BUSINESS FINANCE .. Anthony & Brain

FINC 302
Business Finance II
Lecturer: Dr. Vera O. L. Fiador, UGBS

Contact Information: vfiador@ug.edu.gh
College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
SESSION 0
COURSE DESCRIPTION AND

OBJECTIVES
Slide 2
Description
• This course builds on the Introduction to Business Finance
course by examining the nature and workings of financial
markets and their use by corporations and investors. Building
on the premise that the goal of management is to increase
the value of the firm, we will examine in detail the key
corporate decisions that contribute to shareholder value,
namely investment, financing and payout decisions. From the
point of view of corporations, the investment decision we
would discuss will include capital budgeting and M&A
decisions. The techniques used in selecting capital projects
would be examined. The financing aspect comprises decisions
about capital structure - how much debt relative to equity is
optimal for a particular firm.
Slide 3
• We will also consider how companies can return
value to shareholders via dividend payment and
other "payback" strategies. Topics to be covered
include: the trade-off between risk and return; cost
of capital determination; capital budgeting analysis;
long term financing decisions involving capital
raisings and initial public offerings, capital structure
decisions, dividend policy and mergers and
acquisitions.
Slide 4
Course Objectives
• You will learn how to use financial management techniques to
make corporate finance and personal finance decisions.
• Specifically, on successful completion of this subject, students
would be able to:
– Explain the trade-off between risk and return,
– Evaluate the different techniques used on capital budgeting
decisions
– Analyze long-term financing decisions, including dividend policy,
– Identify the determinants of dividend policy
– Discuss the theory and practice of cost of capital and capital
structure decisions.
– Explain the basics of mergers and acquisition
Slide 5
Reading Lists
• Van Horne, J. C. and Wachowicz, J. M. (VH&W), Fundamentals of

Financial Management, Twelfth Edition or better, Prentice Hall, FT.
• Abor, J. Y. Financial Markets & Institutions: A Frontier Market Perspective,

First Edition, DigiBooks.
• Mensah, S. Securities Markets and Investments A Ghanaian Primer Fifth

Edition, Smartline Ltd.
•
Slide 6
Reading List
• Keown Arthur J., Martin John D., Petty William J.,
Scott David F. Jr. (2001), Financial Management,
International Edition; Pearson Prentice Hall.
• Brealey, Myres and Marcus (BMM), Fundamentals of

Corporate Finance, Third Edition or better, McGraw
Hill or any other edition of the text book.
•
• Ross, S. A; Westerfield R.W., Jordan B, D.,
Foundations of Corporate Finance, McGraw Hill,
2006 or better
Slide 7
SESSION 1
BOND VALUATION
Slide 1
Session Overview
• At the end of this session, students should be able to:
– Differentiate between bonds and other debt instruments
– Explain the basic types of bonds and important bond
features
– value bonds for investment or funding purposes
– Understand the term structure of interest rates and the
determinants of bond yields
Slide 2
Session Outline
The key topics to be covered in the session are as follows:
• Topic 1 – Bonds, Bond features and types of bonds
• Topic - Understand bond values, fluctuations and

determinants of Bond Yields
Slide 3
Topic One
BONDS AND IMPORTANT BOND

FEATURES
FINC 301 Slide 4

Definition of a Bond
• A bond is a loan by one party (the investor or holder) to
another party (the issuer). The issuer gives the investor a
guarantee that he or she will pay interest on the
• loan at regular intervals and repay the principal at a
specified time in the future.
• A bond is a legally binding agreement between a
borrower and a lender that specifies the:
– Par (face) value
– Coupon rate
– Coupon payment
– Maturity Date
Bond Definitions Cont’d
• Par value (face value): The amount that will be

repaid after the loan term is called par value( face
value)
• Coupon payment: Regular promise interest payment.
• Coupon rate: The annual coupon divided by the face
value is called the coupon rate.
• Maturity date: The number of years until the face
value is paid.
• Yield or yield to maturity: The interest rate required
on the market for a bond.
Bond Features
• A bond can generally be described in terms of its:
– issuer;
– size and currency;
– type;
– coupon payments and frequency;
– redemption amount and maturity dates;
– embedded options, such as whether and under what
circumstances the bond can be redeemed early;
– guarantees relating to the payment of interest and return
of capital; and
– where quoted and traded.
– Default risk: Risk that issuer will not make interest or
principal payments.
Bond types
• Bonds can be categorized as coupon-paying or non-
coupon paying
• Bonds that pay coupons are referred to as coupon-
paying bonds, in contrast to non-coupon paying
bonds that are typically referred to as zeroes or pure
discount bonds. Other bonds pay coupons
indefinitely and never mature, e.g. consols
Slide 8
BOND VALUATION
A typical bond thus pays a fixed amount of money per period
(coupon) for a defined period of time and at maturity pays a
lump sum. Since the cash flows from the bond will continue
for a time into the future, the value is given as:
• Bond Value = PV of coupons + PV of par
• Bond Value = PV of annuity + PV of lump sum
• As interest rates increase, present values decrease
• So, as interest rates increase, bond prices decrease
and vice versa
The Basic Bond Pricing Equation
 1 
1 - (1  r) t  FV
Bond Value  C  
 r  (1  r) t
 
Valuing a Discount Bond with Annual Coupons
• Consider a bond with a coupon rate of 10% and annual

coupons. The par value is GH¢1,000, and the bond has 5 years
to maturity. The yield to maturity is 11%. What is the value of
the bond?
 1 
1 - (1  r) t  FV
Bond Value  C  
 r  (1  r) t
 
Valuing a Zero Coupon Bond
• Suppose you are reviewing a bond that has a face value of

GH¢1000. There are 20 years to maturity, and the yield to
maturity is 8%. What is the price of this bond?
– Since this bond pays no coupons, the present value component for the
coupons is not included, hence
FV
Bond Value 
(1  r) t
Valuing a Consol
• Suppose you are reviewing a bond that has no maturity, pays

coupon of GHS100 and the yield to maturity is 8%. What is the
price of this bond?
– Hint: since the bond does not mature, there will be no FV to discount
and since t approaches infinity, (1/(1+r^)t) becomes negligible, hence
C
Bond Value 
r
The Bond Indenture
• Contract between the company and the bondholders

that includes
– The basic terms of the bonds
– The total amount of bonds issued
– A description of property used as security, if applicable
– Sinking fund provisions
– Call provisions
– Details of protective covenants
Bond Classifications
• Security
– Collateral – secured by financial securities
– Mortgage – secured by real property, normally land or
buildings
– Debentures – unsecured
– Notes – unsecured debt with original maturity less than 10
years
• Seniority
Bond Characteristics and Required Returns
• The coupon rate depends on the risk characteristics
of the bond when issued
• Which bonds will have the higher coupon, all else
equal?
– Secured debt versus a debenture
– Subordinated debenture versus senior debt
– A bond with a sinking fund versus one without
– A callable bond versus a non-callable bond
Bond Ratings – Investment Quality
• High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very strong
• Medium Grade
– Moody’s A and S&P A – capacity to pay is strong, but more
susceptible to changes in circumstances
– Moody’s Baa and S&P BBB – capacity to pay is adequate,
adverse conditions will have more impact on the firm’s ability to
pay
Bond Ratings - Speculative
• Low Grade
– Moody’s Ba and B
– S&P BB and B
– Considered possible that the capacity to pay will
degenerate.
• Very Low Grade
– Moody’s C (and below) and S&P C (and below)
• income bonds with no interest being paid, or
• in default with principal and interest in arrears
Government Bonds
• Treasury Securities
– Federal government debt
– T-bills – pure discount bonds with original maturity of one year or less
– T-notes – coupon debt with original maturity between one and ten
years
– T-bonds – coupon debt with original maturity greater than ten years
• Municipal Securities
– Debt of state and local governments
– Varying degrees of default risk, rated similar to corporate debt
– Interest received is tax-exempt at the federal level
Other Bond Types
• Disaster bonds
• Income bonds
• Convertible bonds
• Put bonds
• There are many other types of provisions that can be
added to a bond and many bonds have several
provisions – it is important to recognize how these
provisions affect required returns
Bond Markets
• Primarily over-the-counter transactions with dealers

connected electronically
• Extremely large number of bond issues, but generally
low daily volume in single issues
• Makes getting up-to-date prices difficult, particularly
on small company or municipal issues
• Treasury securities are an exception
The Fisher Effect
• The Fisher Effect defines the relationship between
real rates, nominal rates, and inflation
• (1 + R) = (1 + r)(1 + h), where
– R = nominal rate
– r = real rate
– h = expected inflation rate
• Approximation
– R=r+h
Term Structure of Interest Rates
• Term structure is the relationship between time to
maturity and yields, all else equal
• Yield curve – graphical representation of the term
structure
– Normal – upward-sloping; long-term yields are higher than
short-term yields
– Inverted – downward-sloping; long-term yields are lower
than short-term yields
Upward-Sloping Yield Curve
Downward-Sloping Yield Curve
Factors Affecting Bond Yields
• Default risk premium – remember bond ratings

• Taxability premium – remember municipal versus
taxable
• Liquidity premium – bonds that have more frequent
trading will generally have lower required returns
• Anything else that affects the risk of the cash flows to
the bondholders will affect the required returns
Graphical Relationship Between Price
and Yield-to-maturity (YTM)
1500
1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
Bond Prices: Relationship Between
Coupon and Yield to maturity
• If YTM = coupon rate, then par value = bond price

• If YTM > coupon rate, then par value > bond price
– Why? The discount rate provides yield above coupon rate
– Price below par value, called a discount bond
• If YTM < coupon rate, then par value < bond price
– Why? Higher coupon rate causes value above par
– Price above par value, called a premium bond
Interest Rate Risk
• Price Risk: Change in price due to changes in interest rates
– Long-term bonds have more price risk than short-term bonds
– Low coupon rate bonds have more price risk than high coupon rate
bonds
• Reinvestment Rate Risk: Uncertainty concerning rates at which
cash flows can be reinvested
– Short-term bonds have less reinvestment rate risk than long-term
bonds
– High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds
Interest rate risk and time to maturity
Computing Yield to Maturity
• Yield to Maturity (YTM) is the rate implied by the

current bond price
• Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the
process for finding r with an annuity
YTM with Annual Coupons
• Consider a bond with a 10% annual coupon rate, 15
years to maturity and a par value of GH¢1,000. The
current price is GH¢928.09.
– Will the yield be more or less than 10%?
YTM with Semiannual Coupons
• Suppose a bond with a 10% coupon rate and

has a face value of GH¢1,000, 20 years to
maturity and is selling for GH¢1,197.93.
– Is the YTM more or less than 10%?
– What is the semiannual coupon payment?
– How many periods are there?
Refresh
Current Yield vs. Yield to Maturity
• Current Yield = annual coupon / price

• Yield to maturity = current yield + capital gains yield
• Example: 10% coupon bond, with semiannual
coupons, face value of 1,000, 20 years to maturity,
GH¢1,197.93 price
– Current yield = 100 / 1,197.93 = .0835 = 8.35%
• Price in one year, assuming no change in YTM =
1,193.68
– Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -
.0035 = -.35%
– YTM = 8.35 - .35 = 8%, which is the same YTM computed
earlier
Bond Pricing Theorems
• Bonds of similar risk (and maturity) will be priced to

yield about the same return, regardless of the
coupon rate
• If you know the price of one bond, you can estimate
its YTM and use that to find the price of the second
bond
• This is a useful concept that can be transferred to
valuing assets other than bonds
SESSION 2
STOCK VALUATION
Slide 1
Session Overview and Objectives
• Stocks, also known as shares, form the fundamental
units of a business. Stock valuation is thus
intrinsically business valuation. This session
introduces valuation methods for stocks.
– Understand the dependence of stock values on future
dividends and dividend growth
– Be able to compute stock prices using dividend growth
model
– Be able to compute stock prices under different growth
scenarios
Slide 2
Session Outline
The key topics to be covered in the session are as follows:
• Topic 1 – Basic Stock valuation approach
• Topic 2 –Stock valuation in different growth settings
Slide 3
Topic One
BASIC STOCK VALUATION

APPROACH
Slide 4
Cash Flows for Stockholders
• When investors buys shares or stocks, they receive
cash in two ways:
– The dividends received
– The price received and the capital gains
– As with bonds and investments, the price of the stock is

the present value of the expected cash flows
• The dividend that an investor receives when holding
a stock/share is depends on whether it undergoing
zero growth; constant growth or differential growth
Slide 5
Case 1: Zero Growth
• Assume that dividends will remain at the same level
forever
D iv 1  D iv 2  D iv 3  
 Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:
Div 1 Div 2 Div 3

P0    
(1  R ) (1  R )
1 2
(1  R ) 3
Div
P0 
R
Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
D iv 1  D iv 0 (1  g )
D iv 2  D iv 1 (1  g )  D iv 0 (1  g ) 2
D iv 3  D iv 2 (1  g )  D iv 0 (1  g ) 3
.
Since future cash flows grow at a constant rate forever,
..
the value of a constant growth stock is the present value
of a growing perpetuity:
Div 1
P0 
Rg
Constant Growth Example
• Suppose Big D, Inc., just paid a dividend of $.50. It is
expected to increase its dividend by 2% per year. If
the market requires a return of 15% on assets of this
risk level, how much should the stock be selling for?
• P0 = .50(1+.02) / (.15 - .02) = $3.92
Case 3: Differential Growth
• Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
• To value a Differential Growth Stock, we need
to:
– Estimate future dividends in the foreseeable future.
– Estimate the future stock price when the stock becomes a
Constant Growth Stock (case 2).
– Compute the total present value of the estimated future
dividends and future stock price at the appropriate
discount rate.
A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.
With Cash Flows
$2(1.08) $2(1.08) 2 $ 2 (1 . 0 8 ) 3 $2(1.08)3 (1.04)
…
0 1 2 3 4
$2.62 The constant
$ 2 .1 6 $ 2 .3 3 $2.52  growth phase
.08
beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$ 2 . 62
P3   $ 32 . 75
. 08
$2.16 $2.33 $2.52  $32.75

P0   2
 3
 $28.89
1.12 (1.12) (1.12)
Estimates of Parameters
• The value of a firm depends upon its growth rate,
g, and its discount rate, R.
– Where does g come from?
g = Retention ratio × Return on retained
earnings
Where does R come from?
• The discount rate can be broken into two parts.
– The dividend yield
– The growth rate (in dividends)
• In practice, there is a great deal of estimation error
involved in estimating R.
Using the DGM to Find R
• Start with the DGM:
D 0 (1  g) D1
P0  
R -g R -g
Rearrange and solve for R:
D 0 (1  g) D1
R g g
P0 P0
Valuing Common Stocks
• If a firm elects to pay a lower dividend, and reinvest
the funds, the stock price may increase because
future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as

dividends
Plowback Ratio - Fraction of earnings retained by the
firm
Sustainable Growth Rate - Steady rate at which firm can
grow; return on equity x plowback ratio
Growth can be derived from applying the return on
equity to the percentage of earnings plowed back
into operations.
g = return on equity X plowback ratio

Example
Our company forecasts to pay a $5.00
dividend next year, which represents
100% of its earnings. This will provide
investors with a 12% expected return.
Instead, we decide to plowback 40% of
the earnings at the firm’s current return
on equity of 20%. What is the value of
the stock before and after the plowback
decision?
Example
Our company forecasts to pay a $5.00 dividend next year, which represents
100% of its earnings. This will provide investors with a 12% expected
return. Instead, we decide to plowback 40% of the earnings at the firm’s
current return on equity of 20%. What is the value of the stock before and
after the plowback decision?
No Growth With Growth
5 g .20.40 .08
P0   $41.67
.12
3
P0   $75.00
.12 .08
Stock Market Reporting
52 WEEKS YLD VOL NET
HI LO STOCK SYM DIV % PE 100s CLOSE CHG
25.72 18.12 Gap Inc GPS 0.18 0.8 18 39961 21.35 …
Gap pays a
dividend of 18
Gap has cents/share. Gap ended trading at
been as high $21.35, which is
as $25.72 in unchanged from yesterday.
the last year. Given the current
price, the dividend
yield is .8%.
3,996,100 shares traded

Gap has been as Given the current hands in the last day’s
low as $18.12 in price, the PE ratio is trading.
the last year. 18 times earnings.
Random Walk Theory
• The movement of stock prices from day to day DO
NOT reflect any pattern.
• Statistically speaking, the movement of stock prices
is random.
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
230
Level
180
130
80
Month
Efficient Market Theory
Microsoft
Stock Price
$90
Actual price as soon as upswing is
recognized
70
50
Cycles
disappear
once Last This Next
identified Month Month Month
• Weak Form Efficiency
– Market prices reflect all historical information
• Semi-Strong Form Efficiency
– Market prices reflect all publicly available information
• Strong Form Efficiency
– Market prices reflect all information, both public and
private
Weak Form EMH
• Current prices reflect all security-market information,

including the historical sequence of prices, rates of
return, trading volume data, and other market-
generated information.
• This implies that past rates of return and other

market data should have no relationship with future
rates of return
Semi-strong Form EMH
• Current security prices reflect all public information,
including market and non-market information.
• This implies that decisions made on new information

after it is public should not lead to above-average
risk-adjusted profits from those transactions
Strong Form EMH
• Stock prices fully reflect all information from public

and private sources.
• This implies that no group of investors should be able

to consistently derive above-average risk-adjusted
rates of return.
• This assumes perfect markets in which all

information is cost-free and available to everyone at
the same time.
Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow
Technical Analysts
– Forecast stock prices based on watching the
fluctuations in historical prices (thus “wiggle
watchers”)
Announcement Date
Cumulative Abnormal Return (%) 39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date
Quick Quiz
• How do you find the value of a bond, and why do
bond prices change?
• What is a bond indenture, and what are some of the
important features?
• What determines the price of a share of stock?
• What determines g and R in the DGM?
• Decompose a stock’s price into constant growth and
NPVGO values.
• Discuss the importance of the PE ratio.
SESSION THREE
INVESTMENT APPRAISAL
Slide 1
Session Overview and Objectives
A successful firm is a firm that consistently selects value
creating projects. This competence ensures that the
firm always embarks on investments that bring in more
money than it cost the firm to implement. This session
presents the various techniques employed in the
capital project selection process and also looks at the
strengths and weaknesses of the various tools.
• At the end of this session, students should:
– Be able to compute payback and discounted payback and
understand their shortcomings
Slide 2
Key Concepts and Skills
– Be able to compute the internal rate of return and
profitability index, understanding the strengths and
weaknesses of both approaches
– Be able to compute the net present value and
understand why it is the best decision criterion
– Understand accounting rates of return and their
shortcomings
Session Outline
Topic one (Part A)- Non-discounted cash flow
techniques: The Payback Period Method and Average
Accounting Return Method
Topic Two (Part B) - Discounted cash flow techniques:

Net Present Value; Internal Rate of Return;
Profitability Index; The Discounted Payback Period
PART A
NON-DISCOUNTED CASH FLOW

TECHNIQUES
Slide 5
Average Accounting Return
Average N et Income
AAR 
Average Book Value of Investment
• Another attractive, but fatally flawed, approach

• Ranking Criteria and Minimum Acceptance Criteria
set by management
Illustration of - AAR
• Suppose the investment requires $240
 Average net income:
Year
1 2 3
Sales $440 $240 $160
Costs 220 120 80
Gross profit 220 120 80
Depreciation 80 80 80
Earnings before taxes 140 40 0
Taxes (25%) 35 10 0
Net income $105 $30 $0
Average net income = ($105 + 30 + 0)/3 = $45

• Average book value:
Initial investment = $240
Average investment = ($240 + 0)/2 = $120
Average net income 45

AAR=   37.5%
Average book value 120
Computing AAR for THE Project
• Assume we require an average accounting return of
25%
• Average Net Income(NI):
– (13,620 + 3,300 + 29,100) / 3 = 15,340
• AAR = 15,340 / 72,000 = .213 = 21.3%
• Do we accept or reject the project?
Decision Criteria Test - AAR
• Does the AAR rule account for the time value of
money?
• Does the AAR rule account for the risk of the cash
flows?
• Does the AAR rule provide an indication about the
increase in value?
• Should we consider the AAR rule for our primary
decision rule?
Average Accounting Return
• Disadvantages:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values
• Advantages:
– The accounting information is usually available
– Easy to calculate
The Payback Period Method
• How long does it take the project to “pay back” its
initial investment?
• Payback Period = number of years to recover initial
costs
• Minimum Acceptance Criteria:
– Set by management
• Ranking Criteria:
– Set by management
The Payback Period Method
• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
– A project accepted based on the payback criteria may
not have a positive NPV
• Advantages:
– Easy to understand
– Biased toward liquidity
Part B
DISCOUNTED CASH FLOW

TECHNIQUES
Slide 1
The Net Present Value (NPV) Rule
• Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
• Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
Why Use Net Present Value?
• Accepting positive NPV projects benefits
shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the project
 NPV discounts the cash flows properly
• Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the discount
rate.
The Internal Rate of Return
• IRR: the discount rate that sets NPV to zero
– Accept if the IRR exceeds the required
return
– Select alternative with the highest IRR
• Reinvestment assumption:
– All future cash flows assumed reinvested
at the IRR
Internal Rate of Return (IRR)
• Disadvantages:
– Does not distinguish between investing and
borrowing
– IRR may not exist, or there may be multiple
IRRs
– Problems with mutually exclusive
investments
• Advantages:
– Easy to understand and communicate
The Discounted Payback Period
• How long does it take the project to “pay back” its
initial investment, taking the time value of money
into account?
• Decision rule: Accept the project if it pays back on a
discounted basis within the specified time.
• By the time you have discounted the cash flows, you
might as well calculate the NPV.
IRR: Example
Consider the following project:
$50 $100 $150
0 1 2 3
-$200
The internal rate of return for this project is 19.44%
$ 50 $ 100 $ 150
N P V  0   200   
(1  IRR ) (1  IRR ) 2
(1  IRR ) 3
NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
0% $100.00 $120.00
4% $73.88 $100.00
8% $51.11 $80.00
12% $31.13 $60.00
16% $13.52 $40.00 IRR = 19.44%
NPV
20% ($2.08) $20.00

24% ($15.97) $0.00
28% ($28.38) ($20.00)
-1% 9% 19% 29% 39%
32% ($39.51) ($40.00)
36% ($49.54) ($60.00)
40% ($58.60) ($80.00)
44% ($66.82)
Discount rate
Problems with IRR
 Multiple IRRs
 Are We Borrowing or Lending
 The Scale Problem
Mutually Exclusive vs. Independent
• Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
– RANK all alternatives, and select the best one.
• Independent Projects: accepting or rejecting one

project does not affect the decision of the other
projects.
– Must exceed a MINIMUM acceptance criteria
Multiple IRRs
There are two IRRs for this project:
$200 $800 Which one should
we use?
0 1 2 3
-$200 - $800
NPV
$100.00
$50.00
100% = IRR2
$0.00
-50% 0% 50% 100% 150% 200%
($50.00) 0% = IRR1 Discount rate
($100.00)
The Scale Problem
Would you rather make 100% or 50% on your

investments?
What if the 100% return is on a $1
investment, while the 50% return is on a
$1,000 investment?
NPV versus IRR
• NPV and IRR will generally give the same decision.
• Exceptions:
– Non-conventional cash flows – cash flow signs change
more than once
– Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
The Profitability Index (PI)
Total P V of F uture C ash F lows

PI 
Initial Investent
– Accept if PI > 1
– Select alternative with highest PI
The Profitability Index
• Disadvantages:
– Problems with mutually exclusive investments
• Advantages:
– May be useful when available investment funds
are limited
– Easy to understand and communicate
– Correct decision when evaluating independent
projects
The Practice of Capital Budgeting
• Varies by industry:
– Some firms use payback, others use accounting rate of
return.
• The most frequently used technique for large
corporations is IRR or NPV.
Quick Quiz
• Consider an investment that costs $100,000 and has
a cash inflow of $25,000 every year for 5 years. The
required return is 9%, and payback cutoff is 4 years.
– What is the payback period?
– What is the discounted payback period?
– What is the NPV?
– What is the IRR?
– Should we accept the project?
• What method should be the primary decision rule?
• When is the IRR rule unreliable?
Related Issue
• Read on Lease versus Buy Decision

PART C
RELEVANT CASH FLOWS & APPRAISING

INVESTMENTS WITH UNEQUAL LIVES
Slide 1
Objectives
At the end of this part, students should be :
• Understand how to determine the relevant cash
flows for various types of capital investments
• Be able to compute depreciation expense for tax
purposes
• Incorporate inflation into capital budgeting
• Understand the various methods for computing
operating cash flow
• Apply the Equivalent Annual Cost approach
Chapter Outline
Topic one - Incremental and relevant Cash Flows

Topic two -Investments of Unequal Lives: The
Equivalent Annual Cost Method
Incremental Cash Flows
• Cash flows matter—not accounting earnings.
• Sunk costs do not matter.
• Incremental cash flows matter.
• Opportunity costs matter.
• Side effects like cannibalism and erosion matter.
• Taxes matter: we want incremental after-tax cash
flows.
• Inflation matters.
Cash Flows—Not Accounting Income
• Consider depreciation expense.

– You never write a check made out to
“depreciation.”
• Much of the work in evaluating a project
lies in taking accounting numbers and
generating cash flows.
• Sunk costs are not relevant
– Just because “we have come this far” does not mean that
we should continue to throw good money after bad.
• Opportunity costs do matter. Just because a project
has a positive NPV, that does not mean that it should
also have automatic acceptance. Specifically, if
another project with a higher NPV would have to be
passed up, then we should not proceed.
• Side effects matter.
– Erosion and cannibalism are both bad
things. If our new product causes existing
customers to demand less of current
products, we need to recognize that.
– If, however, synergies result that create
increased demand of existing products, we
also need to recognize that.
Estimating Cash Flows
• Cash Flow from Operations
– Recall that:
OCF = EBIT – Taxes + Depreciation
• Net Capital Spending
– Do not forget salvage value (after tax, of course).
• Changes in Net Working Capital
– Recall that when the project winds down, we enjoy a
return of net working capital.
Example: Estimating Relevant Cash Flows
Costs of test marketing (already spent): $250,000
Current market value of proposed factory site
(which we own): $150,000
Cost of bowling ball machine: $100,000
(depreciated according to MACRS 5-year)
Increase in net working capital: $10,000
Production (in units) by year during 5-year life of
the machine: 5,000, 8,000, 12,000, 10,000, 6,000
Price during first year is $20 per unit; price increases
2% per year thereafter.
Production costs during first year are $10 per unit
and increase 10% per year thereafter.
Annual inflation rate: 5%
Working Capital: initial $10,000 changes with sales
Solution
($ thousands) (All cash flows occur at the end of the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]
Recognizing opportunity cost
Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
Computing Sales Revenue
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.
Computing Production Cost

Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
Adjusting for Depreciation

Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
Depreciation is calculated using the Accelerated Year MACRS %

Cost Recovery System (shown at right).
Our cost basis is $100,000. 1 20.00%
Depreciation charge in year 4 2 32.00%
3 19.20%
= $100,000×(.1152) = $11,520.
4 11.52%
5 11.52%
6 5.76%
Total 100.00%
Putting the Income statement
together
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
(11) Income before taxes 30.00 43.20 85.32 67.58 30.54
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(13) Net Income 19.80 28.51 56.31 44.60 20.16
Incremental After Tax Cash Flows
(1) Sales $100.00 $163.20 $249.72 $212.20 $129.90

Revenues
(2) Operating -50.00 -88.00 -145.20 133.10 -87.84
costs
(3) Taxes -10.20 -14.69 -29.01 -22.98 -10.38
(4) OCF 39.80 60.51 75.51 56.12 31.68

(1) – (2) – (3)
(5) Total CF of –260. –6.32 –8.65 3.75 192.98
Investment
(6) IATCF –260. 39.80 54.19 66.86 59.87 224.66
[(4) + (5)]
$ 39 .80 $ 54 .19 $ 66 .86 $ 59 .87 $ 224 .66

NPV   $ 260   2
 3
 4

(1 .10 ) (1 .10 ) (1 .10 ) (1 .10 ) (1 .10 ) 5
NPV  $ 51 .588
Investments of Unequal Lives
• There are times when application of the NPV rule can

lead to the wrong decision. Consider a factory that
must have an air cleaner that is mandated by law.
There are two choices:
– The “Cadillac cleaner” costs $4,000 today, has annual
operating costs of $100, and lasts 10 years.
– The “Cheapskate cleaner” costs $1,000 today, has annual
operating costs of $500, and lasts 5 years.
• Assuming a 10% discount rate, which one should we
choose?
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 – 4,000 CF0 –1,000
CF1 –100 CF1 –500

Period 10 Period 5
Interest 10 Interest 10
NPV –4,614.46 NPV –2,895.39
At first glance, the Cheapskate cleaner has a higher NPV, hence better .
• This overlooks the fact that the Cadillac
cleaner lasts twice as long.
• When we incorporate the difference in
lives, the Cadillac cleaner is actually
cheaper (i.e., has a higher NPV).
• Replacement Chain
– Repeat projects until they begin and end at the same
time.
– Compute NPV for the “repeated projects.”
• The Equivalent Annual Cost Method
Replacement Chain Approach
The Cadillac cleaner time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100
0 1 2 3 4 5 6 7 8 9 10
The Cheapskate cleaner time line of cash flows

over ten years:
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500
0 1 2 3 4 5 6 7 8 9 10
Equivalent Annual Cost (EAC)
• Applicable to a much more robust set of circumstances
than the replacement chain
• The EAC is the value of the level payment annuity that
has the same PV as our original set of cash flows.
– For example, the EAC for the Cadillac air cleaner is $750.98.
– The EAC for the Cheapskate air cleaner is $763.80, which
confirms our earlier decision to reject it.
Quick Quiz
• How do we determine if cash flows are relevant to
the capital budgeting decision?
• What are the different methods for computing
operating cash flow, and when are they important?
• How should cash flows and discount rates be
matched when inflation is present?
• What is equivalent annual cost, and when should it
be used?
Reading List
Slide 25
SESSION SIX
RISK & RETURN – THE BASICS
Slide 1
Session Overview
• In the world of investments, risk is a given. What
makes risk bearable is the availability of
commensurate return to compensate investors for
taking risk. An appreciation of risk-return trade-off is
thus important in the investment decision at all
levels. This session introduces the computation of
risk and return statistics for decision-making and the
incorporation of probability of state of economies
into risk and return computations.
Slide 2
Session Objectives
At the end of this session, students should be able to:

• Know how to calculate the returns on an investment
• Compute the variance and standard deviation of returns
• Select viable investments based on risk return trade-offs
Session Outline
Outline
• Topic One - Returns
• Topic Two - Arithmetic mean, geometric mean, holding
period return, Expected Return
• Topic Three - Variance, standard deviation and the Risk-
return relationship
9.1 Returns
• Dollar Returns
the sum of the cash received Dividends
and the change in value of the
asset, in dollars.
Ending
market value
Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset divided by
investment the initial investment.
Investment Returns
• Investment returns measure the financial results of an
investment.
• Total monetary return = income from investment + capital

gain (loss) due to change in price
• Example:
– You bought a bond for GH¢950 one year ago. You have received two
coupons of GH¢30 each. You can sell the bond for GH¢975 today.
What is your total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 975 – 950 = 25
• Total dollar return = 60 + 25 = GH¢85
Percentage Returns
• It is generally more intuitive to think in terms of

percentage, rather than dollar, returns
• Dividend yield = (dividend income / beginning price)
• Capital gains yield = (ending price – beginning price) /
beginning price
• Total percentage return = dividend yield + capital gains
yield
Example – Calculating Returns
• You bought a stock for GH¢35, and you received

dividends of GH¢1.25. The stock is now selling for
GH¢40.
– What is your Cedi return?
• cedi return = 1.25 + (40 – 35) = GH¢6.25
– What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%
9.2 Holding Period Returns
• The holding period return is the return
that an investor would get when holding
an investment over a period of n years,
when the return during year i is given as
ri:
holding period return 
 (1  r1 )  (1  r2 )    (1  rn )  1
Holding Period Return: Example
• Suppose your investment provides the following
returns over a four-year period:
Year Return Your holding period return 

1 10%
 (1  r1 )  (1  r2 )  (1  r3 )  (1  r4 )  1
2 -5%
3 20%  (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .4421  44.21%
9.6 More on Average Returns
• Arithmetic average – return earned in an average
period over multiple periods
• Geometric average – average compound return per
period over multiple periods
• The geometric average will be less than the
arithmetic average unless all the returns are equal.
• Which is better?
– The arithmetic average is overly optimistic for long
horizons.
– The geometric average is overly pessimistic for short
horizons.
Geometric Return: Example
• Note that the geometric average is not the
same as the arithmetic average:
Year Return
r1  r2  r3  r4
1 10% Arithmetic average return 
2 -5%
4
3 20%  10%  5%  20 %  15%  10%
4 15% 4
Geometric Return: Example
• Recall our earlier example:
Year Return Geometric average return 
1 10% (1  r ) 4  (1  r )  (1  r )  (1  r )  (1  r )
g 1 2 3 4
2 -5%
20% rg  (1.10)  (.95)  (1.20)  (1.15)  1
4
3
4 15%  .095844  9.58%
So, our investor made an average of 9.58% per year,
realizing a holding period return of 44.21%.
1 . 4 4 2 1  (1 . 0 9 5 8 4 4 ) 4
9.3 Return Statistics
• The history of capital market returns can be
summarized by describing the:
– average return
( R1    RT )
R
T
– the standard deviation of those returns
( R1  R ) 2  ( R 2  R ) 2   ( RT  R ) 2
SD  VAR 
– the frequency distribution of the returnsT 1
9.5 Risk Statistics
• There is no universally agreed-upon
definition of risk.
• The measures of risk that we discuss are
variance and standard deviation.
– The standard deviation is the standard statistical measure
of the spread of a sample, and it will be the measure we
use most of this time.
– Its interpretation is facilitated by a discussion of the
normal distribution.
Example – Return and Variance
Year Actual Average Deviation from Squared
Return Return the Mean Deviation
1 .15 .105 .045 .002025
2 .09 .105 -.015 .000225
3 .06 .105 -.045 .002025
4 .12 .105 .015 .000225
Totals .00 .0045
Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

The Risk-Return Tradeoff
18%
Small-Company Stocks
16%
Annual Return Average
14%
12% Large-Company Stocks

10%
8%
6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation
Quick Quiz
• Which of the investments discussed has had the
highest average return and risk premium?
• Which of the investments discussed has had the
highest standard deviation?
• Why is the normal distribution informative?
• What is the difference between arithmetic and
geometric averages?
SESSION SEVEN
RISK & RETURNS : EXPECTATIONS,

BETAS AND DIVERSIFICATION
Slide 1
Key Concepts and Skills
At the end of the session, students should be able to:
• Know how to calculate expected returns
• Know how to calculate covariances, correlations, and
betas
• Understand the impact of diversification
• Understand the systematic risk principle
• Understand the security market line
• Understand the risk-return tradeoff
• Be able to use the Capital Asset Pricing Model
Chapter Outline
Topic One - Expected Return, Variance, and Covariance
Topic Two - The Return and Risk for Portfolios
Topic Three- Diversification: An Example
Topic Four – Capital Asset Pricing Module (CAPM)
Expected Return, Variance, and Covariance
Consider the following two risky asset world. There
is a 1/3 chance of each state of the economy, and
the only assets are a stock fund and a bond fund.
Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Expected Return
Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Expected Return
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
E ( rS )  1  (  7 %)  1  (12 %)  1  ( 28 %)
3 3 3
E ( rS )  11 %
Variance

Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
(  7 %  1 1 % )  .0 3 2 4
2
Variance

Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
1
. 0205  (. 0324  . 0001  . 0289 )
3
Standard Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
1 4 .3 %  0 .0 2 0 5
Covariance
Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117
Deviation compares return in each state to the expected return.

Weighted takes the product of the deviations multiplied by the
probability of that state.
Correlation
Cov ( a, b)

 a b
 .0117
  0.998
(.143)(.082)
10.3 The Return and Risk for Portfolios
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Variance 0.0205 0.0067
Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted

average of the expected returns on the securities in the
portfolio.
E ( rP )  w B E ( rB )  w S E ( rS )
9 %  5 0 %  (1 1 % )  5 0 %  ( 7 % )
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets

portfolio is
σ P2  (w B σ B ) 2  (w S σ S ) 2  2 (w B σ B )(w S σ S )ρ B S
where BS is the correlation coefficient between the returns
on the stock and bond funds.
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation.
10.4 The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0% Portfolo Risk and Return Combinations
Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4% 12.0%
100%
15% 4.8% 7.6% 11.0%
stocks
20% 3.7% 7.8% 10.0%
25% 2.6% 8.0% 9.0% 100%
30% 1.4% 8.2% 8.0% bonds
35% 0.4% 8.4%
7.0%
40% 0.9% 8.6%
6.0%
45% 2.0% 8.8%
5.0%
50.00% 3.08% 9.00%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2%
60% 5.3% 9.4% Portfolio Risk (standard deviation)
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80% 9.8% 10.2%
85% 10.9% 10.4%
portfolio weights besides
90% 12.1% 10.6% 50% in stocks and 50% in
95% 13.2% 10.8%
100% 14.3% 11.0% bonds …
The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0% Portfolo Risk and Return Combinations
Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4% 12.0%
15% 4.8% 7.6% 11.0%
20% 3.7% 7.8% 10.0% 100%
25% 2.6% 8.0% 9.0% stocks
30% 1.4% 8.2% 8.0%
35% 0.4% 8.4% 7.0% 100%
40% 0.9% 8.6% 6.0%
45% 2.0% 8.8%
bonds
5.0%
50% 3.1% 9.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2%
60% 5.3% 9.4% Portfolio Risk (standard deviation)
65% 6.4% 9.6%
70% 7.6% 9.8% Note that some portfolios are
75%
80%
8.7%
9.8%
10.0%
10.2%
“better” than others. They have
85% 10.9% 10.4% higher returns for the same level of
90% 12.1% 10.6%
95% 13.2% 10.8%
risk or less.
100% 14.3% 11.0%
Diversification and Portfolio Risk
• Diversification can substantially reduce the variability
of returns without an equivalent reduction in
expected returns.
• This reduction in risk arises because worse than
expected returns from one asset are offset by better
than expected returns from another.
• However, there is a minimum level of risk that cannot
be diversified away, and that is the systematic
portion.
Portfolio Risk and Number of Stocks
In a large portfolio the variance terms are effectively

 diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Systematic Risk
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market risk
• Includes such things as changes in GDP, inflation,
interest rates, etc.
Unsystematic (Diversifiable) Risk
• Risk factors that affect a limited number of assets
• Also known as unique risk and asset-specific risk
• Includes such things as labor strikes, part shortages,
etc.
• The risk that can be eliminated by combining assets
into a portfolio
• If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to risk that
we could diversify away.
Total Risk
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of
total risk.
• For well-diversified portfolios, unsystematic risk is
very small.
• Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk.
Risk in the Market Portfolio
• Researchers have shown that the best measure of
the risk of a security in a large portfolio is the beta
(b)of the security.
• Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic
risk).
Cov ( Ri , R M )
bi 
 ( RM )
2
Estimating b with Regression
Security Returns
Slope = bi
Return on
market %
Ri = a i + biRm + ei
The Formula for Beta
Cov ( Ri , R M )
bi 
 ( RM )
2
Clearly, your estimate of beta will

depend upon your choice of a proxy
for the market portfolio.
Risk and Expected Return (CAPM)
• Expected Return on the Market:
R M  R F  M ark et R isk P remium

• Expected return on an individual security:
R i  RF  βi (R M  RF )
Market Risk Premium

This applies to individual securities held within well-
diversified portfolios.
Expected Return on a Security
• This formula is called the Capital Asset Pricing
Model (CAPM):
R i  RF  βi (R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume bi = 0, then the expected return is RF.

• Assume bi = 1, then R i  R M
Relationship Between Risk & Return
Expected return
R i  RF  βi (R M  RF )
RM
RF
1.0 b
Relationship Between Risk & Return
1 3 .5 %
Expected
return
3%
1.5 b
β i  1 .5 RF  3% R M  10 %
R i  3 %  1 . 5  (1 0 %  3 % )  1 3 . 5 %
Quick Quiz
• How do you compute the expected return and
standard deviation for an individual asset? For a
portfolio?
• What is the difference between systematic and
unsystematic risk?
• What type of risk is relevant for determining the
expected return?
• Consider an asset with a beta of 1.2, a risk-free rate
of 5%, and a market return of 13%.
– What is the expected return on the asset?
Risk, Return and Financial Markets
• We can examine returns in the financial markets to help

us determine the appropriate returns on non-financial
assets
• Lessons from capital market history
– There is a reward for bearing risk
– The greater the potential reward, the greater the risk
– This is called the risk-return trade-off
SESSION SEVEN
Slide 32
SESSION EIGHT
The Weighted Average Cost of Capital

and Company Valuation
Slide 1
Topics Covered
• Geothermal’s Cost of Capital
• Weighted Average Cost of Capital (WACC)
• Measuring Capital Structure
• Calculating Required Rates of Return
• Calculating WACC
• Interpreting WACC
• Valuing Entire Businesses
Cost of Capital
Cost of Capital - The return the firm’s investors could
expect to earn if they invested in securities with
comparable degrees of risk.
Capital Structure - The firm’s mix of long term financing

and equity financing.
Cost of Capital
Example
Geothermal Inc. has
the following
structure. Given that
geothermal pays 8%
for debt and 14% for
equity, what is the
Company Cost of
Capital?
Cost of Capital
Example - Geothermal Inc. has the following structure.
Given that geothermal pays 8% for debt and 14% for
equity, what is the Company Cost of Capital?
Market Value Debt $194 30%

Market Value Equity $453 70%
Market Value Assets $647 100%
Cost of Capital
Portfolio Return = (.3  8%) + (.7  14%) = 12.2%

Cost of Capital
Portfolio Return = (.3  8%) + (.7  14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2%
(i.e. 8 % x .65).
WACC = (.3  5.2%) + (.7  14%) = 11.4%

WACC
Weighted Average Cost of Capital (WACC) The
expected rate of return on a portfolio of all the
firm’s securities, adjusted for tax savings due to
interest payments.
Company cost of capital = Weighted average of debt

and equity returns.
WACC
• Taxes are an important consideration in the company
cost of capital because interest payments are
deducted from income before tax is calculated.
After - tax cost of debt = pretax cost x (1- tax rate)

= rdebt x (1- Tc)
WACC
Weighted Average Cost of Capital = WACC
D  E 
WACC =   (1- Tc )rdebt  +   requity 
V  V 
WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a proportion
of the firm’s market value.
2. Determine the required rate of return on each
security.
3. Calculate a weighted average after tax return on the
debt and the return on the equity.
WACC
Weighted Average Cost of Capital with Preferred Stock
D  E  P 
WACC =   (1- Tc )rdebt  +   requity  +   rPreferred
V  V  V 
WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
WACC = [ 4
12 ] (
x(1-.35).06 + 2
12 ) (
x.12 + 6
12 )
x.18
=.123 or 12.3%
Measuring Capital Structure
• In estimating WACC, do not use the Book Value of
securities.
• In estimating WACC, use the Market Value of the
securities.
• Book Values often do not represent the true market
value of a firm’s securities.
Market Value of Bonds - PV of all coupons
and par value discounted at the current
YTM.
Market Value of Equity - Market price per

share multiplied by the number of
outstanding shares.
Big Oil Book Value Balance Sheet (mil)

Bank Debt $ 200 25.0%
LT Bonds $ 200 25.0%
Common Stock $ 100 12.5%
Retained Earnings $ 300 37.5%
Total $ 800 100%
Big Oil Book Value Balance Sheet (mil) If the long term bonds pay an 8%
Bank Debt $ 200 25.0% coupon and mature in 12 years, what
LT Bonds $ 200 25.0%
Common Stock $ 100 12.5%
is their market value assuming a 9%
Retained Earnings $ 300 37.5% YTM?
Total $ 800 100%
16 16 16 216
PV   2
 3
 ....  12
1.09 1.09 1.09 1.09
 $185.70
Big Oil MARKET Value Balance Sheet (mil)

Bank Debt (mil) $ 200.0 12.6%
LT Bonds $ 185.7 11.7%
Total Debt $ 385.7 24.3%
Common Stock $ 1,200.0 75.7%
Total $ 1,585.7 100.0%
Required Rates of Return
Bonds
rd = YTM
Common Stock
re = CAPM
= rf + B(rm - rf )
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
Div1
P0 =
re - g
solve for re
Div1
re = + g
P0
Expected Return on Preferred Stock
Price of Preferred Stock =
Div1
P0 =
rpreferred
solve for preferred

Div1
rpreferred =
P0
Interpreting WACC
• The WACC is an appropriate discount rate only for a

project that is a carbon copy of the firm's existing
business
• There are two costs of debt financing. The explicit
cost of debt is the rate of interest bondholders
demand. The implicit cost is the required increase in
return from equity.
* FCF and PV *
• Free Cash Flows (FCF) should be the theoretical basis
for all PV calculations.
• FCF is a more accurate measurement of PV than
either Div or EPS.
• The market price does not always reflect the PV of
FCF.
• When valuing a business for purchase, always use
FCF.
Capital Budgeting
• Valuing a Business
– The value of a business or project is usually computed as
the discounted value of FCF out to a valuation horizon
(H).
• The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.
FCF1 FCF2 FCFH PVH

PV    ...  
(1  WACC ) (1  WACC )
1 2
(1  WACC ) H
(1  WACC ) H
FINC 302
BUSINESS FINANCE
SESSION 10 : CAPITAL
STRUCTURE

2014/2015 – 2016/2017
2
Session Overview
The mix of debt and equity that a firm chooses to finance its investments
is one of the core functions of the financial manager’s role. Any mix that is
employed can have implications, one way or the other. The financial
manager’s dilemma is to determine if an appropriate mix can be attained
and how to implement that.
• The capital structure decision affects financial risk and, hence, the value
of the company.
• The capital structure theory helps us understand the factors most
important in the relationship between capital structure and the value of
the company.
Objectives

– Discuss the various positions on the relevance/irrelevance of capital
structure
– Explain how the various theories arrive at conclusions on relevance
– Explain the trade-off in the capital structuring discourse
Slide 3
4
The Capital Structure Decision
Development of the theory of capital structure, beginning with the capital structure
theory of Miller and Modigliani:
Costs of
Asymmetric
Agency Costs Information
Costs of
Financial
Benefit from Distress
Tax
Capital Deductibility
Structure of Interest
Irrelevance
5
Proposition I without Taxes:

Capital Structure Irrelevance
• Franco Modigliani and Merton Miller (MM) developed a theory that
helps us understand how taxes and financial distress affect a company’s
capital structure decision.
• The assumptions of their model are unrealistic, but they help us work
through the effects of the capital structure decision:
1. Investors have homogeneous expectations regarding future cash flows.
2. Bonds and stocks trade in perfect markets.
3. Investors can borrow and lend at the same rate.
4. There are no agency costs.
5. Investment and financing decisions are independent of one another.
6
Proposition I without Taxes:

Capital Structure Irrelevance
MM Proposition I
The market value of a company is not affected by the capital structure of the
company.
• Based on the assumptions that there are no taxes, costs of financial

distress, or agency costs, so investors would value firms with the same
cash flows as the same, regardless of how the firms are financed.
• Reasoning: There is no benefit to borrowing at the firm level because
there is no interest deductibility. Firms would be indifferent to the
source of capital and investors could use financial leverage if they wish.
7
Proposition II without Taxes:

Higher Financial Leverage
MM Proposition II:
The cost of equity is a linear function of the company’s debt/equity ratio.
• Because creditors have a claim to income and assets that has

preference over equity, the cost of debt will be less than the cost of
equity.
• As the company uses more debt in its capital structure, the cost of
equity increases because of the seniority of debt:
• The WACC is constant because as more of the cheaper source of capital
is used (that is, debt), the cost of equity increases.
8
Introducing Taxes into the MM Theory
When taxes are introduced (specifically, the tax deductibility of interest by

the firm), the value of the firm is enhanced by the tax shield provided by
this interest deduction. The tax shield:
– Lowers the cost of debt.
– Lowers the WACC as more debt is used.
– Increases the value of the firm by tD (that is, marginal tax rate times debt)
Bottom line: The optimal capital structure is 99.99% debt.

9
Introducing costs of
financial distress
• Costs of financial distress are costs associated with a company that is
having difficulty meeting its obligations.
• Costs of financial distress include the following:
– Opportunity cost of not making optimal decisions
– Inability to negotiate long-term supply contracts.
– Loss of customers.
• The expected cost of financial distress increases as the relative use of
debt financing increases.
– This expected cost reduces the value of the firm, offsetting, in part, the benefit
from interest deductibility.
– The expected cost of distress affects the cost of debt and equity.
Bottom line: There is an optimal capital structure at which the value of the firm is
maximized and the cost of capital is minimized.
10
Trade-off Theory: Value of the Firm
Market
Value
of the
Firm
Debt/Equity
Value of the unlevered firm

Copyright © 2013 CFA Institute
11
The Optimal Capital Structure
Costs to Financial
Taxes Distress Optimal Capital Structure?
No No No
Yes No Yes, 99.99% debt
Yes Yes Yes, benefits of interest deductibility are offset by the expected costs of
financial distress
We cannot determine the optimal capital structure for a given company, but we
know that it depends on the following:
• The business risk of the company.
• The tax situation of the company.
• The degree to which the company’s assets are tangible.
• The company’s corporate governance.
• The transparency of the financial information.
12
Deviating from Target
A company’s capital structure may be different from its target capital

structure because of the following:
– Market values of outstanding issues change constantly.
– Market conditions that are favorable to one type of security over another.
– Market conditions in which it is inadvisable or too expensive to raise capital.
– Investment banking fees that encourage larger, less frequent security issuance.
13
Practical Issues in
Capital Structure Policy
Debt Ratings
Factors to Consider
Leverage in an
International Setting
14
Evaluating Capital Structure Policy
• Analysts consider a company’s capital structure

– Over time.
– Compared with competitors with similar business risk.
– Considering the company’s corporate governance.
• Analysts must also consider
– The industry in which the company operates.
– The regulatory environment.
– The extent to which the company has tangible assets.
– The degree of information asymmetry.
– The need for financial flexibility.
15
Leverage in an International Setting
• Country-specific factors affect a company’s choice of capital structure

and the maturity structure within the capital structure.
• Types of factors to consider:
– Institutional and legal environments
– Financial markets and banking sector
– Macroeconomic factors
16
The Weighted average Cost of Capital
The weighted average cost of capital (WACC) is the marginal cost of

raising additional capital and is affected by the costs of capital and the
proportion of each source of capital:
𝐷 𝐸
WACC = rWACC = 𝑟 1−𝑡 + 𝑟 (5-1)
𝑉 𝑑 𝑉 𝑒
where
rd is the before-tax marginal cost of debt
re is the marginal cost of equity
t is the marginal tax rate
D is the market value of debt
E is the market value of equity
V=D+E
17
Summary
• The goal of the capital structure decision is to determine the financial leverage
that maximizes the value of the company (or minimizes the weighted average
cost of capital).
• In the Modigliani and Miller theory developed without taxes, capital structure
is irrelevant and has no effect on company value.
• The deductibility of interest lowers the cost of debt and the cost of capital for
the company as a whole. Adding the tax shield provided by debt to the
Modigliani and Miller framework suggests that the optimal capital structure is
all debt.
• In the Modigliani and Miller propositions with and without taxes, increasing a
company’s relative use of debt in the capital structure increases the risk for
equity providers and, hence, the cost of equity capital.
• When there are bankruptcy costs, a high debt ratio increases the risk of
bankruptcy.
• Using more debt in a company’s capital structure reduces the net agency costs
of equity.
18
Summary (continued)
• The costs of asymmetric information increase as more equity is used versus
debt, suggesting the pecking order theory of leverage, in which new equity
issuance is the least preferred method of raising capital.
• According to the static trade-off theory of capital structure, in choosing a
capital structure, a company balances the value of the tax benefit from
deductibility of interest with the present value of the costs of financial distress.
At the optimal target capital structure, the incremental tax shield benefit is
exactly offset by the incremental costs of financial distress.
• A company may identify its target capital structure, but its capital structure at
any point in time may not be equal to its target for many reasons.
• Many companies have goals for maintaining a certain credit rating, and these
goals are influenced by the relative costs of debt financing among the different
rating classes.
• In evaluating a company’s capital structure, the financial analyst must look at
the capital structure of the company over time, the capital structure of
competitors that have similar business risk, and company-specific factors that
may affect agency costs.
19
Summary (continued)
• Good corporate governance and accounting transparency should lower

the net agency costs of equity.
• When comparing capital structures of companies in different countries,
an analyst must consider a variety of characteristics that might differ
and affect both the typical capital structure and the debt maturity
structure.
FINC 302
Business Finance
SESSION 11: DIVIDEND POLICY

2014/2015 – 2016/2017
Session Overview & Objectives
Dividends normally constitute one of the cashflow streams from which an investor
(shareholder) gains from his/her investment, aside from capital gains. Whether or not to pay
dividends, how stable they should be and how large they should be are questions that
confront businesses everyday. This session seeks to walk the students through the various
positions on dividend payment and the dynamics involved.
At the end of the session, students should be able to:

• Understand the dividend retention versus distribution dilemma faced by the firm.
• Explain the Modigliani and Miller (M&M) argument that dividends are irrelevant.
• Explain the counterarguments to M&M - that dividends do matter.
• Identify and discuss the factors affecting a firm's dividend and retention of earnings policy.
• Summarize the standard cash dividend payment procedures and critical dates.
Session Outline
• Passive Versus Active Dividend Policies

• Factors Influencing Dividend Policy
• Dividend Stability
• Stock Dividends and Stock Splits
• Stock Repurchase
• Administrative Considerations
Dividends as a Passive
Residual
Can the payment of cash dividends affect
shareholder wealth?
If so, what dividend-payout ratio will maximize
shareholder wealth?
• The firm uses earnings plus the additional financing that the
increased equity can support to finance any expected
positive-NPV projects.
• Any unused earnings are paid out in the form of dividends.
This describes a passive dividend policy.
Irrelevance of Dividends
• M&M and the total-value principle ensures that the sum of
market value plus current dividends of two firms identical in all
respects other than dividend-payout ratios will be the same.
Investors can “create” any dividend policy they desire by selling
shares when the dividend payout is too low or buying shares
when the dividend payout is excessive.
Relevance of Dividends
• Preference for Dividend: Uncertainty surrounding future
company profitability leads certain investors to prefer the
certainty of current dividends. Investors prefer “large”
dividends.
• Taxes on the investor: Capital gains taxes are deferred until
the actual sale of stock. This creates a timing option. Capital
gains are preferred to dividends, everything else equal.
Thus, high dividend-yielding stocks should sell at a discount
to generate a higher before-tax rate of return. Certain
institutional investors pay no tax.
Factors Influencing Dividend
Policy Legal Rules
• Capital Impairment Rule – many states prohibit the payment of

dividends if these dividends impair “capital” (usually either par
value of common stock or par plus additional paid-in capital).
• Insolvency Rule – some states prohibit the payment of cash
dividends if the company is insolvent under either a “fair market
valuation” or “equitable” sense.
• Undue Retention of Earnings Rule – prohibits the undue
retention of earnings in excess of the present and future
investment needs of the firm.
Factors Influencing Dividend
Policy
Other Issues to Consider
• Funding Needs of the Firm

• Liquidity
• Ability to Borrow
• Restrictions in Debt Contracts
(protective covenants)
• Control
Types of Dividends
Regular Dividend
• The dividend that is normally expected to be
paid by the firm.
Extra dividend
• A nonrecurring dividend paid to shareholders in
addition to the regular dividend. It is brought
about by special circumstances.
Stock Dividends and
Stock Splits
Stock Split – An increase in the number of shares
outstanding by reducing the par value of the
stock.
• Similar economic consequences as a 100% stock dividend.
• Primarily used to move the stock into a more popular trading
range and increase share demand.
• Assume a company with 400,000 shares of $5 par common
stock splits 2-for-1. How does this impact the shareholders’
equity accounts?
Value to Investors of Stock Dividends
or Stock Splits
• Effect on investor total wealth

• Effect on investor psyche
• Effect on cash dividends
• More popular trading range
• Informational content
Stock Dividends and
Stock Splits
Reverse Stock Split – A stock split in which the
number of shares outstanding is decreased.
• Used to move the stock into a more popular trading
range and increase share demand.
• Usually signals negative information to the market upon
its announcement (consistent with empirical evidence).
• Assume a company with 400,000 shares of $5 par
common stock splits 1-for-4. How does this impact the
shareholders’ equity accounts?
Stock Repurchase
Stock Repurchase – The repurchase (buyback) of
stock by the issuing firm, either in the open
(secondary) market or by self-tender offer.
Reasons for stock repurchase:
• Available for management stock-option plans
• Available for the acquisition of other companies
• “Go private” by repurchasing all shares from outside
stockholders
• To permanently retire the shares
Methods of Repurchase
• Fixed-price self-tender offer – An offer by a firm to

repurchase some of its own shares, typically at a set price.
• Dutch auction self-tender offer – A buyer (seller) seeks bids
within a specified price range, usually for a large block of
stock or bonds. After evaluating the range of bid prices
received, the buyer (seller) accepts the lowest price that
will allow it to acquire (dispose of)
the entire block.
• Open-market purchase – A company repurchases its stock
through a brokerage house on the secondary market.
Summary of Repurchasing as Part
of Dividend Policy
• Stock repurchases are most relevant for firms with

large amounts of excess cash that might otherwise
generate a significant taxable transaction to
investors.
• Firms must be careful not to make regularly
occurring repurchases or the IRS may consider the
capital gains as dividends for tax purposes.
Investment or Financing
Decision?
Investing Decision
• Not really, as stock that is repurchased is held as treasury stock and does
not provide an expected return like other investments.
Financing Decision
• It possesses capital structure or dividend policy
motivations.
• For example, a repurchase immediately changes the debt-
to-equity ratio (higher financial leverage).
Administrative Considerations:
Procedural Aspects
May 8 May 29 May 31 June 15
Record Date – The date, set by the board of directors

when a dividend is declared, on which an investor must
be a shareholder of record to be entitled to the
upcoming dividend.
The board of directors met on May 8th to declare a
dividend payable to shareholders on June 15th to the
shareholders of record on May 31st.
Procedural Aspects
Ex-dividend Date – The first date on which a stock

purchaser is no longer entitled to the recently declared
dividend.
The buyer and seller of the shares have several days to settle (pay
for the shares or deliver the shares). The brokerage industry has a
rule that new shareholders are entitled to dividends only if they
purchase the stock at least two business days prior to the record
date.
Procedural Aspects
Declaration Date – The date that the board of directors

announces the amount and date of the next dividend.
Payment Date – The date when the corporation actually

pays the declared dividend.
FINC 302
Business Finance
SESSION 12: MERGERS &
ACQUISITIONS

2014/2015 – 2016/2017
Session Overview & Objectives
• A firm may choose to grow in more ways than one. When businesses
decide to grow, they may choose the path of combining with others or
actually buying up existing firms. This session walks students through
the basics of mergers and acquisitions and related issues.
• At the end of the session, students should be able to:
– Clearly indicate the various pathways within the mergers and acquisitions
concept
– Explain the legitimate and dubious motives for mergers/acquisitions
– Illustrate the defense tactics that may be employed by firms within the
mergers/acquisition terrain.
Slide 2
Session Outline
• Topic 1 - The Market for Corporate Control

• Topic 2 - Motives for Mergers
• Topic 3 - Evaluating Mergers
• Topic 4 - Merger Tactics
Slide 3
4
Mergers and Acquisitions _ Definition
Combining of two business entities under common ownership (Arnold

2005)
Or
Two firms coalesce and share resources in order to realise a common goal
But One party almost always dominates…..

5
Mergers and Acquisitions
Acquisition
One firm buys the assets or shares of another
Takeover implies the acquiring firm is larger than the target

Reverse takeover if the target is larger than the acquirer
Acquisitions
• A firm can be acquired by another firm or individual(s) purchasing

voting shares of the firm’s stock
• Tender offer – public offer to buy shares
• Stock acquisition
– No stockholder vote required
– Can deal directly with stockholders, even if management is unfriendly
– May be delayed if some target shareholders hold out for more money –
complete absorption requires a merger
Mergers and acquisitions Definitions
Merger with Consolidation Acquisition
Company Compa
A ny
X
Company Company
C X
Company
Company
B
Y
7
8
Mergers and Acquisitions Definitions
• Parties to the acquisitions:

– The target company (or target) is the company being acquired.
– The acquiring company (or acquirer) is the company acquiring the target.
• Classified based on endorsement of parties’ management:
– A hostile takeover is when the target company board of directors objects to a
takeover offer.
– A friendly transaction is when the target company board of directors endorses
the merger or acquisition offer.
9
Mergers and Acquisitions Definitions
Classified by the relatedness of business activities of the parties to the

combination:
Type Characteristic Example
Horizontal merger Companies are in the same line of GGBL, ECOBANK+TTB

business, often competitors.
Vertical merger Companies are in the same line of Google acquired Motorola Mobility
production (e.g., supplier–customer). Holdings (June 2012).
Conglomerate merger Companies are in unrelated lines of Berkshire Hathaway acquires Lubrizol
business. (2011).
10
Motives for merger
• Synergy
• Growth
Creating Value • Increasing market power
• Acquiring unique capabilities or resources
• Unlocking hidden value
• Exploiting market imperfections

• Overcoming adverse government policy
Cross-Border
• Technology transfer
Mergers
• Product differentiation
• Following clients
• Diversification
• Bootstrapping earnings
Dubious Motives
• Managers’ personal incentives
• Tax considerations
11
Transaction characteristics
Form of the • Stock purchase

Transaction • Asset purchase
• Cash
Method of
• Securities
Payment
• Combination of cash and securities
Attitude of • Hostile
Management • Friendly
Acquisition of Stock
• A tender offer is a public offer to buy shares made by one firm directly
to the shareholders of another firm.
– If the shareholders choose to accept the offer, they tender their shares by
exchanging them for cash or securities.
– A tender offer is frequently contingent on the bidder’s obtaining some
percentage of the total voting shares.
– If not enough shares are tendered, then the offer might be withdrawn or
reformulated.
Bear Hug
• An offer made by one company to buy the shares of another for a much
higher per-share price than what that company is worth. A bear hug
offer is usually made when there is doubt that the target company's
management will be willing to sell.
14
Hostile vs. Friendly mergers
• The classification of a merger as friendly or hostile is from the

perspective of the board of directors of the target company.
• A friendly merger is one in which the board negotiates and accepts an
offer.
• A hostile merger is one in which the board of the target firm attempts
to prevent the merger offer from being successful.
Takeover defenses
Pre-Offer Takeover Defense Mechanisms Post-Offer Takeover Defense Mechanisms
• Poison pills (flip-in pill and flip-over pill) • “Just say no” defense
• Poison puts • Greenmail
• Incorporation in a state with restrictive takeover • Leveraged recapitalization
laws • “Crown jewels” defenses
• Staggered board of directors • “Pac-Man” defense
• Restricted voting rights • White knight defense
• Supermajority voting provisions • White squire defense
• Fair price amendments
• Golden parachutes
15
16
Acquisitions and Mergers

Defence
• Poison Pills
– A defense against a hostile takeover
• It is a rights offering that gives the target shareholders the
right to buy shares in either the target or an acquirer at a
deeply discounted price.
– Because target shareholders can purchase shares at less than
the market price, existing shareholders of the acquirer
effectively subsidize their purchases, making the takeover so
expensive for the acquiring shareholders that they choose to
pass on the deal.
Poison pills are measures of true desperation to make the firm
unattractive to bidders. They reduce shareholder wealth.
17

Defence
• Golden Parachute
– An extremely lucrative severance package that is guaranteed to a firm’s senior
management in the event that the firm is taken over and the managers are let
go
• Perhaps surprisingly, the empirical evidence suggests that the adoption of a golden
parachute actually creates value.
– If a golden parachute exists, management will be more
likely to be receptive to a takeover, lessening the likelihood of managerial
entrenchment.
18

Defence
• White Knight
– A target company’s defense against a hostile
takeover attempt, in which it looks for another,
friendlier company to acquire it
• White Squire
– A variant of the white knight defense, in which a
large, passive investor or firm agrees to purchase
a substantial block of shares in a target with special voting rights
Pac-Man Defense
• A defensive tactic used by a targeted firm in a hostile takeover

situation. In a Pac-Man defense, the target firm turns around and tries
to acquire the other company that has made the hostile takeover
attempt.
20
Merger analysis
• The discounted cash flow (DCF) method is often used in the valuation of
the target company.
• The cash flow that is most appropriate is the free cash flow (FCF), which
is the cash flow after capital expenditures necessary to maintain the
company as an ongoing concern.
• The goal is to estimate future FCF.
– We can use pro forma financial statements to estimate FCF
– We use a two-stage model when we can more accurately estimate growth in the
near future and then assume a somewhat slower growth out into the future.
21
Summary
• An acquisition is the purchase of some portion of one company by another,

whereas a merger represents the absorption of one company by another.
• Mergers may be a statutory merger, a subsidiary merger, or a consolidation.
• Horizontal mergers occur among peer companies engaged in the same kind of
business, vertical mergers occur among companies along a given value chain,
and conglomerates are formed by companies in unrelated businesses.
• Merger activity has historically occurred in waves.
– Waves have typically coincided with a strong economy and buoyant stock market
activity.
– Merger activity tends to be concentrated in a few industries, usually those
undergoing changes.
• There are number of motives for a merger or acquisition; some are justified,
some are dubious.
22
Summary (continued)
• A merger transaction may take the form of a stock purchase or an asset

purchase.
– The decision of which approach to take will affect other aspects of the
transaction.
• The method of payment for a merger may be cash, securities, or a
mixed offering with some of both.
• Hostile transactions are those opposed by target managers, whereas
friendly transactions are endorsed by the target company’s managers.
• There are a variety of both pre- and post-offer defenses a target can use
to ward off an unwanted takeover bid.

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FINC 302

Lecturer: Dr. Vera O. L. Fiador, UGBS

COURSE DESCRIPTION AND

• Van Horne, J. C. and Wachowicz, J. M. (VH&W), Fundamentals of

• Abor, J. Y. Financial Markets & Institutions: A Frontier Market Perspective,

• Mensah, S. Securities Markets and Investments A Ghanaian Primer Fifth

• Brealey, Myres and Marcus (BMM), Fundamentals of

• Topic 1 – Bonds, Bond features and types of bonds

• Topic - Understand bond values, fluctuations and

BONDS AND IMPORTANT BOND

FINC 301 Slide 4

• Par value (face value): The amount that will be

• Consider a bond with a coupon rate of 10% and annual

• Suppose you are reviewing a bond that has a face value of

• Suppose you are reviewing a bond that has no maturity, pays

• Contract between the company and the bondholders

• Primarily over-the-counter transactions with dealers

• Default risk premium – remember bond ratings

• If YTM = coupon rate, then par value = bond price

• Yield to Maturity (YTM) is the rate implied by the

• Suppose a bond with a 10% coupon rate and

• Current Yield = annual coupon / price

• Bonds of similar risk (and maturity) will be priced to

BASIC STOCK VALUATION

– As with bonds and investments, the price of the stock is

Div 1 Div 2 Div 3

$2.16 $2.33 $2.52  $32.75

Payout Ratio - Fraction of earnings paid out as

g = return on equity X plowback ratio

No Growth With Growth

3,996,100 shares traded

• Current prices reflect all security-market information,

• This implies that past rates of return and other

• This implies that decisions made on new information

• Stock prices fully reflect all information from public

• This implies that no group of investors should be able

• This assumes perfect markets in which all

Topic Two (Part B) - Discounted cash flow techniques:

NON-DISCOUNTED CASH FLOW

• Another attractive, but fatally flawed, approach

Average net income = ($105 + 30 + 0)/3 = $45

Average net income 45

DISCOUNTED CASH FLOW

20% ($2.08) $20.00

• Independent Projects: accepting or rejecting one

Would you rather make 100% or 50% on your

Total P V of F uture C ash F lows

• Read on Lease versus Buy Decision

RELEVANT CASH FLOWS & APPRAISING

Topic one - Incremental and relevant Cash Flows

• Consider depreciation expense.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Depreciation is calculated using the Accelerated Year MACRS %

(1) Sales $100.00 $163.20 $249.72 $212.20 $129.90

(4) OCF 39.80 60.51 75.51 56.12 31.68

$ 39 .80 $ 54 .19 $ 66 .86 $ 59 .87 $ 224 .66

• There are times when application of the NPV rule can

CF1 –100 CF1 –500

NPV –4,614.46 NPV –2,895.39

The Cheapskate cleaner time line of cash flows

RISK & RETURN – THE BASICS

At the end of this session, students should be able to: