash flow series are: • After tax operating cash flows: (Revenue .costs .operating expenses) * (1 .5 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project • The tax shield approach involves disaggregating cash flows into components and taking the present value of each of these. standardize the cash outflow by using an annuity formula where n is the number of cash flows • This standardized cash flow is called the equivalent annual cost • Note that we can only do this because there is no revenue difference between the two investments General Decision to Replace (Advanced) • First.t) + depreciation * t (tax-shield approach) • The only cash flow effect of depreciation is to reduce taxes • t * depreciation is the called the depreciation tax shield 8. • The sum of the present values of each of these cash flow series equals the NPV of the project. it is not enough to choose the machine with the lowest PV for costs • First.costs) * (1 .t) • Changes in NWC.taxes (top-down approach) • (Sales . which is composed of • Required cash balance • Accounts receivable • Accounts payable • Inventory • Other short-term financing mechanisms • Equipment flows • Investing costs • Salvage returns • The tax shield benefits • There are two components to the PV of the tax shield • The incremental cash flow resulting from the CCA • The lost protection after the asset is sold • There components culminate in the following formula • There are three advantages to the tax shield approach • Simplifying formula • The ability to discount different types of cash flows at different rates • There is no necessity to make all cash flows nominal or real. We can simply make the present values of each different stream nominal or real and add these together 8. determine the PV of the cost for holding the old machine for one additional • Compound this PV forward one period and compare it with the EAC for the replacement machine • If this quantity exceeds the EAC. purchase the replacement immediately 42 .

whichever is less. • When an asset is sold.Asset class closed • Three cases • ACD < remaining UCC = terminal loss • The UCC left after the ACD deduction results in a tax savings (treat it as depreciation .Assets remain in class • Cost of all acquisitions .adjust cost of disposal = net acquisitions • If the net acquisitions is positive.Appendix 8A . the 50% rule does not apply Case 2 . we apply the 50% rule to the net acquisitions • If net acquisitions is negative. the UCC in its asset class (or pool) is reduced by what is realized on the asset or by its original cost.Capital Cost Allowance • Since capital cost allowance is deducted in computing taxable income. larger CCA rates reduce taxes and increase cash flows.a tax deductible item) • ACD > remaining UCC = terminal gain (and asset is sold below original cost) • Pay ordinary tax rate on this terminal gain as if it were revenue • ACD > remaining UCC = terminal gain (and asset is sold above original cost) • Pay ordinary tax rate on the the difference between the remaining UCC and the original cost • Pay capital gains tax on the amount by which the asset sale exceeds the original cost • Remember that only 50% of a capital gain is taxed 43 . The amount is called the adjusted cost of disposal (ACD) Case 1 .

the lease is a sales type lease • The lessee uses the asset • There are two broad types of leases • Operating (service) leases • Operating leases are not fully amortized . Class 1 22. The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor • The lessor owns the asset • The lessor can be either the original manufacturer or an independent leasing company • If the company is an independent lessor.Week 11. the lender receives the lease payments 22. The lease permits the purchase of the asset below fair market value III. The lease is for 75% of the asset’s economic life IV. The lease transfers ownership of the property by the end of the term of the lease II. with the offsetting item as the asset’s value • Operating leases are not capitalized • Financial leases are capitalized A lease must be capitalized if one of the following four conditions are met: I.2 Accounting and Leasing • Off-balance sheet financing a firm could arrange to use an asset without reporting it on the balance sheet • Capitalization: report the PV of the lease payments as a liability.the term of the lease is less than the economic life of the asset • Lessor must maintain and insure the leased asset (service) • Cancellation option .4 The Cash Flows of Financial Leasing • There are three important cash flows to consider in leasing: • The lease payments • Remember lease payments are made at the beginning of a period (annuity in advance) 44 .gives the lessee the right to cancel the lease before the expiration date • Financial leases • Do not provide maintenance or service • Financial leases are fully amortized • Lessee usually has a right to renew the lease on expiration • Financial leases cannot be cancelled • The lessee must make all payments are face bankruptcy • There are two specific types of financial leases • Sale and lease-back back: a company sells assets to another firm and immediately leases • Advantages • Lessee immediately receives cash while still retaining use of the asset • Lessor make gain a tax advantage over and above purchase cost (when the PV of the lease payments is included) • Leveraged lease: • The lessor puts up no more than 40-50% of the asset’s cost • Lenders supply the remaining financing • Lender has two protections: • First lien on the asset • In the event of loan default.1 Types of Leases • A lease is a contactual agreement between a lessee and a lessor.3 Taxes and Leases • The lessee gets a tax deduction on the full lease payments 22. the lease is called a direct lease • If the company is the manufacturer. The PV of the lease payments is above 90% of the asset’s fair market value at the beginning of the lease 22.

9 Reasons for Leasing • Taxes may be reduced • If the lessor’s tax rate exceeds the lessees (or the lessee does not have the income to use the tax shield). risk-less cash flows should be discounted at the after-tax risk-free rate • In a world with corporate taxes. the lessee (usually the smaller company) passes this risk onto the lessor (usually the larger company capable of absorbing this risk with a wider asset base) • Transaction cost • The transaction cost ownership transfer is typically lower than leasing • Leasing is most beneficial when the transaction cost of purchase and resale outweigh the agency costs and monitoring cost of a lease • There are many bad reasons for leasing • Leasing to improve ROA • Return . it reduces the asset base • 100% financing • Leasing does not free up debt capacity (since intelligent bankers will realize a lease payment is identical in form to an interest payment) • Other reasons • Circumventing capex (therefore increasing cash flow) 22.leasing payments are often lower than sum of the depreciation and interest expense associated with acquiring an asset • Assets . the two tend to go hand-in-hand • Leasing for manufacturers v. value is created from the lease • Many smaller firms do not have the income to utilize the accelerated tax shield in the early years of an asset acquisition • The lessor must pass some of the tax savings on to the lessee to create value for both parties • Reservation payments are the payments level at which the lessee or lessor will be indifferent to the lease • The lease payment must fall between the reservation payments • Reduction of uncertainty • The true residual value of an asset is not certain • This cash flow is therefore risky • By leasing. and the lessor has the income to utilize the tax shield.5 NPV Analysis of the Lease-Versus-Buy Decision • Discount all cash flows at the after-tax interest rate • The lease payment is similar to the interest payment made to service debt • This implies that lease payments should be discounted approximately equal to the cost of serving debt (the after-tax cost of debt) • The textbook discounts both cash flows (tax shield and lease payments) at the after-tax cost of debt for the lessee 22. independent leasers • Manufacturing companies calculate CCA based on cost • independent leasers calculate CCA based on selling price • Why are some assets commonly not leased? • The more sensitive an asset is to maintenance/service costs.because leasing is off-balance-sheeting financing.• Remember that lease payments are discounted at the after-tax rate (since they are tax deductible) • The tax shield • The initial investment outlay / salvage value 22.9 Some Unanswered Questions • Even though leasing does not free-up debt capacity. one determines the increase in the firm’s optimal debt level by discounting a future guaranteed after-tax inflow at the after-tax risk-less interest rate 22.8 Does Leasing Ever Pay? The Base Case • As long as: • Both parties have identical interest rates and tax rates • Transaction costs are ignored • No value is created from a lease agreement 22. the less likely that it will be leased (because ownership encourages responsibility) • Leasing may allow price discrimination 45 .4 A Detour on Discounting and Debt Capacity with Corporate Taxes • In a world with corporate taxes.

The steps are • determine the NPV of each branch • discount the NPV of each branch to t=0 • weight each branch NPV by probability • deduct initial investment costs which are common to all branches • Often times different parts of the decision trees will have different discount rate .1 Decision Trees • In decision-tree modelling.2 Sensitivity Analysis. we apply the following framework: PV of cash inflows = PV of cash outflows PV of After-tax revenue + PV of CCA tax shield = PV of after-tax Variable Costs + PV of after-tax Fixed Costs + Initial Investment Cost 9. we construct probabilities for each variable in a cash flow projection and run the model many times to get a cash flow distribution • This is divided into a number of steps: • 1 .Specify the basic models • Break the cash flow model into variables 46 . we create base-case. Scenario Analysis and Break-Even Analysis Sensitivity analysis • In a sensitivity analysis. we break our analysis into branches which are weighted by probability.apply the correct rates when moving through time on the tree 9. pessimistic and optimistic assumption) • Advantages • Removes the false sense of security • Reveals which variables are most important (to which variables is NPV most sensitive?) and therefore require further research • Disadvantages • Make unwittingly create a false sense of security (if the ‘pessimistic projections’ are too optimistic) • Sensitivity analysis treats each variable as autonomous when this is not the case (many variables are related) Scenario analysis • Scenario analysis removes this last disadvantage of sensitivity analysis but considering a variety of scenarios where multiple variables are changes Break-even analysis • Accounting break-even refers to level of sales required to set net income = 0 • Financial break-even refers to the level of sales required to set NPV = 0 • In financial break even. pessimistic and optimistic case for the variables • Revenue • Market size • Market share • Price • Cost • Variable • Fixed • Investment size • A different NPV is calculated for each projection (each variable’s NPV is calculated under a base-case.3 Monte Carlo Simulation • In a Monte Carlo simulation. Class 2 9.Week 11.

Specify a probability distribution for each variable in the model .• • • • 2 3 4 5 .Calculate NPV • Determine a distribution for the cash flows and use this to calculate the NPV 47 .The computer draws one outcome .Repeat the procedure .

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