Course Outline

Topic Reference
1 Introduction to Financial Management Chapter 1
2 Financial Statements Analysis Chapter 2, 3, 4
3 The Time Value of Money Chapter 5
4 Discounted Cash Flow Valuation Chapter 6
5 Investment Decisions Chapter 9
6 Bond and Stock Valuation Chapter 7, 8
7 Capital Budgeting Chapter 10, 11
8 Market Efficiency Chapter 12
9 Risk and Return Chapter 13
10 Cost of Capital Chapter 14

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Table of Contents

1 Topic 1 – Introduction to Financial Management.............................................................. 9

1.1 Introduction ................................................................................................................. 9
1.1.1 Why Study Financial Management ...................................................................... 9
1.1.2 The Objective of Financial Management ............................................................. 9
1.1.3 The Financial Decisions ....................................................................................... 9
1.2 The Corporate Firm ................................................................................................... 10
1.2.1 Sole Proprietorship............................................................................................. 10
1.2.2 Partnership ......................................................................................................... 11
1.2.3 Corporation ........................................................................................................ 11
1.2.4 A Comparison .................................................................................................... 12
1.3 The Agency Problem and Control of the Corporation .............................................. 12
1.3.1 Principal-Agency Relationship .......................................................................... 13
1.3.2 Evidence from the Oil Industry.......................................................................... 15
2 Topic 2 – Financial Statements Analysis ......................................................................... 16
2.1 The Balance Sheet ..................................................................................................... 16
2.1.1 Assets ................................................................................................................. 17
2.1.2 Liabilities ........................................................................................................... 17
2.1.3 Equity ................................................................................................................. 18
2.1.4 The Accounting Identity .................................................................................... 18
2.1.5 Managerial Issues............................................................................................... 18
2.2 The Income Statement ............................................................................................... 19
2.2.1 Revenues ............................................................................................................ 19
2.2.2 Expenses ............................................................................................................ 20
2.2.3 Depreciation ....................................................................................................... 20
2.2.4 Taxes .................................................................................................................. 20
2.3 Cash Flow .................................................................................................................. 22
2.3.1 The Importance of Cash Flow............................................................................ 22
2.3.2 The Cash Flow Identity...................................................................................... 22
2.4 Financial Ratio Analysis ........................................................................................... 25
2.4.1 Liquidity Ratios ................................................................................................. 27
2.4.2 Solvency Ratios ................................................................................................. 27

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 2.4.3 Asset Management Ratios.................................................................................. 28
2.4.4 Profitability Ratios ............................................................................................. 30
2.4.5 Market Value Ratios .......................................................................................... 30
2.4.6 Linking Ratios .................................................................................................... 32
2.4.7 Managerial Implications .................................................................................... 32
2.5 Growth Analysis ........................................................................................................ 33
2.5.1 Sustainable Growth ............................................................................................ 33
2.5.2 Du Pont Decomposition ..................................................................................... 34
2.5.3 Capital Structure and Sustainable Growth ......................................................... 35
2.5.4 A Note on Sustainable Growth Rate .................................................................. 35
3 Topic 3 – The Time Value of Money .............................................................................. 37
3.1 A Motivating Example .............................................................................................. 37
3.1.1 Basis for Comparison ......................................................................................... 40
3.2 Future Value and Compounding ............................................................................... 40
3.2.1 Effects of Compounding .................................................................................... 40
3.2.2 Calculate Future Values with BAII Plus ............................................................ 43
3.3 Present Value and Discounting ................................................................................. 43
3.3.1 Effects of Discounting ....................................................................................... 44
3.3.2 Calculate Present Values with BAII Plus .......................................................... 45
3.4 The Discount Rate ..................................................................................................... 46
3.5 The Number of Periods ............................................................................................. 48
3.6 Spreadsheet Application ............................................................................................ 49
4 Topic 4 – Discounted Cash Flow Valuation .................................................................... 50
4.1 Multiple Cash Flows ................................................................................................. 50
4.1.1 Future Value of a Series of Cash Flows............................................................. 50
4.1.2 Present Value of a Series of Cash Flows ........................................................... 51
4.2 Annuity ...................................................................................................................... 52
4.2.1 Present Value of an Annuity .............................................................................. 52
4.2.2 Future Value of an Annuity ............................................................................... 56
4.3 Annuity Due .............................................................................................................. 57
4.4 Perpetuity .................................................................................................................. 58
4.5 Comparing Rates ....................................................................................................... 58
4.5.1 Effective Annual Rate (EAR) ............................................................................ 59

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 4.5.2 Annual Percentage Rate (APR) ......................................................................... 60
5 Topic 5 – Investment Decisions ....................................................................................... 62
5.1 Capital Investment Projects ....................................................................................... 62
5.2 Net Present Value ...................................................................................................... 63
5.2.1 Why Positive NPV? ........................................................................................... 64
5.2.2 More than Two Alternatives .............................................................................. 65
5.2.3 Investment Projects with Different Lives .......................................................... 66
5.3 The Internal Rate of Return (IRR) ............................................................................ 67
5.3.1 Nonconventional Cash Flows ............................................................................ 69
5.3.2 Mutually Exclusive Investments ........................................................................ 70
5.4 The Payback Rule...................................................................................................... 72
5.5 The Average Accounting Return............................................................................... 74
5.6 Profitability Index ..................................................................................................... 75
5.7 Comprehensive Problems.......................................................................................... 76
6 Topic 6 – Bond and Stock Valuation ............................................................................... 79
6.1 What is a Bond? ........................................................................................................ 79
6.2 How to Value Bonds? ............................................................................................... 79
6.2.1 Pure Discount Bonds.......................................................................................... 79
6.2.2 Coupon Bonds .................................................................................................... 80
6.2.3 Consol ................................................................................................................ 83
6.3 Yield to Maturity ....................................................................................................... 83
6.4 What is a Common Stock? ........................................................................................ 84
6.5 How to Value Stocks? ............................................................................................... 84
6.6 Modeling Dividends .................................................................................................. 85
6.6.1 Zero Growth ....................................................................................................... 86
6.6.2 Constant Growth ................................................................................................ 86
6.6.3 Nonconstant Growth .......................................................................................... 89
6.7 Total Return............................................................................................................... 89
6.8 Stock Price and Growth Opportunities...................................................................... 90
6.8.1 Concluding Remarks .......................................................................................... 94
7 Topic 7 – Capital Budgeting ............................................................................................ 95
7.1 Identify the Project Cash Flows ................................................................................ 95
7.1.1 Relevant Cash Flows.......................................................................................... 96

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 7.2 Compute the Project Cash Flows .............................................................................. 97
7.2.1 Operating Cash Flow ......................................................................................... 97
7.2.2 Depreciation ....................................................................................................... 99
7.2.3 After Tax Salvage ............................................................................................ 100
7.2.4 Changes in Net Working Capital ..................................................................... 102
7.3 A Comprehensive Example ..................................................................................... 103
7.4 Evaluating NPV Estimates ...................................................................................... 105
7.4.1 Scenario Analysis............................................................................................. 105
7.4.2 Sensitivity Analysis ......................................................................................... 107
7.5 Case Study – Danforth & Donnalley Laundry Products Company ........................ 109
8 Topic 8 – Market Efficiency .......................................................................................... 114
8.1 Differences between Investment and Financing Decisions..................................... 114
8.2 Efficient Capital Markets ........................................................................................ 115
8.2.1 Implications of the Efficient Market Hypothesis ............................................. 116
8.2.2 Three Forms of Market Efficiency .................................................................. 117
8.2.3 Weak Form Efficiency ..................................................................................... 117
8.2.4 Semi-strong Form Efficiency........................................................................... 118
8.2.5 Strong Form Efficiency.................................................................................... 118
8.2.6 Concluding Remarks ........................................................................................ 118
9 Topic 9 – Risks and Returns .......................................................................................... 119
9.1 Risk, Return and Investment Decision .................................................................... 119
9.2 Returns .................................................................................................................... 119
9.2.1 Dollar Returns .................................................................................................. 119
9.2.2 Percentage Returns........................................................................................... 120
9.2.3 The Historical Record ...................................................................................... 121
9.2.4 Arithmetic and Geometric Returns .................................................................. 122
9.3 Risks ........................................................................................................................ 123
9.3.1 Risk Premiums ................................................................................................. 123
9.3.2 Variance and Standard Deviation .................................................................... 123
9.4 Expectation .............................................................................................................. 124
9.4.1 Expected Returns ............................................................................................. 125
9.4.2 Expected Variance and Standard Deviation .................................................... 125
9.5 Portfolio Risks and Returns .................................................................................... 126

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 9.5.1 Portfolio Expected Returns .............................................................................. 126
9.5.2 Systematic and Unsystematic Risks................................................................. 127
9.5.3 Diversification.................................................................................................. 127
9.5.4 Decomposition of Total Risk ........................................................................... 128
9.5.5 Measuring Systematic Risk.............................................................................. 129
9.5.6 Beta and the Risk Premium.............................................................................. 129
9.6 The Capital Asset Pricing Model (CAPM) ............................................................. 131
10 Topic 10 – Cost of Capital ............................................................................................. 133
10.1 The Cost of Capital: Some Preliminaries ............................................................ 133
10.2 Cost of Equity ...................................................................................................... 134
10.2.1 The Dividend Growth Model Approach .......................................................... 134
10.2.2 The CAPM Approach ...................................................................................... 135
10.3 Cost of Debt ......................................................................................................... 136
10.4 Cost of Preferred Stock........................................................................................ 137
10.5 Weighted Average Cost of Capital ...................................................................... 138
10.6 A Comprehensive Example ................................................................................. 139

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1 Topic 1 – Introduction to Financial Management

1.1 Introduction

1.1.1 Why Study Financial Management

The course begins with the assumption that you are the Chief Financial Officer (CFO) of City
Corporation. As a senior executive, every day, the major role of your job is going to make
corporate financial decisions. Every decision that you made has financial implications. If
your choice is right, then the implementation of business activities will subsequently create
value.

To prepare you to become a competent CFO, an understanding of why and how financial
decisions are made is essential. The focus of this course is to teach you how to make optimal
corporate financial decisions.

1.1.2 The Objective of Financial Management

Before learning how to make optimal decisions, we better first think about “What is the
objective of financial management?”

In theory, the objective of financial management is to maximize firm value. Since you are
working for City Corporation, you act in shareholders’ best interest by making decisions that
increase the value of the stock. Any decision that increases the stock price is considered to be
“good”, whereas one that decreases the stock price is considered to be “bad”.

1.1.3 The Financial Decisions

In general, your role as a CFO will center on helping City Corporation find money to run and
develop its business, manage its assets, acquire other firms, and plan for their financial future.

More precisely, you will involve in deciding four major financial decisions:

1. Investment Decisions
 How much should City Corporation invest?
 Which project should City Corporation invest?

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2. Working Capital Decisions
 What should be the level of investment in current assets?
 How should City Corporation mange its short-term assets and liabilities?

3. Financing Decisions
 How to finance the investment?
 What is the optimal debt/equity ratio?

4. Distribution Decisions
 How much dividend should be paid to shareholders?

1.2 The Corporate Firm

At the startup, one problem of City Corporation is how to raise capital. Organizing the firm
as a corporation is the standard method for solving the problems encountered in raising large
amounts of cash. However, the firm can organize itself in other forms.

Let’s learn the three basic legal forms of organizing firms and compare their advantages and
disadvantages under each form.

1.2.1 Sole Proprietorship

A sole proprietorship is a business owned by a single individual.

The advantage:
 It is the simplest type of business to start.
 It is the least regulated form of organization.
 The owner of a sole proprietorship keeps all the profits.

The disadvantage:
 The owner has unlimited liability for business debts.
 The amount of capital that can be raised is limited to the proprietor’s personal wealth.
 Ownership of a sole proprietorship may be difficult to transfer.

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1.2.2 Partnership

Partnership is a business formed by two or more individuals or entities.

In a general partnership,
 All the partners share in gains or losses, and all have unlimited liability for all
partnership debts.
 The partners share gains and losses as described in the partnership agreement.

In a limited partnership,
 One or more general partners will run the business and have unlimited liability.
 There will be one or more limited partners who do not actively participate in the
business.
 A limited partner’s liability is limited to the amount that partner contributes to the
partnership.

The advantage:
 It is based on relatively informal agreement and is easy and inexpensive to form.

The disadvantage:
 The partnership terminates when a general partner wishes to sell out or dies.
 Ownership by a general partner is not easily transferred since a new partnership must
be formed.
 Although a limited partner can sell his interest without dissolving the partnership,
finding a partner may be difficult.

1.2.3 Corporation

Corporation is a business created as a distinct legal entity owned by one or more individuals
or entities. A corporation is a legal “person” separate and distinct from its owners, and it has
many of the rights, duties, and privileges of an actual person.

Corporations can borrow money and own property, can sue and be sued, and can enter into
contracts.

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The advantage:
 Stockholders in a corporation have limited liability.
 The separation of ownership and management makes transferring of ownership a lot
easier.
 Easier to raise capital.

The disadvantage:
 There is agency problem as a result of the separation of ownership and management.
 Double taxation.

1.2.4 A Comparison

Let’s summarize some basic characteristics between partnership and corporation.

Partnership Corporation
Liquidity  Subject to substantial  Shares can be easily
restrictions exchanged
Voting Rights  General partner is in charge  Usually each share gets one
 Limited partners may have vote
some voting rights
Taxation  Partners pay taxes on  Double taxation
distributions
Reinvestment and  All net cash flow is  Broad latitude
Dividend Payout distributed to partners
Liability  General partners have  Limited liability
unlimited liability
 Limited partners enjoy
limited liability
Continuity  Limited life  Perpetual life

1.3 The Agency Problem and Control of the Corporation

The separation of ownership and management can facilitate shares exchange. Usually in a
large corporation, the ownership is dispersed. This means that a corporation has large
number of shareholders who only own small number of shares.

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1.3.1 Principal-Agency Relationship

Those small shareholders do not have effective control over the corporation. The
shareholders (the principal) will hire managers (the agent) to represent their interest.
However, we are not sure whether the managers will act in the best interests for them.

The possibility of conflict of interest between owners and management of a corporation is

called an agency problem.

Here are some possibilities of conflict of interest between owners and managers in daily life:

1. Career Concern
 Managers may reluctant to take risky investments because there is a possibility
that things will turn out badly and the management jobs will be lost.

2. Empire Building
 Managers would tend to maximize the amount of resources over which they have
control.
 They have intention to over expand. For example, acquire and overpay irrelevant
businesses just to demonstrate corporate power.

3. Private Benefits of Control

 Managers may take advantage of inside information for personal trading.
 They may overuse corporate resources, such as frequent business travel with first
class ticket.

4. Shirking
 The managers do not put their best effort to act in shareholders’ interest.

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Example 1.1

Suppose City Corporation is going to hire a salesman, and you decide to offer him an annual
wage of w. Your objective is to hire a hardworking salesman with a minimum wage. If the
salesman works hard, he can bring $270,000 revenue to the firm; otherwise, he can only bring
$70,000 revenue if he does not work hard.

The salesman utility can be described as U  w, e   w  e . His reservation level of utility is

81,000. Once this salesman accepts the offer, he can put “high” (e = 25,000) or “low” (e = 0)
effort.

What is the minimum wage that you have to offer to this salesman for accepting the job?
 The salesman won’t accept the job unless the wage exceeds his reservation utility.
That is, w  81, 000 .

Will the salesman act in the best interests (by working hard) of City Corporation?
 No.
 City Corporation can only get $70,000 but paying $81,000 wage.

How should you decide the wage if you want to hire a hardworking salesman?
 His utility from working hard should exceed his reservation utility.
 That is,
U  w, e   81, 000
w  25, 000  81, 000
w  106, 000
 The first-best contract should offer the salesman $106,000 and “trust” that he will
work hard.

From this example, the salesman (agent) takes an action that affects his utility as well as the
corporation (principal). The insight of this example is to show you the agent does not
necessarily choose the action in the interest of the principal.

It is therefore important that managers’ incentives are aligned with those of shareholders.

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1.3.2 Evidence from the Oil Industry

The radical changes in the oil market since 1973 generated large increases in free cash flow in
the industry. From 1973 to the late 1970’s, crude oil prices increased sharply.

Price increases generated large cash flows in the industry. For example, the 1984 cash flows
of the ten largest oil companies were US$48.5 billion, 28% of the total cash flows of the top
200 firms in Dun’s Business Month survey.

The management did not pay out the excess resources to shareholders. Instead, the industry
continued to spend heavily on exploration and development (E&D) activity even though
average returns were below the cost of capital. Two studies indicate that oil industry E&D
expenditures have been too high since the late 1970’s:
 John McConnell and Chris Muscarella (1986) find that announcements of increases
in E&D expenditures by oil companies in the period 1975 – 1981 were associated
with systematic decreases in the announcing firm’s stock price.
 B. Picchi’s study of returns on E&D expenditures for 30 large oil firms did not earn
even a 10% return on its pretax outlays in the period 1982 – 1984.

Oil industry managers also launched diversification programs to invest funds outside the
industry. For example:
 Retailing: Marcor by Mobil.
 Manufacturing: Reliance Electric by Exxon.
 Office equipment: Vydec by Exxon.
 Mining: Kennecott by Sohio; Anaconda Minerals by Arco; Cyprus Mines by Amoco.

These acquisitions turned out to be among the least successful, partly because of bad luck and
partly because of a lack of managerial expertise outside the oil industry.

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2 Topic 2 – Financial Statements Analysis

The focus of this topic is not on preparing financial statements. As a CFO, what you need is
to understand the information inside the financial statements, and recognize the importance of
cash flow.

To start with, financial statements are the key source of information for financial decisions.
The two important financial statements that we often use are:

1. The Balance Sheet

 Shows a firm’s value on a particular date.

2. The Income Statement

 Summarizes a firm’s performance over a period of time.

2.1 The Balance Sheet

The balance sheet is a snapshot of the firm. It summarizes what a firm owns (the assets) and
what a firm owes (the liabilities), and the difference between the two (the equity).

A simplified balance sheet:

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Below is a balance sheet for U.S. Corporation.

2.1.1 Assets

An asset is a resource controlled by the corporation as a result of past events and from which
future economic benefits are expected to flow to the corporation.

Assets can be classified into current and fixed.

 Current asset has a life of less than a year, for example, inventory.
 Fixed asset has a relatively long life, for example, land and building.

2.1.2 Liabilities

A liability is an obligation owed by the corporation to repay the claims in the future.

Liabilities can also be classified into current and long-term.

 Current liability reflects the amount of money the firm owes and must pay within the
coming year, for example, accounts payable.
 Long-term liability is debt due after one year from the date of the balance sheet.

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2.1.3 Equity

Shareholders’ equity is the total equity interest that all shareholders have in a corporation. It
is the residual value remained to the shareholders after repaying all debts by selling its assets.

Equity can be separated into capital stock and retained earnings.

 Capital stock is the owners’ initial investment in the firm.
 Retained earnings represent the accumulated total of after-tax earnings and losses
from operations over the life of the firm that has been retained in the corporation.

2.1.4 The Accounting Identity

The most basic accounting identity is that the balance sheet must balance. That is,

Assets = Liabilities + Equity

Although this balance sheet identity is trivial, understanding the implication behind this
identity is important. You need to know how the changes in asset value in City Corporation
would have impact on your debtholders and equityholders. For example, during the financial
crisis, the asset value of the firm dropped much. The fall in the asset value must be
compensated by the drop in either the value of debt or equity, or both.

2.1.5 Managerial Issues

1. Net Working Capital

 Net working capital is the difference between a firm’s current assets and its
current liabilities.
 The level of working capital naturally expands and contracts with sales activities.
 Too little working capital can put a firm in a bad position since the firm may be
unable to pay its bills or to take advantage of profitable opportunities.
 Too much working capital reduces profitability since that capital has a carrying
cost.

2. Inventory
 Having too many inventories can fill customer orders without delay and provides
a buffer against potential production stoppages.
 The flip side of plentiful inventory is the risk of deterioration in the market value
of inventory itself.

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3. Financial Leverage
 Financial leverage refers to the use of debt in acquiring an asset. The more debt a
firm has, the greater is its degree of financial leverage.
 Financial leverage creates an opportunity for a firm to gain a higher return on the
capital invested.

2.2 The Income Statement

The income statement indicates the results of operations over a specified period. Unlike the
balance sheet, which is a snapshot of the firm’s position at a point in time, the income
statement indicates cumulative business results within a defined time frame.

The simple income statement equation is:

Revenues – Expenses = Income

An income statement for U.S. Corporation is shown below:

2.2.1 Revenues

An income statement starts with the firm’s revenues. According to the recognition principle,
revenue is recognized when the earnings process is virtually complete and the value of an
exchange of goods or services is known or can be reliably determined.

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2.2.2 Expenses

Expenses shown on the income statement are based on the matching principle. The basic
idea is to first determine revenues and then match those revenues with the costs associated
with producing them.

As a result of the way revenues and expenses are reported, the figures reported in the
statements may not be at all representative of the actual cash inflows and outflows that
occurred during a particular period.

2.2.3 Depreciation

Depreciation is counted on the income statement as an expense, even though it involves no

cash outflows. Depreciation is a way of estimating the consumption of an asset over time.
For example, if a computer loses about a third of its value each year, the firm would not
expense the full value of the computer in the first year of its purchase, but deduct one-third
each year as an expense.

The depreciation deduction is simply an application of the matching principle in accounting.

2.2.4 Taxes

In making financial decisions, it is important to distinguish between average and marginal

tax rates.
 Average tax rate is the total taxes paid divided by total taxable income.
 Marginal tax rate is the amount of tax payable on the next dollar earned.

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Example 2.1

The corporate tax rates in effect for 2007 are shown below.

Taxable Income Tax Rate

0 - 50,000 15%
50,001 - 75,000 25%
75,001 - 100,000 34%
100,001 - 335,000 39%
335,001 - 10,000,000 34%
10,000,001 - 15,000,000 35%
15,000,001 - 18,333,333 38%
18,333,334 + 35%

Suppose City Corporation earns $4 million in taxable income.

What is the firm’s tax liability?

0.15  50, 000   0.25  75, 000  50, 000   0.34 100, 000  75, 000 
 0.39  335, 000  100, 000   0.34  4, 000, 000  335, 000 
 1,360, 000

What is the average tax rate?

1,360, 000
  34%
4, 000, 000

What is the marginal tax rate?

 34%

If City Corporation is considering a project that will increase the firm’s taxable income by $1
million, what tax rate should you use in your analysis?
 We should use the marginal rate with an expected additional $340,000 in taxes.

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2.3 Cash Flow

Cash flow is simply the difference between the number of dollars that came in and the
number that went out.

2.3.1 The Importance of Cash Flow

Remember that the objective of financial management is to maximize firm value. As a CFO,
your job is to create value from the firm’s investing, financing, and net working capital
activities, but how?

The answer is that you must create more cash flow than it uses. For example:
 Try to buy assets that generate more cash than they cost.
 Sell bonds and stocks that raise more cash than they cost.

2.3.2 The Cash Flow Identity

In order to understand how to create more cash flow, let us step back and study the cash flow
identity.

Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Shareholders

This identity says that a firm generates cash through its various activities, and that cash is
either used to pay creditors or to distribute back to shareholders.

Here, we can break down the identity in details.

1. Cash Flow from Assets

= Operating Cash Flow – Net Capital Spending – Change in Net Working Capital

2. Cash Flow to Creditors

= Interest Paid – Net New Borrowing

3. Cash Flow to Shareholders

= Dividend Paid – Net New Equity Raised

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Example 2.2

Using the financial statements of U.S. Corporation, calculate the cash flow from assets, cash
flow to creditors, and cash flow to shareholders in 2008.

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1. Calculate Cash Flow from Assets
a. Operating Cash Flow
= EBIT + Depreciation – Tax
= 694 + 65 – 212
= 547

b. Net Capital Spending

= Ending Net Fixed Assets – Beginning Net Fixed Assets + Depreciation
= 1,709 – 1,644 + 65
= 130

c. Change in Net Working Capital

= Ending NWC – Beginning NWC
= (CA – CL)2008 – (CA – CL)2007
= (1,403 – 389) – (1,112 – 428)
= 1,014 – 684
= 330

Thus, Cash Flow from Assets

= Operating Cash Flow – Net Capital Spending – Change in Net Working Capital
= 547 – 130 – 330
= 87

2. Calculate Cash Flow to Creditors

= Interest Paid – Net New Borrowing
= 70 – (454 – 408)
= 70 – 46
= 24

3. Calculate Cash Flow to Shareholders

= Dividend Paid – Net New Equity Raised
= 103 – (640 – 600)
= 63

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2.4 Financial Ratio Analysis

Next, we are going to analyze the financial statements in a meaningful manner.

Quantitatively, we can compute financial ratios to interpret the financial results.

Financial ratios can help us to examine the financial health of a corporation. The ratios fall
into five classes:
 Liquidity
 Solvency
 Asset Management
 Profitability
 Market Value

Let us look at the financial statements of City Corporation and calculate some common
financial ratios.

City Corporation
2008 Income Statement
($ in thousands)

Sales 1,506
Less: Cost of goods sold 1,004
Gross profit 502

Depreciation 10
Lease rental costs 30
Other operating expenses 360
EBIT 102

Interest 5
Taxable income 97
Tax 47
Net income 50
Less: Dividends
- Preferred 1
- Common 29
Change in retained earnings 20

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 City Corporation
Balance Sheet as of 31 December, 2007 2008
($ in thousands)
2008 2007
Current assets:
Cash 20 30
Accounts receivable 95 95
Inventory 130 110
Total current assets 245 235

Fixed assets:
Land 10 10
Building and equipment 120 100
Total fixed assets 130 110

Other assets:
Goodwill 10 10

TOTAL ASSETS 385 355

Current liabilities:
Accounts payable 50 40
Estimated income taxes payable 10 10
Total current liabilities 60 50

Fixed liabilities:
Mortgage bonds, 10% 50 50

TOTAL LIABILITIES 110 100

Shareholders’ equity:
Convertible preferred stock, 5% 20 20
Common stock (10,000 shares) 50 50
Retained earnings 205 185
Total shareholders’ equity 275 255

TOTAL LIABILITIES AND

385 355
SHAREHOLDERS’ EQUITY

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2.4.1 Liquidity Ratios

A corporation’s liquidity is measured by its ability to raise cash to meet its current obligations.

1. Current Ratio
Current Assets

Current Liabilities
245
 The current ratio in 2008   4.1 times
60
 The higher the ratio, the more protection the firm has against liquidity problems.
 However, the ratio may be distorted by seasonal influences, slow-moving
inventories built up out of proportion to market opportunities, or abnormal
payment of accounts payable just prior to the balance sheet date.

2. Quick Ratio (Acid-Test Ratio)

Current Assets - Inventory

Current Liabilities
245  130
 The quick ratio in 2008   1.9 times
60
 The quick ratio measures the ability of a firm to use its “near-cash” assets to
immediately extinguish its current liabilities.

3. Cash Ratio
Cash

Current Liabilities
20
 The cash ratio in 2008   0.3 times
60
 Very short-term creditor might be interested in this ratio.

2.4.2 Solvency Ratios

Solvency ratios generate insight into a firm’s ability to meet long-term debt payment.

1. Total Debt Ratio

Total Liabilities

Total Assets
110
 The total debt ratio in 2008   0.29
385
 Total debt ratio indicates the proportion of a firm’s total assets financed by short-
and long-term credit sources.

27
Another variation of this ratio is to measure the relative mix of funds provided by the owners
and the creditors.

2. Debt-equity Ratio
Total Liabilities

Shareholders' Equity
110
 The debt-equity ratio in 2008   0.4
275

3. Times Interest Earned Ratio

EBIT

Interest
102
 Times interest earned in 2008   20.4 times
5
 This ratio indicates the extent to which operating profits can decline without
impairing the firm’s ability to pay the interest on its long-term debt.

4. Cash Coverage Ratio

EBIT  Depreciation

Interest
102  10
 Cash coverage in 2008   22.4 times
5
 This ratio uses EBIT plus non-cash charges as the numerator. The modification
indicates the ability of the firm to cover its cash outflow for interest from its funds
from operations.

2.4.3 Asset Management Ratios

Asset management ratios measure how a firm manages its investment and fixed assets. The
focus of these ratios is on the efficiency of the uses of the assets. That is, how good a firm
utilizes its assets.

1. Inventory Turnover
Cost of Goods Sold

Inventory
1,004
 The inventory turnover in 2008   7.7 times
130
 The inventory turnover ratio indicates how fast inventory items move through a
business.

28
2. Days’ Sales in Inventory
365 days

Inventory Turnover
365
 The average days’ sales in inventory in 2008   47 days
7.7
 This ratio estimates the average length of time items spent in inventory.

3. Receivables Turnover
Sales

Accounts Receivable
1,506
 The receivable turnover in 2008   15.9 times
95
 Only credit sales should be used.
 This ratio shows a firm’s credit policy. It looks at how fast the firm collects on
the credit sales.

4. Average Collection Period

365 days

Receivables Turnover
365
 The average collection period in 2008   23 days
15.9

5. Asset Turnover
Sales

Total Assets
1,506
 The asset turnover in 2008   3.9 times
385
 This ratio is an indicator of how efficiently management is using its investment in
total assets to generate sales.
 High turnover rates suggest efficient asset management.

29
2.4.4 Profitability Ratios

We look at profits in two ways. First, as a percentage of net sales; second, as a return on the
funds invested in the business.

1. Profit Margin
Net Income

Sales
50
 The profit margin in 2008   3.3%
1,506
 It measures the total operating and financial ability of management.

2. Return on Assets (ROA)

Net Income

Total Assets
50
 The ROA in 2008   13%
385
 This ratio measures the return on total assets after recognition of taxes and
financing costs.

3. Return on Equity (ROE)

Net Income

Total Equity
50
 The ROE in 2008   18%
275
 The fact that ROE exceeds ROA reflects the firm’s use of financial leverage.

2.4.5 Market Value Ratios

The market value ratios are based on information on the market price of the stocks. These
measures can be calculated directly for publicly traded companies.

1. Earnings Per Share (EPS)

Net Income

Shares Outstanding
50
 The EPS in 2008   $5 per share
10
 This EPS figure is known as “basic earnings per share”.

30
2. Price-Earnings Ratio (PE)
Price Per Share

Earnings Per Share
 Assume the price for the stock of City Corporation is $40, the PE ratio
40
  8 times
5
 PE ratio measures how much investors are willing to pay per dollar of current
earnings.
 Higher PEs are often taken to mean that the firm has significant prospects for
future growth.

3. Price-Sales Ratio
Price Per Share

Sales Per Share
 Assume the price for the stock of City Corporation is $40, the price-sales ratio
40
  0.27 times
150.6
 Price-Sales ratio can be used when the firm reported negative earnings for the
period.

4. Market-to-Book Ratio (MB)

Market Value Per Share

Book Value Per Share
40
 The MB ratio in 2008   1.45 times
27.5
 Note that book value per share is total equity divided by the number of shares
outstanding.
 A value less than 1 could mean that the firm has not been successful overall in
creating value for its shareholders.

31
2.4.6 Linking Ratios

We can gain greater insights into a firm’s ROA and ROE by linking together selected
financial ratios.

1. ROA
 Profit Margin  Asset Turnover = ROA
Net Income Sales Net Income
 
 Sales Total Assets Total Assets
3.3%  3.9  13%
 This formula indicates that the return on assets is closely related to the
profitability and turnover.

2. ROE (Du Pont Identity)

 Profit Margin  Asset Turnover  Equity Multiplier = ROE
Net Income Sales Total Assets Net Income
  
 Sales Total Assets Total Equity Total Equity
3.3%  3.9 1.4  18%
 Du Pont identity is a popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.

2.4.7 Managerial Implications

So far, we have looked at the five major types of financial ratios. As a CFO, you would
probably ask “How can we interpret all the ratios together?”

A simple way to analyze the overall picture is to group the ratios into a matrix. For example:

Liquidity / Solvency Profitability Implications

Liquid / Solvent High Low Risk but High Return
Illiquid / Insolvent High High Risk and High Return
Liquid / Solvent Low Low Risk and Low Return
Illiquid / Insolvent Low High Risk but Low Return

32
Some caveats when you are using financial ratios:
 Ratio analysis deals only with quantitative data. It does not look at qualitative factors
such as the quality of management.
 Management can take short-run actions to influence the ratios.
 Comparison of ratios between companies must be on a comparable accounting basis.
Differences in accounting practices in such areas as depreciation, income recognition
and intangible assets can make the comparisons misleading.
 Accounting records are maintained in historical dollars. In periods of inflation the
ratios may be biased upwards.
 Ratios must be evaluated in a correct business context.
 Past data does not necessarily reflect current situation or future expectations.

2.5 Growth Analysis

The past and the expected growth rates of a corporation’s sales, profits and dividends is a
major focus of the analysis. We are interested because there is a close relationship between
the growth rate and the equity value.

2.5.1 Sustainable Growth

Sustainable growth rate is the most realistic estimate of the growth in a firm’s earnings,
assuming that the corporation does not alter its capital structure. A common method of
estimation is:

Sustainable Growth = Return on Equity  Retention Rate

g = ROE  b

The retention rate (b) is the percentage of earnings retained by the firm – not paid out in the
form of dividends.

33
Example 2.3

City Corporation had earnings of $10 million during the year just ended; a net worth of $100
million at the beginning of that year; and a permanent dividend payout policy of 50%.

Thus, City Corporation earned 10% on its beginning net worth, retained $5 million of
earnings. And the ending net worth will be $105 million.

If the 10% return on beginning equity is repeated during the next year, then the firm’s earning
will grow to $10.5 million.

This 5% earnings growth rate will be repeated annually as long as City Corporation continued
to earn 10% on each year’s beginning net worth and pay out 50% of its earnings in dividends.

2.5.2 Du Pont Decomposition

This growth rate is assumed to be sustainable because the firm is growing from internally
generated funds. We can associate the sustainable growth with fundamental factors using Du
Pont decomposition.

Recall that:
Net Income
ROE 
Total Equity
Net Income Sales Total Assets
  
Sales Total Assets Total Equity

EPS  DPS
Retention Rate 
EPS
DPS
=1 
EPS
=1  Dividend Payout Ratio

Putting the two equations together and remembering that capital structure is held constant,
we can see the sustainable growth is affected by profitability, asset utilization, and earnings
retention.

g  ROE  b
Net Income Sales Total Assets  DPS 
    1  
Sales Total Assets Total Equity  EPS 

34
We can link the sustainable growth to fundamental factors.

Fundamental Factors Relationship with Sustainable Growth

Profitability Positive
Asset Utilization Positive
Financial Leverage Held Constant
Dividend Payout Negative

2.5.3 Capital Structure and Sustainable Growth

When we define sustainable growth, we assume the corporation does not alter its capital
structure. A firm’s capital structure is its mix of debt and equity that is used to finance its
long-term investment.

The intuition is that even a corporation could grow by simply increasing its borrowing, but
this practice is eventually not sustainable because there is a point at which the corporation
may not be able to handle the debt burden.

Therefore, sustainable growth is determined assuming that the firm’s capital structure
remains the same. In other words, if the firm generates and retains earnings – hence
increasing its equity, it is assumed that the firm would also borrow so that the firm’s capital
structure is constant. This is consistent to the idea that a corporation usually maintains a
relatively constant target capital structure.

2.5.4 A Note on Sustainable Growth Rate

Recall that ROE is calculated as net income divided by total equity. If the total equity is
taken from the “beginning” of the period, then:

g = ROE  b

However, if total equity is taken from an “ending” balance sheet, then the formula changes
slightly:

ROE  b
g
1  ROE  b

35
To reconcile the two formulae, denote:

TEb  Total Equity taken from the "beginning" of the period

TEe  Total Equity taken from the "ending" of the period

If the total equity is taken from an “ending” balance sheet, the sustainable growth rate:

ROEe  b
g
1  ROEe  b
NI
b
TEe

NI
1 b
TEe
NI
b
TEe TE
  e
NI
1  b TEe
TEe
NI  b

TEe  NI  b
NI  b

TEb
NI
 b
TEb
 ROEb  b

36
3 Topic 3 – The Time Value of Money

As a CFO of City Corporation, you have to oversee many investment decisions from time to
time. You invest the money now in hopes of yielding future returns.

However, making such decisions is difficult for a number of reasons. Perhaps the most
significant one is to predict future returns. Even if the future returns could be forecasted with
certainty, choosing among alternative investments is not without its difficulties. The problem
is that the timing of the returns associated with each alternative investment may be different.

In this topic, we are going to deal with this problem by introducing the concept of the time
value of money, understanding the relationship between future value and present value.

3.1 A Motivating Example

City Corporation has two simple investment projects. The projects have three things in
common. Each requires an initial outlay of $50,000, has returns lasting just three years into
the future, and these returns are certain to occur.

Investment 1 returns $20,000 per year at the end of the next three years. And Investment 2
pays $40,000 a year from now, and $9,000 per year at the end of the second and third years.

We can show these future patterns of returns and initial investment graphically.

So which one of these investments do you prefer? When you sum up the cash flows,
 Investment 1 pays back $60,000.
 Investment 2 pays back only $58,000.

Can you simply conclude you prefer Investment 1 because it pays you $2,000 more than
Investment 2?

You notice that Investment 2 pays $20,000 more in the first year. You may suggest to City
Corporation that you could do something with that extra $20,000. At least you could get -
say 5% - from a deposit account. If you are smart, you can do even better.

37
You think the time that you get the money is important as well as how much you get.

Suppose you know where to invest your extra funds and you are smart enough to earn 10%
interest. Let’s compare the two investments when the interest rate is 10%.

38
Investment 1
Year 1 Year 2 Year 3
Beginning balance 0 20,000 42,000
Earnings on the balance at 10% 0 2,000 4,200
Inflow at the end of year 20,000 20,000 20,000
Ending balance 20,000 42,000 66,200

Investment 2
Year 1 Year 2 Year 3
Beginning balance 0 40,000 53,000
Earnings on the balance at 10% 0 4,000 5,300
Inflow at the end of year 40,000 9,000 9,000
Ending balance 40,000 53,000 67,300

The results indicate that Investment 2 leaves you better off if you can earn 10% interest.

What happens if you can only earn 5% interest?

Investment 1
Year 1 Year 2 Year 3
Beginning balance 0 20,000 41,000
Earnings on the balance at 5% 0 1,000 2,050
Inflow at the end of year 20,000 20,000 20,000
Ending balance 20,000 41,000 63,050

Investment 2
Year 1 Year 2 Year 3
Beginning balance 0 40,000 51,000
Earnings on the balance at 5% 0 2,000 2,550
Inflow at the end of year 40,000 9,000 9,000
Ending balance 40,000 51,000 62,550

In this case, Investment 1 looks better.

This example shows that not only the amount of cash flows is important, but also the timing
of receipt. The more you can earn on the receipts, the better if you can get them earlier.

39
3.1.1 Basis for Comparison

You have to think of money as having a “time unit” denoting when it is received or paid. We
can only compare money in the same time units. For instance, it does not make sense to
compare $20,000 received today with $20,000 received next year.

In order to have a fair comparison, we have to ensure the two monetary values have the same
time units.

3.2 Future Value and Compounding

One way to obtain the same time units is to get the future value. Future value refers to the
amount of money an investment will grow to over some period of time at some given interest
rate. By compounding, we can move the time units forward.

Example 3.1

Instead of investing the $50,000 in the project, you decide to deposit the $50,000 in a bank
for three years at 10%. We assume the interest rate does not change. How much you can get
after three years?

Beginning Ending
Year Interest Formula
Balance Balance
50, 000 1.1
1
1 50,000 5,000 55,000
50, 000 1.1
2
2 55,000 5,500 60,500
50, 000 1.1
3
3 60,500 6,050 66,550

In general, the formula for future value when interest is compounded annually is:

Vt  V0 1  r 
t

3.2.1 Effects of Compounding

In the motivating example, we understand that if we can earn a higher interest rate, it will be
better to have earlier cash flows. The secret behind this effect comes from the power of
interest on interest. That is, there will be interest earned on the reinvestment of previous
interest payment.

40
Example 3.2

Given the interest rate is 10%, what would your $100 be worth after five years?

Vt  V0 1  r 
t

 100 1.1
5

 161.05

Without compounding, you can only earn a simple interest, that is, interest is only earned on
the principal. The simple interest is 100 10%  10 per year . Over the five year span of
investment, you accumulate $50 simple interest.

The difference $11.05 is the interest on interest from compounding.

Future values depend critically on the assumed interest rate, particularly for long-lived
investments.

41
We can study how $1 of investment grows at different rates and lengths of time.

Notice that the future value of $1 after 10 years is about $6.20 at a 20% return, but it is only
about $2.60 at 10%. Doubling the interest rate more than doubles the future value.

42
3.2.2 Calculate Future Values with BAII Plus

We use Example 3.2 as an illustration. Given the interest rate is 10%, what would your $100
be worth after five years?

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Enter the Inputs

 -100 PV
 10 I/Y
 5N

3. Compute and Return the Outputs

 CPT FV

The screen should show you FV = 161.0510

3.3 Present Value and Discounting

Another way to obtain the same time units is to get the present value. Present value is the
current value of future cash flows discounted at the appropriate discount rate. By discounting,
we can move the time units backward.

Example 3.3

Suppose you need $66,550 in three years, and you can earn 10% on your money. How much
do you have to invest today in order to reach your goal?

Vt  V0 1  r 
t

66,550  V0 1.1
3

V0  50, 000

In general, the formula for present value is:

Vt
V0 
1  r 
t

43
The two simple examples serve to illustrate discounting and compounding are the inverse of
one another.

Future Value of $50,000 in three years at 10%:

Present Year 1 Year 2 Year 3

Cash Flow 50,000
66,550

Present Value of $66,550 in three years at 10%:

Present Year 1 Year 2 Year 3

Cash Flow 66,550
50,000

3.3.1 Effects of Discounting

There are two important relationships between present value, interest rate and time:
 For a given interest rate, the longer the time period, the lower the present value.
 For a given time period, the higher the interest rate, the smaller the present value.

We can plot out the present value of $1 for different periods and rates.

44
3.3.2 Calculate Present Values with BAII Plus

Redo Example 3.3. Figure out the present value.

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Enter the Inputs

 66,550 FV
 10 I/Y
 3N

3. Compute and Return the Outputs

 CPT PV

You should get PV = -50,000.0000

Example 3.4

Instead of comparing the future value for the two investments in our motivating example,
let’s figure out the present value of each investment under a 10% discount rate.

Present Value of Investment 1 at 10%:

Present Value Year 0 Year 1 Year 2 Year 3

-50,000.00 -50,000 +20,000 +20,000 +20,000
20, 000
18,181.82 
1.1
20, 000
16,528.93 
1.12
20, 000
15,026.30 
1.13
-262.96

45
Present Value of Investment 2 at 10%:

Present Value Year 0 Year 1 Year 2 Year 3

-50,000.00 -50,000 +40,000 +9,000 +9,000
40, 000
36,363.64 
1.1
9, 000
7,438.02 
1.12
9, 000
6,761.83 
1.13
563.49

Once again, we confirm Investment 2 is better.

3.4 The Discount Rate

We always need to determine what discount rate is implicit in an investment. Recall that the
present value is found by discounting the future cash flow:

FVt
PV 
1  r 
t

Rearrange the equation, the discount rate is:

1
 FV  t
r   t  1
 PV 

Example 3.5

You are looking at an investment that will pay $1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?

1
 FV  t
r   t  1
 PV 
1
 1, 200  5
  1
 1, 000 
 3.71%

46
Using financial calculator,

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Enter the Inputs

 1,200 FV
 - 1,000 PV
 5N

3. Compute and Return the Outputs

 CPT I/Y

We can verify I/Y = 3.7137%

Example 3.6

Suppose you are offered an investment that will allow you to double your money in 6 years.
You have $10,000 to invest. What is the implied rate of interest?

1
 FV  t
r   t  1
 PV 
1
 20, 000  6
  1
 10, 000 
 12.25%

In this example, we can apply the “Rule of 72” to get an approximate of r. For reasonable
rates of return, the time it takes to double your money is given approximately by 72 / r.

72
6
r
 r 12%

47
3.5 The Number of Periods

Example 3.7

You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10%
per year and you currently have $15,000, how long will it be before you have enough money
to pay cash for the car?

We start with the present value formula.

FVt
PV 
1  r 
t

Rearrange the formula and solve for t,

ln FVt  ln PV
t
ln 1  r 

In this example,
ln FVt  ln PV
t
ln 1  r 
ln 20, 000  ln15, 000

ln1.1
 3.02

Using financial calculator,

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Enter the Inputs

 20,000 FV
 - 15,000 PV
 10 I/Y

3. Compute and Return the Outputs

 CPT N

We can verify N = 3.0184

48
3.6 Spreadsheet Application

We can also use Excel to solve for the problems of time value of money. So far, we have
learnt to solve for any one of the following four potential unknowns:
 Future value
 Present value
 Discount rate
 Number of periods

In Excel, there is a separate formula to solve for each of the unknown.

To Solve for Excel Formula

Future Value = FV(rate, nper, pmt, pv)
Present Value = PV(rate, nper, pmt, fv)
Discount Rate = RATE(nper, pmt, pv, fv)
Number of Periods = NPER(rate, pmt, pv, fv)

Some tricks when you are using Excel spreadsheet:

 The rate should be entered as a decimal, instead of a percentage.
 Put a negative sign on the present value.

49
4 Topic 4 – Discounted Cash Flow Valuation

In Topic 3, most of the examples only focus on single cash flows. In reality, most
investments have multiple cash flows. For example, if City Corporation is planning to open a
convenient store, there will be a large cash outlay in the beginning and then cash inflows for
many years.

Building on the concept of time value of money, we offer you more tools to value cash flows.
In particular, we will look at some special cash flows – annuity and perpetuity. We will also
compare various interest rates in depth.

4.1 Multiple Cash Flows

4.1.1 Future Value of a Series of Cash Flows

Example 4.1

You estimate that an investment project will receive net cash inflows at the end of each of the
first five years. They are $10,000, $20,000, $30,000, $45,000, and $60,000. What is the
future value of these cash flows at the end of year 5, if the interest rate is 20% per annum?

n
FV   Ct 1  r 
n t

t 1

 10, 000 1.2   20, 000 1.2   30, 000 1.2   45, 000 1.2   60, 000
4 3 2

 212, 496

50
4.1.2 Present Value of a Series of Cash Flows

Example 4.2

What is the present value of three cash flows $100, $200 and $600, to be received at the end
of year 1, 3 and 6, respectively, if the discount rate is 10% per annum?

n
Ct
PV  
1  r 
t
t 1

100 200 600

  
1.1 1.1 1.16
3

 579.85

If you use financial calculator, first, notice the cash flow pattern.

Year Cash Flow

0 0
1 100
2 0
3 200
4 0
5 0
6 600

Noted that the “F” displayed in the calculator means the number of times a given cash flow
occurs in consecutive years. For example, at year 4, there are 2 consecutive years of having
zero cash flow.

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

51
2. Input
 CF
 (CF0=) 0 ENTER ↓
 (C01=) 100 ENTER ↓
 (F01=) 1 ENTER ↓
 (C02=) 0 ENTER ↓
 (F02=) 1 ENTER ↓
 (C03=) 200 ENTER ↓
 (F03=) 1 ENTER ↓
 (C04=) 0 ENTER ↓
 (F04=) 2 ENTER ↓
 (C05=) 600 ENTER ↓
 (F05=) 1 ENTER ↓
 NPV
 (I=) 10 ENTER ↓
 CPT

You can verify the answer is 579.85.

4.2 Annuity

Annuity formula is useful in discounted cash flow valuation. Annuity means the value of
cash flows is the same for a number of years.

To use the ordinary annuity formula, the following conditions should be satisfied:
 The value of the cash flows in each period is the same.
 The period or the interval for the cash flows remains unchanged.
 The receipt / payment of the cash flows should occur at the end of each regular period.

4.2.1 Present Value of an Annuity

1 1 
Present Value of an Annuity  C  1  
r  1  r t 


52
Example 4.3

A project is expected to have an economic life of five years. The value of this project’s net
cash inflows is estimated to be $2,000 for each year and this is to be received at the end of
each year. The appropriate discount rate is 15% per annum. What is the present value of this
project’s cash inflows?

Using our old discounting approach,

n
Ct
PV  
t 1 1  r 
t

2, 000 2, 000 2, 000 2, 000 2, 000

    
1.15 1.15  1.15  1.15  1.15 5
2 3 4

 6, 704.31

Using the annuity formula,

1 1 
PV  C  1  
r  1  r t 

1  1 
 2, 000  1  
0.15  1.15 5 
 6, 704.31

To find annuity present value with financial calculators, we need to use the PMT key.

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Enter the Inputs

 2,000 PMT
 5N
 15 I/Y

3. Compute and Return the Outputs

 CPT PV

You will also get PV = - 6,704.31.

53
Example 4.4

A project’s annual net cash inflows, to be received at the end of each year, are estimated as
follows. For the first nine years the project does not generate any cash inflow. For the next
eleven years, that is, from the tenth to the twentieth years inclusive, it generates $60 per year.
The discount rate is 10% per annum. What is the present value of this project?

The timeline of the project’s cash flow:

0 0 60 60
PV      
1.1 1.1 1.1
9 10 20
1.1
 165.27

There is another way to view this example. We know the annuity cash flows only start at
year 10. Therefore, we can first figure out the present value of this annuity at year 9 and then
discount the whole sum back to year 0.

1  1  1  
PV  9 
60   1  
11 
1.1  0.1  1.1 
 165.27

Example 4.5

You are 20 years old now and want to retire as a millionaire by the time you turn 70. How
much will you have to save at the end of each year if you can earn 5% compounded annually?

1 1 
PV  C  1  
r  1  r t 

1, 000, 000 1  1 
 C   1  
1.05
50
0.05  1.05 50 
 C  4, 776.74

54
Example 4.6

Suppose you want to borrow $20,000 for new car. You can borrow at 8% per year,
compounded monthly (8/12 = 0.67% per month). If you take a 4-year loan, what is your
monthly payment?

1 1 
PV  C  1  
r  1  r t 

1  1 
20, 000  C  1  
0.0067  1.0067  
48

 C  488.63

Example 4.7

Suppose you borrow $10,000 from your friend. You agree to pay $207.58 per month for 60
months. What is the monthly interest rate?

Using financial calculator,

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Enter the Inputs

 - 207.58 PMT
 60 N
 10,000 PV

3. Compute and Return the Outputs

 CPT I/Y

You will also get I/Y = 0.7499.

55
Without a financial calculator, then you have to go through the trial and error process.
 Choose an interest rate and compute the PV of the payments based on this rate.
 Compare the computed PV with the actual loan amount.
 If the computed PV > loan amount, then the interest rate is too low.
 If the computed PV < loan amount, then the interest rate is too high.
 Adjust the rate and repeat the process until the computed PV and the loan amount are
equal.

4.2.2 Future Value of an Annuity

We already know the formula of present value of annuity. To get the future value of an
annuity, we can simply multiply that present value by 1  r  .
t

1  r  1
t

Future Value of an Annuity  C 

r

Example 4.8

Suppose you begin saving for your retirement by depositing $2,000 per year in MPF. If the
interest rate is 7.5%, how much will you have in 40 years?

1  r  1
t

FV  C 
r
1.075 1
40

 2, 000 
0.075
 454,513.04

56
4.3 Annuity Due

Recall that one of the conditions for applying ordinary annuity is that the receipt / payment of
the cash flows should occur at the end of each regular period.

In many situations, however, the cash flows occur at the beginning of the period. For
example, when you lease an apartment, the first lease payment is usually due immediately.

An annuity due is an annuity for which the cash flows occur at the beginning of each period.
To calculate the annuity due value, we simply multiply the ordinary annuity by 1  r  .

Annuity Due  Ordinary Annuity  1  r 

Example 4.9

Suppose an annuity due has five payments of $400 each, and the relevant discount rate is
10%. What is the present value of the cash flows?

Using the annuity due formula,

Annuity Due  Ordinary Annuity  1  r 

1 1 
 C  1    1  r 
r  1  r t 

1  1 
 400  1    1.1
0.1  1.15 
 1, 667.95

We can verify the answer by finding the present value of each cash flow.

400 400 400 400

PV  400    
1.1 1.1 1.1 1.14
2 3

 1, 667.95

57
4.4 Perpetuity

Perpetuity is a special case of an annuity in which the number of equal cash flows is infinite.
The formula for the present value of a perpetuity is:

C
Present Value of a Perpetuity 
r

Example 4.10

In the early 1900's the Canadian Government issued $100 par value 2% Consol bonds. The
holder of these bonds is entitled to receive a coupon (or interest) payment of $2 per year
forever. If the current appropriate discount rate is 5% p.a. and the next coupon is due one
year from now, how much is one of the Consols worth?

C
PV 
r
2

0.05
 40

4.5 Comparing Rates

Suppose a bank offers you two deals: (1) pays you 10% interest per year or (2) pays you 5%
interest compounded every six months. Which deal would you prefer?

If you invest $1, then after a year,

Option (1) will give you:

$1 1.1  $1.1

Option (2) will give you:

$1 1.05  $1.1025
2

Obviously, option 2 is better as you can enjoy the interest on interest. As the example
illustrates, 10% compounded semiannually is actually equivalent to 10.25% per year.

58
4.5.1 Effective Annual Rate (EAR)

In the example, the 10% is called the quoted interest rate. The 10.25%, which is actually the
rate that you can earn, is called the effective annual rate (EAR). If you want to compare two
alternative investments with different compounding periods, you need to compute the EAR
and use that for comparison.

To get the effective annual rate,

m
 Quoted Rate 
EAR  1   1
 m 

Where m is the number of times the interest is compounded during the year.

Example 4.11

Suppose a bank offers a nominal interest rate of 5% on your time deposit. Compare the
different EARs with various times the interest is compounded each year.

Compounding Formula Effective Annual Rate

1
 0.05 
Annually r  1   1 5.0000%
 1 
2
 0.05 
Semiannually r  1   1 5.0625%
 2 
4
 0.05 
Quarterly r  1   1 5.0945%
 4 
12
 0.05 
Monthly r  1   1 5.1162%
 12 
52
 0.05 
Weekly r  1   1 5.1246%
 52 
365
 0.05 
Daily r  1   1 5.1267%
 365 
8760
 0.05 
Hourly r  1   1 5.1271%
 8760 
Continuously r  e0.05  1 5.1271%

You will always prefer more compounding periods to less.

59
Example 4.12

You are looking at two savings accounts. HSBC pays you 5.25%, with daily compounding.
BOC pays 5.3% with semiannual compounding. Which account should you use?

HSBC:
365
 0.0525 
EAR  1   1
 365 
 5.3899%

BOC:
2
 0.053 
EAR  1   1
 2 
 5.3702%

4.5.2 Annual Percentage Rate (APR)

Another rate we often calculate is the annual percentage rate (APR). APR is the interest rate
charged per period multiplied by the number of periods per year. Since the law requires that
lenders disclose an APR on all loans, this rate must be displayed on a loan document in an
unambiguous way.

Example 4.13

What is the APR if (1) the monthly rate is 0.5%; (2) the semiannual rate is 0.5%?

For (1):
APR  0.5% 12  6%

For (2):
APR  0.5%  2  1%

Remember, APR is only an annual rate that is quoted by law. In order to figure out the
actual rate, you need to compute the EAR.

60
The relationship between EAR and APR:

m
 APR 
EAR  1   1
 m 

If you have an effective rate, you can compute the APR.

 1

APR  m 1  EAR  m  1
 

Example 4.14

Suppose you want to earn an effective rate of 12% and you are looking at an account that
compounds on a monthly basis. What APR must this account pay?

 1

APR  m 1  EAR  m  1
 
 1

 12 1.12 12  1
 
 11.39%

61
5 Topic 5 – Investment Decisions

After learning the techniques of discounted cash flow valuation, you are now ready to deal
with one important question: “What long-term investment should City Corporation take?”

5.1 Capital Investment Projects

City Corporation has $40,000 that it can expand the current production of its smart phone by
investing in any or all of the four capital projects.

Cash Flow
Project Year 0 Year 1 Year 2 Year 3
A Investment -10,000
Revenue 21,000
Expenses 11,000

B Investment -10,000
Revenue 15,000 17,000
Expenses 5,833 7,833

C Investment -10,000
Revenue 10,000 11,000 30,000
Expenses 5,555 4,889 15,555

D Investment -10,000
Revenue 30,000 10,000 5,000
Expenses 15,555 5,555 2,222

All the projects’ capital investment will be depreciated to zero on a straight-line basis. The
marginal corporate tax rate is 40%. None of the projects will have any salvage value at the
end of their lives.

What is your advice to the management?

In this case, City Corporation processes four possible investments. Some are valuable and
some are not. Of course, our important goal is to identify which are which. We will try to
present several investment criteria commonly used in practice and introduce the techniques
used to analyze investment decisions.

62
5.2 Net Present Value

The net present value (NPV) of an investment is defined as the present value of all future
cash flows produced by an investment, less the initial cost of the investment.

n
Ct
NPV    I0
1  r 
t
t 1

Whether an investment is worth undertaking, we have to see if it creates value for its owner.
A positive NPV says the investment is worth more than it costs, and therefore creates value.
A negative NPV suggests once the investment is implemented, it will destroy value.

Based on the simple logic, in determining whether to accept or reject a particular investment,
the NPV decision rule is:
 Accept an investment if its NPV > 0.
 Reject an investment if its NPV < 0.

Example 5.1

Consider the following investment proposal:

Year 0 Year 1 Year 2 Year 3 … Year 25

Cash Flow -100 11 11 11 11 11

Assuming the discount rate is 10%, is it a worthwhile investment?

n
Ct
NPV    I0
1  r 
t
t 1

25
11
  100
1.1
t
t 1

 1  1 
 11  1  25    100
 0.1  1.1  
 0.15  0

Since NPV < 0, we should reject the proposal.

63
5.2.1 Why Positive NPV?

Example 5.2

You have the following investment project:

Year 2010 Year 2011 Year 2012 Year 2013

Cash Flow -100 50 30 80

The discount rate is 10%. What is the NPV of the project?

n
Ct
NPV    I0
1  r 
t
t 1

50 30 80
    100
1.1 1.12 1.13
 30.35  0

We understand this is a good investment project since the NPV is greater than zero. But what
does this 30.35 really mean?

The 30.35 is exactly the additional amount of money you can spend today if you take the
project. Suppose you can borrow and lend at 10%, then you can do the following strategy:
 Spend 30.35 today and borrow the money from the bank.
 Repay the loan by using the project cash flows.

Let us illustrate the strategy with the following table.

Year 2010 Year 2011 Year 2012 Year 2013

Project Cash Flow -100.00 +50.00 +30.00 +80.00
Loan Cash Flow +130.35 -50.00 -30.00 -80.00
Interest 0.00 13.04 9.34 7.27
Balance -130.35 -93.39 -72.73 0.00
Your Cash Flow 30.35 0.00 0.00 0.00

A positive NPV means you can earn extra cash flow for your consumption. In the example
here, 30.35 is your riskless profit since your project cash flow can completely repay your loan
in future. Hence, if you undertake this project, you will be better off.

64
5.2.2 More than Two Alternatives

In many cases, a firm will be faced with a choice between more than two alternatives. For
example, a firm may be considering whether to rebuild a new office building or to refurbish
an old building.

When there are more than one investment projects, the decision rule becomes:
 For many independent projects, take all with positive NPV.
 For mutually exclusive projects, take the one with the highest and positive NPV.

Example 5.3

City Corporation is deciding purchasing new machines, A and B. The two machines will
bring the firm the following cash flows.

Machine A
Year 0 1 2 3 4
Cash Flow -3,000 1,000 1,000 1,000 1,000

Machine B
Year 0 1 2 3 4
Cash Flow -2,000 700 700 700 700

The discount rate is 10%. What are the NPVs of the two machines?

1, 000 1, 000 1, 000 1, 000

NPV  A   3, 000    
1.1 1.12 1.13 1.14
 169.87

700 700 700 700

NPV  B   2, 000    
1.1 1.12 1.13 1.14
 218.91

Purchasing both machines will bring positive NPV to the firm. When there is no constraint,
City Corporation should purchase both machines. However, if the purchasing decisions are
mutually exclusive (either purchasing Machine A or B), then the decision is to choose the
highest NPV. Machine B is thus the preferred alternative.

65
5.2.3 Investment Projects with Different Lives

Example 5.4

In the coming year, City Corporation decides to replace the old machine. It is deciding
between Machine C and D. Machine C has a life of 4 years and Machine D has a life of 2
years. Both machines cost $1,000.

Machine C
Year 0 1 2 3 4
Cash Flow -1,000 350 350 350 350

Machine D
Year 0 1 2
Cash Flow -1,000 750 500

The discount rate is 10%. What are the NPVs of the two machines?

350 350 350 350

NPV  C   1, 000    
1.1 1.12 1.13 1.14
 109.45

750 500
NPV  D   1, 000  
1.1 1.12
 95.04

Should the firm choose Machine C or Machine D?

Even though Machine C has a higher NPV, we cannot simply draw a conclusion that
Machine C is more preferred since it has a longer useful life than Machine D. In order to
have a fair comparison, one way is to compute the relevant NPV and compare the annual
equivalent cash flows of the two alternative machines.

The equivalent annuity is a useful tool for simplifying the analysis of problems of investment
projects with different lives. The idea is to calculate the annualized net present value. The
equivalent annuity is the level annuity over the investment’s life that has a present value
equal to the investment’s NPV.

66
The decision rule is to choose the one with highest equivalent annuity. In our example,

Machine C:
EAC EAC EAC EAC
109.45    
1.1 1.12 1.13 1.14
 EAC  34.53

Machine D:
EAD EAD
95.04  
1.1 1.12
 EAD  54.76

Surprisingly, although Machine D has a lower NPV than Machine C, the firm should select
Machine D as it has a higher equivalent annuity.

5.3 The Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate that makes the NPV of an investment
zero. The IRR solves the following equation:

n
Ct
0  I0
1  IRR 
t
t 1

In determining whether to accept or reject an investment, the IRR decision rule is:
 Accept an investment if IRR > required return.
 Reject an investment if IRR < required return.

The logic of IRR reverses the one of the NPV. When computing NPV, we calculate the NPV
for a given discount rate on an investment, and accept an investment whenever the NPV is
positive. If we use IRR rule, we calculate the discount rate that makes the NPV equal to zero.
The two methods are related.

67
Example 5.5

Consider the following investment project:

What is the IRR?

50 100 150
0  200   
1  IRR  1  IRR  1  IRR 3
2

 IRR  19.4377%

Using financial calculator,

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

2. Input
 CF
 (CF0=) -200 ENTER ↓
 (C01=) 50 ENTER ↓
 (F01=) 1 ENTER ↓
 (C02=) 100 ENTER ↓
 (F02=) 1 ENTER ↓
 (C03=) 150 ENTER ↓
 (F03=) 1 ENTER ↓
 IRR CPT

68
If we graph NPV versus the discount rate, we can see the IRR is actually the x-intercept.

$120.00
$100.00
$80.00
$60.00
$40.00
NPV $20.00
$0.00
-$20.00 0% 10% 20% 30% 40% 50%

-$40.00
-$60.00
-$80.00
IRR

We can see that the NPV of the project decreases as we increase the discount rate. The line
cuts the x-axis at the IRR of 19.44%. For all discount rate above 19.44%, the NPV of the
project is negative; for all discount rate below the IRR, the NPV of the project is positive.

Let’s say if the required rate of return is 10%, then based on both decision rules (NPV &
IRR), they all come to the same conclusion – the project should be accepted.

5.3.1 Nonconventional Cash Flows

One problem with the IRR comes about when the cash flows are not conventional.

Example 5.6

Consider the following investment project:

What is the IRR?

69
From the graph, there are two IRRs for this project. The curve crosses the x-axis at 0% and
100%.

70
60
50
40
30
NPV
20
10
0
0% 20% 40% 60% 80% 100% 120%
-10
-20
IRR

The idea is that when cash flows change signs more than once, there will be more than one
IRR. In this situation, you will have to use your judgment to decide which IRR should be
used.

5.3.2 Mutually Exclusive Investments

Another problem with IRR comes about when we are trying to compare two or more
mutually exclusive investments.

Example 5.7

City Corporation has two mutually exclusive projects, A and B. The cash flows of the two
projects are as follow:

Year 0 Year 1 Year 2

Project A -500 325 325
Project B -400 325 200

If the required return for both projects is 10%, which project should the firm accept?

70
We try to compute the NPV and IRR for both projects.

325 325
NPV  A   500  
1.1 1.12
 64.05
325 200
NPV  B   400  
1.1 1.12
 60.74

325 325
0  500  
1  IRRA  1  IRRA 2
 IRRA  19.43%
325 200
0  400  
1  IRRB  1  IRRB 2
 IRRB  22.17%

In this example, NPV(A) > NPV(B) but IRR(B) > IRR(A). Based on NPV rule, we should
choose Project A. However, if we rely on IRR rule, the rule suggests us to choose Project B.
The two rules give conflicting conclusions.

The conflict between the NPV and IRR for mutually exclusive investments can be illustrated
by plotting their profiles.

190.00

140.00

90.00
Project A
NPV
Project B
40.00

(10.00) 0% 5% 10% 15% 20% 25% 30% 35%

(60.00)

71
The crossover point of the two curves can be found by setting NPV(A) = NPV(B).

Crossover point:
NPV  A  NPV  B 
325 325 325 200
500    400  
1  r  1  r  2
1  r  1  r 2
 r  11.80%

Below the crossover point, both NPV and IRR share the same decision – investing in Project
B is more preferred. Notice that when the discount rate is less than 11.8%, the NPV for
Project A is higher even though Project B’s IRR is higher.

Remarks:
 Whenever there is a conflict between NPV and IRR, you should always use NPV.
 IRR is unreliable in the situations of nonconventional cash flows and mutually
exclusive projects.

5.4 The Payback Rule

The payback period is the length of time it takes to recover the initial investment of the
investment.

The payback decision rule is:

 Accept an investment if payback period < pre-specified payback period.
 Reject an investment if payback period > pre-specified payback period.

For mutually exclusive projects, accept the one with the lowest payback period (if payback
period < pre-specified period).

72
Example 5.8

City Corporation is considering purchasing either one machine (mutually exclusive

investment). The firm’s required rate of return is 10%.

Machine E
Year 0 1 2 3
Cash Flow -1,000 200 800 25

Machine F
Year 0 1 2 3
Cash Flow -1,000 600 300 1,000

If City Corporation requires a payback period of three years or less, which machine would
you purchase?

The payback period:

 Machine E: 2 years.
 Machine F: 3 years.

The payback rule dictates that Machine E should be accepted. However, if we calculate the
NPV of the two machines, we get:

200 800 25
NPV  E   1, 000   
1.1 1.12 1.13
 138.24
600 300 1, 000
NPV  F   1, 000   
1.1 1.12 1.13
 544.70

Based on NPV rule, purchasing Machine E is actually not a good investment choice. This
example shows that there are problems with the payback method:

1. It ignores the time value of money.

 A remedy for this problem is to use the discounted payback period.

2. It ignores the cash flows after the payback period.

3. The standard for payback period is arbitrary.

73
5.5 The Average Accounting Return

The average accounting return (AAR) is an investment’s average net income divided by its
average book value. By definition,

Average Net Income

AAR 
Average Book Value

The decision rule is:

 Accept an investment if AAR > target AAR.
 Reject an investment if AAR < target AAR.

Example 5.9

You are looking at a three-year project with a projected net income of $1,000 in year 1,
$2,000 in year 2, and $4,000 in year 3. The cost is $9,000, which will be depreciated
straight-line to zero over the three-year of the project. What is the average accounting return?

1, 000  2, 000  4, 000

Average Net Income 
3
 2,333.33

9, 000  0
Average Book Value 
2
 4,500

Average Net Income

AAR 
Average Book Value
2,333.33

4,500
 51.85%

Although the AAR seems very impressive, there are some drawbacks about this measure.

1. It is not a true rate of return and it also ignores the time value of money.

2. It uses an arbitrary cutoff rate.

3. It is based on accounting net income and book values, not cash flows and market values.

74
5.6 Profitability Index

Profitability index (PI) is the present value of an investment’s future cash flows divided by its
initial cost. PI measures the benefit per unit cost, based on the time value of money.

PV
PI 
I0

The decision rule for PI is:

 Accept an investment if PI > 1.
 Reject an investment if PI < 1.

Example 5.10

City Corporation has a list of investment projects in the coming year. You have prepared a
table summarizing the key measures.

Project Cost PV NPV PI

A 1,000 1,600 600 1.60
B 4,000 6,000 2,000 1.50
C 6,000 8,400 2,400 1.40
D 2,000 2,700 700 1.35
E 5,000 5,500 500 1.10

In the meeting, you know from the budget that $12,000 will be available to invest in the
coming year. Which projects will you select?

By investing all projects, it will cost the firm $18,000. Since the firm only has $12,000
capital, it is not feasible to invest all projects even though all projects have positive NPV. In
this situation, you can rank the project’s PI from highest to lowest and then select from the
top of the list until the capital budget is exhausted.

Based on the PI rule, you will select Project A, B and C as the three projects will give you
highest PI.

75
However, the PI will lead you to the wrong conclusion. If you calculate the aggregate NPV
of various combinations, you have:

NPV  A  B  C   600  2, 000  2, 400

 5, 000

NPV  B  C  D   2, 000  2, 400  700

 5,100

In this example, the best alternative is Project B, C and D with an aggregate NPV of $5,100.

5.7 Comprehensive Problems

We revisit our opening case. City Corporation has $40,000 that it can expand the current
production of its smart phone by investing in any or all of the four projects.

Cash Flow
Project Year 0 Year 1 Year 2 Year 3
A Investment -10,000
Revenue 21,000
Expenses 11,000

B Investment -10,000
Revenue 15,000 17,000
Expenses 5,833 7,833

C Investment -10,000
Revenue 10,000 11,000 30,000
Expenses 5,555 4,889 15,555

D Investment -10,000
Revenue 30,000 10,000 5,000
Expenses 15,555 5,555 2,222

All the projects’ capital investment will be depreciated to zero on a straight-line basis. The
marginal corporate tax rate is 40%. None of the projects will have any salvage value at the
end of their lives.

76
For purpose of analysis,

1. Rank the four investments according to the four commonly used criteria:
a. The payback period.
b. The average accounting return. The formula of AAR in this problem can be
modified as [Average Net Income / (Required Investment / 2)].
c. Internal rate of return.
d. Net present value, assuming alternately a 10% discount rate and a 35% discount
rate.

2. Why do the rankings differ? What does each technique measure and what assumptions
does it make?

3. If the investment projects are independent of each other, which should be accepted? If
they are mutually exclusive, which one is the best?

77
The procedures for analyzing the problems involve:

Step 1: Compute the Cash Flows

A B C D
Year 1 Year 1 Year 2 Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Revenue 21,000 15,000 17,000 10,000 11,000 30,000 30,000 10,000 5,000
Less: Expenses (11,000) (5,833) (7,833) (5,555) (4,889) (15,555) (15,555) (5,555) (2,222)
Less: Depreciation (10,000) (5,000) (5,000) (3,333) (3,333) (3,333) (3,333) (3,333) (3,333)
EBIT 0 4,167 4,167 1,112 2,778 11,112 11,112 1,112 (555)
Less: Tax (40%) 0 1,667 1,667 445 1,111 4,445 4,445 445 (222)
Net Income 0 2,500 2,500 667 1,667 6,667 6,667 667 (333)

EBIT 0 4,167 4,167 1,112 2,778 11,112 11,112 1,112 (555)

Depreciation 10,000 5,000 5,000 3,333 3,333 3,333 3,333 3,333 3,333
Tax 0 1,667 1,667 445 1,111 4,445 4,445 445 (222)
OCF 10,000 7,500 7,500 4,000 5,000 10,000 10,000 4,000 3,000

A summary of the project cash flows:

Cash Flow
Project Year 0 Year 1 Year 2 Year 3
A -10,000 10,000
B -10,000 7,500 7,500
C -10,000 4,000 5,000 10,000
D -10,000 10,000 4,000 3,000

Step 2: Compute the Four Measures

Project Payback AAR IRR NPV(10%) NPV(35%)

A 1 0% 0% -909 -2,593
B 2 50% 32% 3,017 -329
C 3 60% 34% 5,282 -229
D 1 47% 43% 4,651 822

Step 3: The Rankings

Rankings Payback AAR IRR NPV(10%) NPV(35%)

1 A, D C D C D
2 B C D C
3 B D B B B
4 C A A A A

78
6 Topic 6 – Bond and Stock Valuation

When a firm needs funds for investment, it can borrow money by issuing bonds or stocks, or
both. The focus of this topic is to give you an overview on how to value bonds and stocks.

6.1 What is a Bond?

A bond is a certificate showing that a borrower owes a specified sum. To repay the money,
the borrower has agreed to make interest and principal payments on designated dates.

Example 6.1

City Corporation issued 2,000 bonds for $1,000 each, where the bonds have a coupon rate of
5% and a maturity of two years. Interest on the bonds is to be paid annually.

This means that:

 $2,000,000 has been borrowed by the firm.
 The firm must pay interest of $100,000 at the end of one year.
 The firm must pay both $100,000 of interest and $2,000,000 of principal at the end
of two years.

6.2 How to Value Bonds?

6.2.1 Pure Discount Bonds

The pure discount bond promises a single payment at a fixed future date. If the payment is
one year from now, it is called a one-year discount bond. If it is two years from now, it is
called a two-year discount bond, and so on.

The date when the issuer of the bond makes the last payment is called the maturity date of the
bond. The payment at maturity is termed the bond’s face value or par value.

Pure discount bonds are often called zero coupon bonds to emphasize the fact that the
bondholder receives no cash payments until maturity.

79
Consider a zero coupon bond that pays a face value of F in T years. The value of this zero
coupon bond is the present value of the face amount.

F
P
1  r 
T

Example 6.2

A zero coupon bond that matures in 20 years has a par value of $1,000. If the required return
is 4.3%, what is the value of the zero?

F
P
1  r 
T

1, 000

1.04320
 430.83

6.2.2 Coupon Bonds

Corporate bonds usually offer cash payments not just at maturity, but also at regular times in
between.

The payments on corporate bonds are made every six months until the bonds mature. These
payments are called the coupons of the bond.

The cash flow for a coupon bond consists of an annuity of fixed coupon interest and the par
value at maturity.

$C $C $C $C+$F

1 2 3 T

80
In general, the price of a bond is given by:

C C C CF
P    
1  r 1  r 2 1  r 
T 1
1  r 
T

 1 1 1   1 
C    F  
1  r 1  r  1  r   1  r 
2 T T
 
1  1   1 
 C   1    F   T 
 r  1  r  
 1  r  
T
 

Example 6.3

A 30-year bond with an 8% (4% per 6 months) coupon rate and a par value of $1,000 has the
following cash flows:
 Semiannual coupon = $1,000×4% = $40
 Par value at maturity = $1,000

Therefore, there are 60 semiannual cash flows of $40 and a $1,000 cash flow 60 six-month
periods from now.

$40 $40 $40 $40+$1,000

1 2 3 60

The price of this 30-year bond:

40 40 40 1, 040
P    
1 r   1  r 2  1  r 2 
2 59 60
2 1 r 2
where :
r  annual discount rate

81
Suppose the discount rate is 8% annually or 4% per 6-month, the price of the bond is:

1  1   1 
P  C   1    F   T 
 r  1  r     
T
 
 1 r 
 1  1   1 
 40   1     1, 000   60 
 0.04  1.04     1.04  
60

 904.94  95.06
 1, 000

What if the discount rate rises to 10% annually, then the bond price will fall by $189.29 to
$810.71.

1  1   1 
P  40  1    1000   60 
0.05  1.05 60   1.05  
 757.17  53.54
 810.71

The central feature of fixed income securities is that there is an inverse relation between bond
price and discount rate.

82
In this example, the price/interest relationship for a 30-year, 8% coupon bond:

Interest 4% 6% 8% 10% 12%

Price 1,695.22 1,276.76 1,000.00 810.71 676.77

Note:
 When the coupon rate equals the discount rate, the price equals the par value.
 When the coupon rate is less than the discount rate, the price is less than the par
value.
 When the coupon rate is greater than the discount rate, the price is greater than the
par value.

6.2.3 Consol

Not all bonds have a final maturity. Consol is a bond that never stop paying a coupon, has no
final maturity date. Thus, a consol is a perpetuity.

Example 6.4

What is the price of a consol with a yearly interest of $50 if the interest rate is 10%?

C
P
r
50

0.1
 500

6.3 Yield to Maturity

Yield to maturity (YTM) is the average rate of return that will be earned on a bond if it is
bought now and held until maturity.

Given its maturity, the principal and the coupon rate, there is a one to one mapping between
the price of a bond and its YTM.

T
Ct F
P 
1  YTM  1  YTM 
t T
t 1

83
Example 6.5

Consider a 30-year bond with $1,000 face value has an 8% coupon. Suppose the bond sells
for $1,276.76, the YTM:

60
40 1000
1276.76   
   
t 60
t 1 1  YTM 1  YTM
2 2

Solve for the discount rate, YTM = 6%.

The yield-to-maturity considers the return from interest-on-interest. It assumes that the
coupon interest can be reinvested at YTM.

6.4 What is a Common Stock?

A common stock represents an ownership interest in a firm and confers three rights on the
owner of a share:
 Vote at the company meetings.
 Collect periodic dividend payments.
 Sell the share at the owner’s discretion.

Contrary to payments to bondholders, payments to common stockholders are uncertain in

both magnitude and timing.

There are some important characteristics of common stock:

 Residual claim.
 Limited liability.
 Voting rights.

6.5 How to Value Stocks?

Like bonds and other assets, the value of a stock can be determined by the present value of its
future cash flows. A stock provides two kinds of cash flows. First, stocks often pay
dividends. Second, an investor will receive the sale price when selling the stock.

84
Let’s assume you buy a stock and hold it for one year. The price you are willing to pay for
the stock today is equal to the present value of the cash flows you will receive for holding a
year:
Div1 P
P0   1
1 r 1 r

P1 can be determined by the dividend you will receive and the sale price at year 2:
Div2 P2
P1  
1 r 1 r

You can substitute the expression of P1 back into P0 :

 Div2 P 
  2 
Div1  1  r 1  r 
P0  
1 r 1 r
Div1 Div2 P2
  
1  r 1  r  1  r 2
2

If you repeat this logic, the stock price for today eventually becomes:
Div1 Div2 Div3
P0    
1  r 1  r  1  r 3
2


Divt

1  r 
t
t 1

Thus, the value of a firm’s common stock to the investor is equal to the present value of all of
the expected future dividends. The method that we have applied to value common stocks is
called dividend discount model.

6.6 Modeling Dividends

To apply dividend discount model, what we have to do is to estimate the pattern of future
dividends. We can make some simplifying assumptions about the pattern.

85
6.6.1 Zero Growth

The case of zero growth assumes that dividend is constant through time. So the value of the
stock is:
Div Div Div
P0    
1  r 1  r  1  r 3
2

Div

r

6.6.2 Constant Growth

Suppose that the dividend always grows at a constant rate g in perpetuity. That is,
Div1  Div0  1  g 

The dividend in two periods will be:

Div2  Div1  1  g 
  Div0  1  g    1  g 
 Div0  1  g 
2

If we repeat this process, then:

Divt  Div0  1  g 
t

Thus, the value of a stock under this constant growth dividend is:
Div1 Div2 Div3
P0    
1  r 1  r  1  r 3
2

Div0  1  g  Div0  1  g  Div0  1  g 

2 3

   
1 r 1  r  1  r 
2 3

86
Simplifying the expression,
Div0  1  g  Div0  1  g  Div0  1  g 
2 3

P0    
1 r 1  r  1  r 
2 3

1  g  1  g  2  1  g 3 
 Div0       
 1  r  1  r   1  r  
 1 r   1  g  1  g  2  1  g 3 
  0
P  Div0 1       
 1 g   1  r  1  r   1  r  
 
 1 
 Div0 
1 g 
1  
 1 r 
Div0  1  g 
P0 
rg
Div1

rg

The price of the stock P0 is higher when:

 The expected dividend per share is larger.
 The risk-adjusted discount rate or the required rate of return is lower.
 The expected growth rate of dividend is higher.

Example 6.6

Suppose City Corporation just paid a dividend of $0.50. It is expected to increase its
dividend by 2% per year. If the market requires a return of 15%, how much should the stock
be selling for?

Div0  1  g 
P0 
rg
0.5  1  0.02 

0.15  0.02
 3.92

87
Example 6.7

The next dividend for City Corporation will be $4 per share and it is expected to grow at 6%
per year. The required return is 16%.

What is the current price?

Div1
P0 
rg
4

0.16  0.06
 40

What is the price expected to be in year 4?

Div4  1  g 
P4 
rg


 Div  1  g    1  g 
1
3

rg
4 1.064

0.16  0.06
 50.5

What is the implied return given the change in price during the four year period?

P4  P0  1  r 
4

50.5  40  1  r 
4

 r  6%

This example illustrates that the constant growth model makes the implicit assumption that
the stock price will grow at the same constant rate as the dividend. In this model, both stock
price and dividends grow at g.

88
6.6.3 Nonconstant Growth

To value stock price using zero and constant growth model, the models require the growth
rate must be less than the required return. In reality, however, there are cases where growth
rates can be “supernormal” over some finite length of time.

Example 6.8

Suppose City Corporation is expected to increase dividends by 20% in one year and by 15%
in two years. After that, dividends will increase at a rate of 5% per year indefinitely. If the
last dividend was $1 and the required return is 20%, what is the price of the stock?

Div1  1 1.2  1.2

Div2  1.2  1.15  1.38
Div3  1.38  1.05  1.449

Div1 Div2 P2
P0   
1  r 1  r  1  r 2
2

Div3
Div1 Div2 rg
  
1  r 1  r 2 1  r 2
1.449
1.2 1.38 0.2  0.05
  
1.2 1.22 1.22
 8.67

6.7 Total Return

Div1
Rearranging the dividend growth model P0  , the model implies:
rg
Div1
r g
P0

Div1
This expression tells us that the total return has two components. The first part is
P0
called the dividend yield, and the second part of the return is the capital gain.

89
Example 6.9

Suppose a share of City Corporation is selling for $10.50. It just paid a $1 dividend and
dividends are expected to grow at 5% per year. What is the required return?

Div1
r g
P0
11.05
  0.05
10.5
 15%

6.8 Stock Price and Growth Opportunities

As a CFO, you will be interested to know how your investment decisions are going to affect
the stock price. Let us look at the relationship between stock price and growth opportunities
in the following examples.

Example 6.10

Suppose “Growth Inc.” has an existing asset that generates an expected $5 EPS each year.
The firm pays out part of the earnings and the rest is reinvested. The payout ratio is 0.4, ROE
is 15% and the required rate of return is 12.5%, what is its stock price?

Div  Payout ratio  EPS

 0.4  5
2

g  ROE  b
 0.15  0.6
 0.09

Div1
P0 
rg
2

0.125  0.09
 57.14

90
Example 6.10

Suppose “No-Growth Inc.” has exactly the same asset that generates an expected $5 EPS
each year. This company pays out all its earnings as dividend, what is its stock price?

Since this company pays out all its earnings as dividend,

Div  EPS  5

g  ROE  b
 0.15  0
0

Div1 EPS
P0  
rg r
5

0.125
 40

The difference between the stock price with growth and the stock price without growth is
called the present value of growth opportunities (PVGO).

EPS
P0   PVGO
r
57.14  40  17.14

The stock is like perpetuity if PVGO is 0. $40 is the present value of perpetuity with $5 each
year. It is also called capitalized earnings, or value of assets in place.

The two examples illustrate that stock price has two components:
 Present value of earnings under a no-growth policy.
 Present value of growth opportunities.

91
Example 6.11

City Corporation currently has assets in place that generates x of EBIT in perpetuity. At
time t, there is an investment opportunity I t that gives a return of r * in perpetuity.

Let:
x  EBIT of current activities (perpetuity)
I t  Investment at time t
r *  Return on investment
r  Discount rate

The cash flows of City Corporation will be:

What is the present value of current assets in place?

x
PV0  AIP  
r

What is the present value of income streams from investment at time t?

r * It
PVt  I  
r

92
What is the NPV of the investment at time t?

r * It
NPVt  I    It
r
r*  r
 It
r

What is the NPV of the investment at time 0?

1  r* It 
NPV0  I   t 
 It 
1  r   r 
1  r *  r  
 t   It 
1  r   r  

What is the price of the firm at time 0?

x 1  r *  r  
P0     It 
r 1  r t  r  

If at each year t there is an investment = I t , what will be the price then?

x  1  r *  r  
P0     It 
r t 1 1  r t   r  

Once again, this example shows that the stock price equals the present value of assets in place
plus the net present value of growth opportunities.

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6.8.1 Concluding Remarks

Example 6.11 demonstrates how the investment decisions will affect the stock price. If City
Corporation is satisfied with its current activities by only relying on its current assets in place
x
to generate cash flows, then its stock price will stay at .
r

When City Corporation takes the investment, its stock price will be changed accordingly. In
the case where the investment has a positive NPV ( r *  r ), the stock price will be increased
by such amount. In the previous topic, we always emphasis firms should only accept an
investment when the NPV is greater than zero. Because by undertaking the investment, we
x 1  r *  r   x
can increase the value of the firm as P0     It   .
r 1  r t  r   r

However, the stock price will be decreased when firms undertake a negative NPV investment
( r *  r ). It is always bad to have negative NPV investment since it will destroy the value of
x 1  r *  r   x
the firm. It is better not to undertake the investment as P0     It   .
r 1  r t   r   r

94
7 Topic 7 – Capital Budgeting

So far we have learnt various techniques to evaluate an investment project. We have also
learnt that capital budgeting decisions have a major effect on the value of the firm and its
stock price. The focus of this topic is to setup a complete assessment of the capital budgeting
process. By applying the discounted cash flow analysis, we can determine whether the long-
term capital investments are worth pursuing.

In Topic 6, we have argued why valuing projects by NPV rule can help us to make
investment decisions which are consistent with the principle of maximizing firm value.

Recall that:
n
Ct
NPV    I0
1  r 
t
t 1

In order to compute the NPV of an investment project, the general capital budgeting
procedures involve:

1. Analyze the project cash flows.

2. Estimate the appropriate discount rate.

3. Consider other strategic options if any.

We are going to start bringing all these steps together.

7.1 Identify the Project Cash Flows

The first part of the capital budgeting process is to estimate the cash flows associated with the
project. To analyze the project cash flows, we have to:

1. Identify a project’s relevant cash flows.

2. Calculate initial investment outlay, operating cash flows and terminal cash flows for asset
expansion and asset replacement project.

3. Determine the effects of depreciation on after-tax cash flows.

4. Separate the investment decision from the financing decision and distinguish between
project flows and financing flows.

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7.1.1 Relevant Cash Flows

What are the relevant cash flows for a project? To answer this question, we need to employ a
number of principles and concepts.

1. The Stand-alone Principle

 A project’s relevant cash flows can be calculated by comparing the total future
cash flows of the firm “with” and “without” the project.
 In practice, comparing the “with” and “without” the project’s cash flows would be
very cumbersome.
 The stand-alone principle suggests that only the project’s incremental cash flows
need to be considered.

2. Opportunity Cost
 When a firm undertakes a project, various resources will be used and not be
available for other projects.
 The cost to the firm of not being able to use these resources for other projects is
referred to as an opportunity cost.
 The opportunity cost is the value of the most valuable alternative that is given up
if the proposed investment project is undertaken.

Example 7.1

City Corporation proposes to establish a new call center. The call center will be located
within the office building that the firm already owns. The estimated rental of the office space
is $300,000 per year. The space has not been rented in the past, but it is expected to be rented
in the future.

Since City Corporation will lose $300,000 “with” the project, the opportunity cost is
$300,000 per year in rent forgone and it should be included as a cash outflow.

Suppose City Corporation has no intention to rent and sell the office space in the future, in
this situation, the $300,000 will not be included as a cash outflow.

3. Sunk Cost
 A sunk cost is an amount spent in the past but which cannot now be recovered by
the current decision.
 Sunk costs are past and irreversible. They should not be included in the cash
flows.

96
Example 7.2

Two years ago, City Corporation hired a consultancy firm to do a marketing study in online
shopping at a cost of $20,000. And now it is planning to develop an online ordering site for
its latest product. Should the cost be included in the project’s cash flows?

No. This money cannot be recovered whether the proposed project is undertaken or not.

7.2 Compute the Project Cash Flows

Capital budgeting relies heavily on pro forma accounting statements. Recall from Topic 2:

Cash Flow from Assets  Operating Cash Flow

 Net Capital Spending
Change in Net Working Capital

We consider these items one by one.

7.2.1 Operating Cash Flow

Suppose City Corporation can sell 50,000 units of goods per year at a price of $4 each. Each
good is cost about $2.5 to produce. The fixed cost for the project is $12,000 per year. It also
requires an investment of $90,000 in new equipment. The equipment can perform for three
years and will be worthless afterwards. This project has three-year life. Tax rate is 34%.

Consider the pro forma income statement for illustration.

Sales (50,000 units at $4.00/unit) 200,000

Variable Costs ($2.50/unit) 125,000
Gross profit 75,000
Fixed costs 12,000
Depreciation ($90,000/3) 30,000
EBIT 33,000
Taxes (34%) 11,220
Net Income 21,780

97
We have three approaches to calculate operating cash flow (OCF).

1. The Top-down Approach

OCF  Sales  Costs  Taxes

 200, 000  125, 000  12, 000  11, 220
 51, 780

2. The Bottom-up Approach

OCF  Net Income  Depreciation

 21, 780  30, 000
 51, 780

3. The Tax Shield Approach

OCF   Sales  Costs   1  T   Depreciation  T

  200, 000  125, 000  12, 000   1  0.34   30, 000  0.34
 51, 780

All the three approaches give you the same OCF. The best one to use is whichever happens
to be the most convenient for the problem at hand.

98
7.2.2 Depreciation

We have two approaches to calculate depreciation.

1. Straight-line
 Depreciation   Initial Cost  Salvage   No of Years

Example 7.3

You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed.
Based on past information, you believe that you can sell the equipment for $17,000 when you
are done with it in 6 years. What is the depreciation suppose the appropriate schedule is
straight-line?

Depreciation   Initial Cost  Salvage   No of Years

 100, 000  10, 000  17, 000   6
 15,500

2. Modified Accelerated Cost Recovery System (MACRS)

 Need to know which asset class is appropriate for tax purposes.
 Multiply MACRS percentage by the initial cost.
 Depreciate to zero.

The MACRS Property Classes

3-year Equipment used in research
5-year Autos and computers
7-year Most industrial equipment

MACRS Table
Year 3-year 5-year 7-year 10-year
1 0.333 0.200 0.143 0.100
2 0.445 0.320 0.245 0.180
3 0.148 0.192 0.175 0.144
4 0.074 0.115 0.125 0.115
5 0.115 0.089 0.092
6 0.058 0.089 0.074
7 0.089 0.066
8 0.045 0.066
9 0.065
10 0.065
11 0.033

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Example 7.4

You purchase a car costing $12,000. What is the depreciation schedule if you apply MACRS?

Autos are classified as 5-year property. The depreciation each year is:

Year MACRS Percentage Depreciation

1 0.200
2 0.320
3 0.192
4 0.115
5 0.115
6 0.058
0.200 × 12,000 = 2,400.00
0.320 × 12,000 = 3,840.00
0.192 × 12,000 = 2,304.00
0.115 × 12,000 = 1,380.00
0.115 × 12,000 = 1,380.00
0.058 × 12,000 = 696.00

Notice that the MACRS percentages sum up to 100%. As a result, you write off $12,000 of
the cost of the asset.

7.2.3 After Tax Salvage

If the salvage value is different from the book value of the asset, then there is a tax effect.

The definition:
Book Value = Initial Cost – Accumulated Depreciation

After Tax Salvage = Salvage – T × (Salvage – Book Value)

Example 7.5

Suppose you want to sell your car after five years. The sale price is $3,000 at year 5 and the
tax rate is 34%. What is the after tax salvage?

Year Beginning Book Value Depreciation Ending Book Value

1 12,000 2,400 9,600
2 9,600 3,840 5,760
3 5,760 2,304 3,456
4 3,456 1,380 2,076
5 2,076 1,380 696
6 696 696 0

After Tax Salvage  3,000  0.34   3,000  696  2, 216.64

100
Example 7.6

Consider a replacement problem. City Corporation has an old machine purchased 5 years
ago. The initial cost of this old machine is $100,000. The annual depreciation is $9,000.
The salvage today is $65,000. If the machine is used for another 5 years, the salvage in 5
years will be $10,000.

If City Corporation decides to replace the old machine, the new machine will cost $150,000
and is last for 5 years. Depreciation follows 3-year MACRS. Salvage in 5 years will be zero.
This new machine helps saving $50,000 cost per year. The required return is 10% and the tax
rate is 40%.

Should City Corporation replace the machine?

Remember that we are interested in incremental cash flows. If we buy the new machine, then
we will sell the old machine.

First, we have to look at the cash flow consequences of selling the old machine today instead
of in 5 years. Then, figure out the OCF.

Year 1 Year 2 Year 3 Year 4 Year 5

Cost Saving 50,000 50,000 50,000 50,000 50,000

Depreciation
- New 49,950 66,750 22,200 11,100 0
- Old 9,000 9,000 9,000 9,000 9,000
Incremental 40,950 57,750 13,200 2,100 -9,000

EBIT 9,050 -7,750 36,800 47,900 59,000

Tax 3,620 -3,100 14,720 19,160 23,600
NI 5,430 -4,650 22,080 28,740 35,400

OCF 46,380 53,100 35,280 30,840 26,400

= NI + Dep

Second, we have to deal with the incremental net capital spending.

Year 0 Year 5
Cost of New Machine -150,000
After Tax Salvage (Old Machine) 61,000 -10,000
= Salvage – T × (Salvage – Book Value)
Incremental Net Capital Spending -89,000 -10,000

101
Third, we can compute the cash flow from assets.

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

OCF 46,380 53,100 35,280 30,840 26,400
NCS -89,000 -10,000
NWC 0 0
-89,000 46,380 53,100 35,280 30,840 16,400

Finally, we can compute the NPV and IRR based on the cash flows we have.

NPV = 54,801
IRR = 36.27%

7.2.4 Changes in Net Working Capital

Recall that net working capital (NWC) is the difference between current assets and current
liabilities.

Changes in NWC  NWCt  NWCt 1

An investment in net working capital arises when:

1. Inventory is purchased.

2. Cash is kept in the project as a buffer against unexpected expenditure.

3. Credit sales are made and therefore generated accounts receivable rather than cash.

4. Credit purchases are made and therefore generated accounts payable rather than cash.

102
7.3 A Comprehensive Example

City Corporation is planning to expand its business in manufacturing fine zithers. The
market for zithers is growing quickly. The firm bought some land three years ago for $1.4
million in anticipation of using it as a toxic waste dump site but has recently hired another
firm to handle all toxic materials. Based on a recent appraisal, the firm believes it could sell
the land for $1.5 million on an after tax basis. In four years, the land could be sold for $1.6
million after taxes. The firm also hired a marketing firm to analyze the zither market, at a
cost of $125,000. An excerpt of the marketing report is as follows:

“The zither industry will have a rapid expansion in the next four years. With the brand name
recognition that City Corporation brings to bear, we feel that the company will be able to sell
3,200, 4,300, 3,900 and 2,800 units each year for the next four years respectively. Again,
capitalizing on the name recognition of City Corporation, we feel that a premium price of
$780 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of
the four-year period, sales should be discontinued.”

City Corporation believes that fixed costs for the project will be $425,000 per year, and
variable costs are 15% of sales. The equipment necessary for production will cost $4.2
million and will be depreciated according to a three-year MACRS schedule below. At the
end of the project, the equipment can be scrapped for $400,000. Net working capital of
$125,000 will be required immediately. City Corporation has a 38% tax rate, and the
required return on the project is 13%. What is the NPV of the project? Assume the firm has
other profitable projects.

Exhibit 7.1

MACRS Schedule
Year 3-year
1 33.33%
2 44.45%
3 14.81%
4 7.41%

103
We will begin by calculating the after tax salvage value of the equipment at the end of the
project’s life. The after tax salvage value is the market value of the equipment minus any
taxes paid (or refunded), so the after tax salvage value in four years will be:

After Tax Salvage = Salvage – T × (Salvage – Book Value)

= 400,000 – 0.38 × (400,000 – 0)
= 248,000

Now we need to calculate the operating cash flow each year. Using the bottom up approach
to calculating operating cash flow, we find:

Year 0 Year 1 Year 2 Year 3 Year 4

Revenues 2,496,000 3,354,000 3,042,000 2,184,000
Fixed costs 425,000 425,000 425,000 425,000
Variable costs 374,400 503,100 456,300 327,600
Depreciation 1,399,860 1,866,900 622,020 311,220
EBT 296,740 559,000 1,538,680 1,120,180
Taxes 112,761 212,420 584,698 425,668
Net income 183,979 346,580 953,982 694,512

OCF 1,583,839 2,213,480 1,576,002 1,005,732

Capital spending –4,200,000 248,000

Land –1,500,000 1,600,000
NWC –125,000 125,000

Total cash flow –5,825,000 1,583,839 2,213,480 1,576,002 2,978,732

Notice the calculation of the cash flow at time 0. The capital spending on equipment and
investment in net working capital are cash outflows are both cash outflows. The after tax
selling price of the land is also a cash outflow. Even though no cash is actually spent on the
land because the company already owns it, the after tax cash flow from selling the land is an
opportunity cost, so we need to include it in the analysis. The company can sell the land at
the end of the project, so we need to include that value as well. With all the project cash
flows, we can calculate the NPV, which is:

NPV = 229,266.82

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7.4 Evaluating NPV Estimates

NPVs are just estimates. There are two primary reasons for a positive NPV:
 We have constructed a good project.
 We have done a bad job of estimating NPV.

A positive NPV is a good start. Now we need to take a closer look on forecasting risk. How
sensitive is our NPV to changes in the cash flow estimates. The more sensitive is the
estimate, the greater will be the forecasting risk.

7.4.1 Scenario Analysis

One basic approach to evaluating cash flow and NPV estimates involves asking what-if
questions. What happens to the NPV under different cash flow scenarios?

At the very least, we can look at:

 Best case – high revenues, low costs.
 Worst case – low revenues, high costs.

We can measure the range of possible outcomes. Although best case and worst case are not
necessarily probable, they can still be possible.

Example 7.7

The project under consideration costs $200,000, has a five-year life, and has no salvage value.
Depreciation is straight line to zero. The required return is 12% and the tax rate is 34%. In
addition, we have the following information:

Base Case Lower Bound Upper Bound

Unit sales 6,000 5,500 6,500
Price per unit 80 75 85
Variable costs per unit 60 58 62
Fixed costs per unit 50,000 45,000 55,000

105
Based on the information, we can establish three possible scenarios.

Base Case Worst Case Best Case

Unit sales 6,000 5,500 6,500
Price per unit 80 75 85
Variable costs per unit 60 62 58
Fixed costs per unit 50,000 55,000 45,000

We can apply the tax shield approach to compute the operating cash flows for each scenario.

OCF  Sales  Costs   1  T   Depreciation  T

OCF  Base    480, 000  360, 000  50, 000   1  0.34   40, 000  0.34
 59,800

OCF  Worst    412,500  341, 000  55, 000   1  0.34   40, 000  0.34
 24, 490

OCF  Best    552,500  377, 000  45, 000   1  0.34   40, 000  0.34
 99, 730

Once we have the OCF, we can calculate the NPV. Noted that the five-year annuity factor is
 1  1 
 1     3.6048 .
 0.12  1.12   
5

NPV  Base   200, 000  59,800  3.6048

 15,567.04

NPV Worst   200, 000  24, 490  3.6048

 111, 718.45

NPV  Best   200, 000  99, 730  3.6048

 159,506.70

106
In summary,

Scenario Cash Flow NPV IRR

Base Case 59,800 15,567 15.1%
Worst Case 24,490 -111,718 -14.4%
Best Case 99,730 159,506 40.9%

7.4.2 Sensitivity Analysis

A subset of scenario analysis is to look at the specific variables on NPV. That is, what
happens to NPV when only one variable is changed at a time?

The greater the volatility in NPV in relation to a specific variable, the larger the forecasting
risk associated with that variable, and the more attention we want to pay to its estimation.

The basic idea with a sensitivity analysis is to freeze all of the variables except one and then
see how sensitive our estimate of NPV is to changes in that variable.

Example 7.8

We follow the same setting as in Example 7.7. We perform a sensitivity analysis by freezing
all variables except unit sales.

Base Case Worst Case Best Case

Unit sales 6,000 5,500 6,500
Price per unit 80 80 80
Variable costs per unit 60 60 60
Fixed costs per unit 50,000 50,000 50,000

Scenario Cash Flow NPV IRR

Base Case 59,800 15,567 15.1%
Worst Case 53,200 -8,225 10.3%
Best Case 66,400 39,359 19.7%

107
Graphical illustration:

50000

40000

30000

20000
NPV
10000

0
5,400 5,600 5,800 6,000 6,200 6,400 6,600
-10000

-20000
Unit Sales

The drawback of scenario and sensitivity analysis is that both methods are useful for pointing
out where forecasting errors will do the most damage, but they do not tell us what to do about
possible errors.

A final thought:
 At some point, you have to make a decision.
 If the majority of your scenarios have positive NPVs, then you can feel reasonably
comfortable about accepting the project.
 If you have a crucial variable that leads to a negative NPV with a small change in the
estimates, then you may want to forgo the project.

108
7.5 Case Study – Danforth & Donnalley Laundry Products Company

On April 14, 1993, at 3:00 p.m., James Danforth, President of Danforth & Donnalley (D&D)
Laundry Products Company, called to order a meeting of the financial directors. The purpose
of the meeting was to make a capital budgeting decision with respect to the introduction and
production of a new product, a liquid detergent called Blast.

D&D was formed in 1968 with the merger of Danforth Chemical Company, headquartered in
Seattle, Washington, producers of Lift-Off detergent, the leading laundry detergent on the
West Coast, and Donnalley Home Products Company, headquartered in Detroit, Michigan,
makers of Wave detergent, a major midwestern laundry product. As a result of the merger,
D&D was producing and marketing two major product lines. Although these products were
in direct competition, they were not without product differentiation: Lift-Off was a low-suds,
concentrated powder, and Wave was a more traditional powdered detergent. Each line
brought with it considerable brand loyalty, and by 1993, sales from the two detergent lines
had increased tenfold from 1968 levels, with both products now being sold nationally.

In the face of increased competition and technological innovation, D&D spent large amounts
of time and money over the past four years researching and developing a new, highly
concentrated liquid laundry detergent. D&D’s new detergent, which they called Blast, had
many obvious advantages over the conventional powdered products. It was felt that with
Blast the consumer would benefit in three major areas. Blast was so highly concentrated that
only 2 ounces were needed to do an average load of laundry as compared with 8 to 12 ounces
of powdered detergent. Moreover, being a liquid, it was possible to pour Blast directly on
stains and hard-to-wash spots, eliminating the need for a pre-soak and giving it cleaning
abilities that powders could not possibly match. And, finally, it would be packaged in a
lightweight, unbreakable plastic bottle with a sure-grip handle, making it much easier to use
and more convenient to store than the bulky boxes of powdered detergents with which it
would compete.

The meeting was attended by James Danforth; Jim Donnalley, director of the board; Guy
Rainey, vice-president in charge of new products; Urban McDonald, controller; and Steve
Gasper, a newcomer to D&D’s financial staff, who was invited by McDonald to sit in on the
meeting. Danforth called the meeting to order, gave a brief statement of its purpose, and
immediately gave the floor to Guy Rainey.

Rainey opened with a presentation of the cost and cash flow analysis for the new product. To
keep things clear, he passed out copies of the projected cash flows to those present (see
Exhibits 7.2 and 7.3). In support of this information, he provided some insight as to how
these calculations were determined. Rainey proposed that the initial cost for Blast included
$500,000 for the test marketing, which was conducted in the Detroit area and completed in
the previous June, and $2 million for new specialized equipment and packaging facilities.
The estimated life for the facilities was 15 years, after which they would have no salvage
value. This 15-year estimated life assumption coincides with company policy set by

109
Donnalley not to consider cash flows occurring more than 15 years into the future, as
estimates that far ahead "tend to become little more than blind guesses."

Rainey cautioned against taking the annual cash flows (as shown in Exhibit 7.2) at face value
because portions of these cash flows actually are a result of sales that had been diverted from
Lift-Off and Wave. For this reason, Rainey also produced the annual cash flows that had
been adjusted to include only those cash flows incremental to the company as a whole (as
shown in Exhibit 7.3).

At this point, discussion opened between Donnalley and McDonald, and it was concluded
that the opportunity cost on funds is 10%. Gasper then questioned the fact that no costs were
included in the proposed cash budget for plant facilities, which would be needed to produce
the new product.

Exhibit 7.2
D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast
(Including flows resulting from sales diverted from the existing product lines)

Year Cash Flows Year Cash Flows

1 280,000 9 350,000
2 280,000 10 350,000
3 280,000 11 250,000
4 280,000 12 250,000
5 280,000 13 250,000
6 350,000 14 250,000
7 350,000 15 250,000
8 350,000

Exhibit 7.3
D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast
(Not including those flows resulting from sales diverted from the existing product lines)

Year Cash Flows Year Cash Flows

1 250,000 9 315,000
2 250,000 10 315,000
3 250,000 11 225,000
4 250,000 12 225,000
5 250,000 13 225,000
6 315,000 14 225,000
7 315,000 15 225,000
8 315,000

Rainey replied that, at the present time, Lift-Off’s production facilities were being used at
only 55% of capacity, and because these facilities were suitable for use in the production of
Blast, no new plant facilities other than the specialized equipment and packaging facilities

110
previously mentioned need be acquired for the production of the new product line. It was
estimated that full production of Blast would require only 10% of the plant capacity.

McDonald then asked if there had been any consideration of increased working capital needs
to operate the investment project. Rainey answered that there had and that this project would
require $200,000 of additional working capital; however, as this money would never leave
the firm and always would be in liquid form, it was not considered an outflow and hence was
not included in the calculations.

Donnalley argued that this project should be charged something for its use of the current
excess plant facilities. His reasoning was that, if an outside firm tried to rent this space from
D&D, it would be charged somewhere in the neighborhood of $2 million, and since this
project would compete with the current projects, it should be treated as an outside project and
charged as such; however, he went on to acknowledge that D&D has a strict policy that
forbids the renting or leasing out of any of its production facilities. If they didn’t charge for
facilities, he concluded, the firm might end up accepting projects that under normal
circumstances would be rejected.

From here, the discussion continued, centering on the questions of what to do about the "lost
contribution from other projects," the test marketing costs, and the working capital.

1. If you were put in the place of Steve Gasper, would you argue for the cost from market
testing to be included as a cash outflow?

2. What would your opinion be as to how to deal with the question of working capital?

3. Would you suggest that the product be charged for the use of excess production facilities
and building?

4. Would you suggest that the cash flows resulting from erosion of sales from current
laundry detergent products be included as a cash inflow? If there were a chance of
competition introducing a similar product if you do not introduce Blast, would this affect
your answer?

5. What are the NPV, IRR, and PI of this project, including cash flows resulting from lost
sales from existing product lines? What are the NPV, IRR, and PI of this project
excluding these flows? Under the assumption that there is a good chance that competition
will introduce a similar product if you do not, would you accept or reject this project?

111
1. No. The cash flows associated with test marketing have already occurred at the time of
the case and as such should be considered "sunk costs." Within the capital budgeting
decision we are only interested in incremental cash flows on an after-tax basis. This flow
is clearly not incremental; regardless of the decision with respect to acceptance or
rejection of the project, this cash outflow will remain. At an earlier date, prior to the
occurrence of this expenditure, it should have been included as a cash outflow in the
evaluation of this project, but after its occurrence, it is no longer an incremental cash flow.

2. While major cash outflows for most projects will be associated with plant and equipment
expenditures, many times these expenditures will be accompanied by an increase in
working capital needs. These increased needs are those associated with funds needed for
inventories, payroll, and other cash needs and receivables from customers. As increased
working capital needs involve the tying up of funds over the life of the project, they
should be considered as cash outflows with the residual working capital being recovered
at the termination of operations. In this case, the $200,000 needed for working capital
should be considered an initial outflow and also an inflow at the end of the life of the
project in year 15. At this point, some students may still feel that the investment and
subsequent recovery of funds will balance each other out; here it should be emphasized
that the present value equivalents of these flows are far from equal.

3. Since the production of Blast will occupy current excess capacity, no incremental cash
flows are incurred; hence, none should be charged against Blast.

4. In a strict sense, cash flows resulting from lost sales to the existing product line should
not be included as a cash inflow. These cash flows are not incremental in that if the
project is not accepted, they will occur anyway. If it seems likely that a competitor may
introduce a similar product, the approach to market erosion from existing product lines
may change. In this case, the market erosion may exist whether or not the new project is
introduced; hence, the cash flows may be incremental. In the laundry detergent industry,
where the competition is vigorous, this may in fact be a rational assumption. Thus, if
cash flows from sales erosion are not considered, it may result in the rejection of a project
which would be acceptable to a competitor, resulting in the subsequent introduction of
this product by competition. Hence, the sales erosion of the existing product lines may no
longer be dependent upon the introduction of Blast. In summary, the question seems to
boil down to the ability and likelihood of competition introducing a similar product.

112
5. If the introduction of a similar product by competition is likely, then cash flows from
sales erosion of the existing product line should be included; hence, the project should be
accepted as it has a positive NPV, PI > 1 and the IRR > opportunity rate.

Including Flows from Excluding Flows From

Year Sales Erosion of Existing Line Sales Erosion of Existing Line
0 -2,200,000 -2,200,000

1–5 280,000 × (3.7908) 250,000 × (3.7908)

6 – 10 350,000 × (6.1446 - 3.7908) 315,000 × (6.1446 - 3.7908)

11 – 15 250,000 × (7.6061- 6.1446) 225,000 × (7.6061 - 6.1446)

15 200,000 × (0.2394) 200,000 × (0.2394)

NPV = 98,507 NPV = -134,138

PI = 1.0447 PI = 0.9390

IRR = A little less than 11% IRR = 9%

113
8 Topic 8 – Market Efficiency

We have spent much of our effort to learn how to spend the money by making good capital
budgeting decisions. In the previous topics, we often assume firms have sufficient money for
their projects. In practice, firms always need external funding. It is the time to start putting
our effort to learn how to raise money to finance the capital investments.

8.1 Differences between Investment and Financing Decisions

As a competent CFO, you have already known by undertaking positive NPV projects, you
can create value for the firm. But have you ever think of where might the value come from?

The following are some project characteristics that might be associated with positive NPVs:
 Economies of scale.
 Product differentiation.
 Cost advantages.
 Access to distribution channels.
 Favorable government policy.

Example 8.1

You realize investment and financing decisions are closely related. Suppose your firm has a
project which yields perpetuity of $1 every year. This discount rate for the project is 10%.
The required initial capital outlay is $5.

The NPV of the project:

1
NPV  5 
0.1
5

Suppose your firm has $5 to take this project, then the entire $5 NPV will belong to your firm.
What if your firm only has $3 and needs to sell 40% of the ownership to a new investor in
order to raise the additional $2, is the equity fairly priced?

Once the new investors provide you the additional $2, you will take the project as the NPV is
positive. The new investor will entitle 40% of the project’s NPV, which is $2 ( 40%  $5 ).

In this example, the financing activity has a zero NPV.

114
But why the financing activity has a zero NPV? Before we look at the answer of this
question, let us think about the implications behind the zero NPV.

A zero NPV in financing means the equity issued by the firm is fairly priced. In the example
above, the 40% ownership is worth $2. As a new investor, you are willing to pay for $2 or
less in exchange for the 40% ownership. However, the firm is only willing to sell you its
shares at $2 or more.

If there is trade between the firm and the new investor, we know the shares will be eventually
settled at $2 and both party can only make a zero NPV deal at the end.

Now, the key question becomes “Are securities fairly priced?”

8.2 Efficient Capital Markets

An efficient capital market is one in which stock prices fully reflect available information.
Efficiency here means informational efficiency.

An efficient market refers to a market in which information is widely available to investors

and all relevant information is already reflected in security prices – prices are “right” at any
time.

Any new information disseminates quickly and is instantly reflected in share prices.

Efficient market is an important component of a capitalist system.

 The ideal is a market where prices are accurate signals for capital allocation.
 Prices of securities must be good indicators of value.

115
Example 8.2

Reaction of stock price to new information in efficient and inefficient markets:

8.2.1 Implications of the Efficient Market Hypothesis

From the investor point of view:

 Investors may hope for superior returns but all they can rationally expect in an
efficient market is that they shall obtain a return that is just sufficient to compensate
them for the time value of money and for the risks they bear.

In the words of The Economist (December 5, 1992):

 Because prices are “efficient” – they reflect all available facts. Future prices differ
from current prices only if buyers or sellers get new information. This by definition,
is random. But why should prices be efficient? Put simply, if they are not, it means
the market is ignoring price-sensitive information. But this gives whoever has that
information a chance to make big profits by trading on it. As soon as he does so, the
overlooked information is incorporated in the price. This will make it “efficient”.

116
8.2.2 Three Forms of Market Efficiency

Weak form of market efficiency:

 Stock prices fully reflect all information contained in past prices and volume.
 Stock price movements are independent of what happened in the past.

Semi-strong form of market efficiency:

 Stock prices fully reflect all publicly available information.
 Publicly available information includes historic prices and published accounting
statements.

Strong form of market efficiency:

 Stock prices fully reflect all information, public or private.

8.2.3 Weak Form Efficiency

Debate on market efficiency began with the discovery that stock prices seem to follow a
random walk. Random walk means the past movement or trend of a stock price cannot be
used to predict its future movement.

Technical analysts argue that patterns of past stock prices repeat themselves. Proper charting
of prices and perhaps related series like volume will detect when a shift has occurred.

If a market is weak form efficient, it is impossible to make consistent superior returns by

technical analysis.

117
8.2.4 Semi-strong Form Efficiency

Prices incorporate all publicly available information contained in accounting statements and
in past stock prices, stock returns and trading volume.

Fundamental analysts study firm and industry fundamentals and try to judge whether a stock
is under- or over-valued.

If a market is semi-strong form efficient, then:

 It is impossible to make consistent superior returns by fundamental analysis.
 Markets and stock prices react exceptionally fast to the release of information. That
is, profit opportunities disappear fairly quickly before they become publicly known.

8.2.5 Strong Form Efficiency

Prices incorporate all information, public or private. Anything pertinent to the stock and
known to at least one investor is already incorporated into the stock price.

If a market is strong form efficient, it is impossible to make consistent superior returns from
insider information.

8.2.6 Concluding Remarks

The efficient market hypothesis answers the key question “Are securities fairly priced?” If
market is efficient then price impound all information about the value of each stock.
Therefore, on one can earn a positive NPV in any financing schemes.

118
9 Topic 9 – Risks and Returns

The efficient market hypothesis discussed in Topic 8 provided us a foundation in examining

stock price. In this topic, we wish to investigate the stock price behavior and explore the
managerial implications behind risks and returns.

9.1 Risk, Return and Investment Decision

Since financial resources are finite, there is a hurdle that projects have to cross before being
deemed acceptable. Recall that the IRR investment rule is to accept a project where the IRR
is greater than the required return. We can label this required return as the hurdle rate.

An intuitive notion is that this hurdle rate will be higher for riskier projects than for safer
projects. Before we look at the hurdle rate in details, we can first draw a simple
representation:

Hurdle Rate = Risk-free Return + Risk Premium

Then the two basic questions arise:

1. How do we measure risk and return?

2. How do we translate the risk measure into a risk premium?

9.2 Returns

9.2.1 Dollar Returns

Total Dollar Return = Income from Investment + Capital Gain (Loss)

Example 9.1

You bought a bond for $950 one year ago. You have received two coupons of $30 each.
You can sell the bond for $975 today. What is your total dollar return?

Income = 30 + 30 = 60
Capital gain = 975 – 950 = 25
Total dollar return = 60 + 25 = 85

119
9.2.2 Percentage Returns

It is generally more intuitive to think in terms of percentages than dollar returns.

Total Percentage Return = Dividend Yield + Capital Gains Yield

Divt   Pt  Pt 1 
rt 
Pt 1
Divt Pt  Pt 1
 
Pt 1 Pt 1

Example 9.2

You bought a stock for $35 and you received dividends of $1.25. The stock is now selling
for $40. What is your dollar return?

Dollar return = 1.25 + (40 – 35) = $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%

120
9.2.3 The Historical Record

Lessons from capital market history:

 Small stocks had the highest long-term returns while treasury bills had the lowest
long-term returns.
 Small stocks had the largest fluctuations in price while treasury bills had the lowest
fluctuations.

121
Average returns of different classes of financial assets:

Investment Average Return

Large Stocks 12.3%
Small Stocks 17.4%
Long-term Corporate Bonds 6.2%
Long-term Government Bonds 5.8%
U.S. Treasury Bills 3.8%
Inflation 3.1%

9.2.4 Arithmetic and Geometric Returns

To calculate the return over multiple periods, we can either compute arithmetic or geometric
return.

Arithmetic return is the return earned in an average period over multiple periods.

Geometric return is the average compound return per period over multiple periods.

Example 9.3

What are the arithmetic and geometric averages for the following returns: Year 1 = 5%, Year
2 = -3% and Year 3 = 12%?

0.05   0.03  0.12

Arithmetic return   4.67%
3

Geometric return  1  0.051  0.031  0.12 

1
3
 1  4.49%

Note that the geometric return will be less than the arithmetic return unless all the returns are
equal.
 The arithmetic return is optimistic for long horizons.
 The geometric return is pessimistic for short horizons.

122
9.3 Risks

9.3.1 Risk Premiums

Risk premium is the “extra” return earned for taking on risk. We usually consider treasury
bills to be risk-free.

The risk premium is the return over and above the risk-free rate.

Investment Average Return Risk Premium

Large Stocks 12.3% 12.3 – 3.8 = 8.5%
Small Stocks 17.4% 17.4 – 3.8 = 13.6%
Long-term Corporate Bonds 6.2% 6.2 – 3.8 = 2.4%
Long-term Government Bonds 5.8% 5.8 – 3.8 = 2.0%
U.S. Treasury Bills 3.8% 3.8 – 3.8 = 0%

9.3.2 Variance and Standard Deviation

We use variance and standard deviation to measure the volatility of asset returns. The greater
the volatility, the greater the uncertainty will be.

Variance is the sum of squared deviations from the mean divided by the number of
observations minus one.

1 T
Var    ri  r 
2

T  1 i 1

Standard deviation is the square root of the variance.

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Example 9.4

A stock has a return of 15% in Year 1, 9% in Year 2, 6% in Year 3 and 12% in Year 4. What
are the variance and standard deviation of this stock?

The mean return:

0.15  0.09  0.06  0.12
r
4
 0.105

Year Actual Return Mean Return Deviation from Mean Squared Deviation
1 0.15 0.105 0.045 .002025
2 0.09 0.105 -0.015 .000225
3 0.06 0.105 -0.045 .002025
4 0.12 0.105 0.015 .000225
Total 0.42 .0045

The variance:
1 T
Var    ri  r 
2

T  1 i 1
1
 .0045
4 1
 .0015

The standard deviation:

sd  Var
 .0015
 0.03873

9.4 Expectation

In reality, the stock price in future is an unknown. We now begin to discuss how to analyze
returns and variances when the information we have concerns future possible returns and
their probabilities.

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9.4.1 Expected Returns

Expected returns are based on the probabilities of possible outcomes. The expected return
does not even have to be a possible return.

N
E  r    pi  ri
i 1

Example 9.5

Suppose you have predicted the following returns for Stocks C & T in three possible states of
nature. What are the expected returns?

State Probability Stock C Stock T

Boom 0.3 0.15 0.25
Normal 0.5 0.10 0.20
Recession 0.2 0.02 0.01

E  rC   0.3  0.15  0.5  0.1  0.2  0.02

 9.9%

E  rT   0.3  0.25  0.5  0.2  0.2  0.01

 17.7%

9.4.2 Expected Variance and Standard Deviation

Using unequal probabilities for the entire range of possibilities, expected variance and
standard deviation still measure the volatility of returns.

N
 2   pi   ri  r 
2

i 1

125
Example 9.6

Consider the previous example. What are the variance and standard deviation for each stock?

 C2  0.3  0.15  0.099   0.5  0.1  0.099   0.2  0.02  0.099 

2 2 2

 0.002029
 C  0.045

 T2  0.3  0.25  0.177   0.5  0.2  0.177   0.2  0.01  0.177 

2 2 2

 0.007441
 T  0.086

9.5 Portfolio Risks and Returns

If we hold more than one stock, we are holding a portfolio.

9.5.1 Portfolio Expected Returns

The expected return of a portfolio is the weighted average of the expected returns of the
respective stocks in the portfolio.

E  rp    wi  E  ri 
N

i 1

Example 9.7

Suppose you have $15,000 to invest and you have purchased stocks in the following amounts.

Stock Amount Return

A 2,000 19.65%
B 3,000 8.96%
C 4,000 9.67%
D 6,000 8.13%

What is the expected return for the portfolio?

E  rp  
2, 000 3, 000 4, 000 6, 000
19.65%   8.96%   9.67%   8.13%   10.24%
15, 000 15, 000 15, 000 15, 000

126
9.5.2 Systematic and Unsystematic Risks

When an investor buys a stock, he is exposed to many risks. Some risks may only affect one
or a few firms, and this risk is categorized as unsystematic or firm specific risk. Any price
fluctuation due to a piece of good or bad news about an individual firm is an example of
unsystematic risk.

There is another risk that is much more pervasive and affects many investments. We term
this risk systematic or market risk. News that affects all stocks, such as news about the
economy is an example of systematic risk.

9.5.3 Diversification

When many stocks are combined in a large portfolio, the firm specific risks for each stock
will average out and be diversified. The systematic risk, however, will affect all firms and
will not be diversified. To illustrate the diversification effect, we can create portfolios with
different number of stocks and compute their corresponding standard deviation1.

1
 n n  2
1
The standard deviation of a portfolio can be calculated by  p    wi w j ij  , where  ij is the covariance
 i 1 j 1 
between stock i and j.

127
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 stock are offset by better-than-expected returns from another stock.
However, there is a minimum level of risk that cannot be diversified away – that is the
systematic portion.

9.5.4 Decomposition of Total Risk

The total risk of a stock:

Total Risk = Systematic Risk + Unsystematic Risk

The standard deviation of returns is a measure of total risk. If we hold only one single stock,
we are going to bear both the systematic and unsystematic risk. But if we hold a well-
diversified portfolio, unsystematic risk is very small. Consequently, the total risk for a
diversified portfolio is essentially equivalent to the systematic risk.

Noted that according to the systematic risk principle,

 There is a reward for bearing risk.
 There is not a reward for bearing risk unnecessarily.
 The expected return on a stock depends only on that stock’s systematic risk since
unsystematic risk can be diversified away.

128
9.5.5 Measuring Systematic Risk

Because systematic risk is the crucial determinant of a stock’s expected return, we need some
way of measuring the level of systematic risk.

How do we measure systematic risk?

 We use the beta coefficient to measure systematic risk.
 A beta of 1 implies the stock has the same systematic risk as the overall market.
 A beta < 1 implies the stock has less systematic risk than the overall market.
 A beta > 1 implies the stock has more systematic risk than the overall market.

The idea of beta coefficient is to measure the sensitivity of co-movement between individual
stock return and market return.

Example 9.8

Consider the following information:

Stock Standard Deviation Beta

C 20% 1.25
K 30% 0.95

Which stock has more total risk?

Which stock has more systematic risk?

Which stock should have the higher expected return?

9.5.6 Beta and the Risk Premium

The systematic risk principle says there is a reward for bearing systematic risk. If you
purchase a low beta stock (beta < 1), then you are expected to get a return that is lower than
the market return. But if you purchase a high beta stock (beta > 1), then you are expected to
get a return that is higher than the market return.

Remember that:

Expected Return = Risk-free Return + Risk Premium

The higher the beta, the greater the risk premium should be, and also the greater will be the
expected return.

129
We can illustrate the link between beta and expected return.

Consider 3 stocks: T-bills, S&P500 and Apple Inc. The followings are the information:

Expected Return Beta

T-bills 5% 0
S&P500 (Market Portfolio) 10% 1
Apple Inc. (Stock A) 15% 2

We can plot out there is a linear relationship between beta and expected return. The slope of
the line is the reward-to-risk ratio.

E  rm   rf
Slope 
m
10  5

1
5

130
Suppose Stock S has a beta of 1 and an expected return of 12%. Knowing that Stock S has
the same beta risk as the S&P500, we should expect both stocks should give us the same
expected return. In this case, as the expected return of Stock S is greater than S&P500 (12%
> 10%), every investors in the market will want to buy Stock S instead of S&P500.

This will drive up the price of Stock S and push down its expected return until the reward-to-
risk ratio reaches 5.

Therefore in equilibrium, all stocks and portfolios must have the same reward-to-risk ratio,
and they all must equal the reward-to-risk ratio for the market.

E  rA   rf E  rm   rf

A m

Since the market beta is equal to 1, we can rearrange the above equation and get the
important formula:

E  rA   rf E  rm   rf

A m
E  rA   rf E  rm   rf

A 1
 E  rA   rf   A  E  rm   rf 

This important formula is known as the Capital Asset Pricing Model (CAPM).

9.6 The Capital Asset Pricing Model (CAPM)

The capital asset pricing model defines the relationship between risk and return. If we know
a stock’s systematic risk, we can use the CAPM to determine its expected return.

What are the factors affecting expected return?

 Pure time value of money: measured by the risk-free rate.
 Reward for bearing systematic risk: measured by the market risk premium.
 Amount of systematic risk: measured by beta.

131
Example 9.9

Consider the betas for each of the assets given below. If the risk-free rate is 3.15% and the
market risk premium is 9.5%, what is the expected return for each stock?

Stock Weight Beta

A 0.133 4.03
B 0.200 0.84
C 0.267 1.05
D 0.400 0.59

E  rA   3.15  4.03  9.5   41.44%

E  rB   3.15  0.84  9.5   11.13%
E  rC   3.15  1.05  9.5   13.13%
E  rD   3.15  0.59  9.5   8.76%

If we form a portfolio according to the weight, what will be the portfolio beta?

The portfolio beta is the weighted sum of each individual stock’s beta.

N
 p   wi  i
i 1

 0.133  4.03  0.2  0.84   0.267 1.05   0.4  0.59 

 1.22

132
10 Topic 10 – Cost of Capital

In Topic 7, we have learnt that the general capital budgeting procedures involve:

1. Analyze the project cash flows.

2. Estimate the appropriate discount rate.

3. Consider other strategic options if any.

We have already had extensive discussions on how to analyze the project cash flows. In the
previous topics, for simplicity, we assumed that the discount rate is given.

However, without knowledge of the appropriate discount rate, it is difficult for us to make
good capital budgeting decisions. In this topic, we are going to study how to estimate the
discount rate.

10.1 The Cost of Capital: Some Preliminaries

The cost of capital reflects the opportunity cost of funds for investment in a firm. It is the
rate of return that the firm must earn on its investments in order to satisfy the required rates of
return of all the firm’s sources of financing. In plain language, we need to earn at least the
required return to compensate our investors for the financing they have provided.

When a firm needs funds for investment, it can issue debt or equity, or both. Intuitively, the
cost of capital will be the “average” cost of debt and equity.

Weighted average cost of capital (WACC) can be calculated as follows:

E D
WACC   Re   Rd  1  Tc 
V V
where :
Re  Cost of Equity
Rd  Cost of Debt
E  Market Value of Equity
D  Market Value of Debt
V  DE

We will go over each item one by one.

133
10.2 Cost of Equity

There are two approaches in finding the cost of equity:

 The dividend growth model approach
 The CAPM approach

10.2.1 The Dividend Growth Model Approach

Recall that the constant dividend growth model:

Div1
P0 
Re  g

Rearranging and solve for:

Div1
Re  g
P0

Example 10.1

Suppose that City Corporation is expected to pay a dividend of $1.50 per share next year.
There has been a steady growth in dividends of 5.1% per year and the market expects that to
continue. The current price is $25. What is the cost of equity?

Div1
Re  g
P0
1.50
  .051
25
 11.1%

When we apply the dividend growth model approach, the two inputs: dividends and price are
observable. What we have to estimate is the growth rate. One method for estimating the
growth rate is to use the historical average.

134
Example 10.2

Suppose the dividend history of City Corporation is as follows:

2005 2006 2007 2008 2009

Dividend 1.23 1.30 1.36 1.43 1.50

Estimate the growth rate using historical average.

2005 2006 2007 2008 2009

Dividend 1.23 1.30 1.36 1.43 1.50
% Change 5.7% 4.6% 5.1% 4.9%

Average growth rate = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

The advantages:
 Easy to understand and use.

The disadvantages:
 Only applicable to companies currently paying dividends.
 Not applicable if dividends are not growing at a reasonable constant rate.
 Extremely sensitive to the estimated growth rate – an increase in g of 1% will
increase the cost of equity by 1%.
 Does not explicitly consider risk.

10.2.2 The CAPM Approach

We can apply the CAPM model to compute the cost of equity:

Re  rf  e  E  rm   rf 

135
Example 10.3

Suppose City Corporation has an equity beta of 0.58, and the current risk-free rate is 6.1%. If
the expected market risk premium is 8.6%, what is the cost of equity capital?

Re  rf   e  E  rm   rf 
 6.1  0.58 8.6
 11.1%

The advantages:
 Explicitly adjusts for systematic risk.
 Applicable to all companies, as long as we can estimate beta.

The disadvantages:
 Have to estimate the expected market risk premium, which does vary over time.
 Have to estimate beta, which also varies over time.
 We are using the past to predict the future, which is not always reliable.

10.3 Cost of Debt

The cost of debt is the required return on the firm’s debt. It is best estimated by computing
the yield to maturity (YTM) on the existing debt.

Example 10.4

Suppose City Corporation has a bond issue currently outstanding that has 25 years left to
maturity. The coupon rate is 9%, and coupons are paid semiannually. The bond is currently
selling for $908.72 per $1,000 bond. What is the cost of debt?

Using financial calculator,

1. Clear the Registers

 2nd {CLR TVM}
 2nd {CLR Work}

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2. Enter the Inputs
 45 PMT
 50 N
 -908.72 PV
 1,000 FV

3. Compute and Return the Outputs

 CPT I/Y

I/Y = 5%. Double it to get the YTM = 10%.

10.4 Cost of Preferred Stock

Some firms may issue preferred stocks. In general:

 Preferred stock pays a constant dividend each period.
 Dividends are expected to be paid every period forever.

Preferred stock is a perpetuity. We can take the perpetuity formula and rearrange:
D
P0 
Rp
D
 Rp 
P0

Example 10.5

City Corporation has preferred stock that has an annual dividend of $3. If the current price is
$25, what is the cost of preferred stock?

D
Rp 
P0
3

25
 12%

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10.5 Weighted Average Cost of Capital

Collecting together, without preferred stock,

E D
WACC   Re   Rd  1  Tc 
V V

With preferred stock,

E P D
WACC   Re   Rp   Rd  1  Tc 
V V V
where :
Re  Cost of Equity
R p  Cost of Preferred Stock
Rd  Cost of Debt
E  Market Value of Equity
P  Market Value of Preferred Stock
D  Market Value of Debt
V  DEP

The tax effect:

 We are concerned with after-tax cash flows, so we also need to consider the effect of
taxes on the various costs of capital.
 Interest expense reduces our tax liability. This reduction in taxes reduces our cost of
debt. Therefore the after-tax cost of debt  Rd  1  Tc  .
 Dividends are not tax deductible, so there is no tax impact on the cost of equity.

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10.6 A Comprehensive Example

You are the CFO of City Corporation. City Corporation is looking at setting a manufacturing
plant overseas to produce a new line of radar detection systems (RDS). This will be a five-
year project. The company bought some land three years ago for $6 million in anticipation of
using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard
the chemicals instead. If the land were sold today, the net proceeds would be $6.4 million
after taxes. In five years, the land will be worth $7 million after taxes. The company wants
to build its new manufacturing plant on this land; the plant will cost $9.8 million to build.
The following market data on City Corporation’s securities are current:

Debt: 25,000 6.5% coupon bonds outstanding, 20 years to maturity, selling

for 96% of par. The bonds have a $1,000 par value each and make
semiannual payments.
Common Stock: 400,000 shares outstanding, selling for $89 per share. The beta is 1.2.
Preferred Stock: 35,000 shares of 6.5% preferred stock outstanding, selling for $99 per
share.
Market: 8% expected market risk premium. 5.2% risk-free rate.

The tax rate is 34%. The project requires $825,000 in initial net working capital investment
to get operational.

1. Calculate the project’s time 0 cash flow taking into account all side effects.

2. The new RDS project is somewhat riskier than a typical project for City Corporation,
primarily because the plant is being located overseas. Management has told you to use an
adjustment factor of +2 percent to account for this increased riskiness. Calculate the
appropriate discount rate to use when evaluating the project.

3. The manufacturing plant has an eight-year tax life, and uses straight-line depreciation. At
the end of the project (the end of year 5), the plant can be scrapped for $1.25 million.
What is the after tax salvage value of this manufacturing plant?

4. The company will incur $2,100,000 in annual fixed costs. The plan is to manufacture
11,000 RDS per year and sell them at $10,000 per machine; the variable costs are $9,300
per RDS. What is the annual operating cash flow from this project?

5. Finally, CEO wants you to throw all your calculations and all you assumptions. He wants
to know what are the IRR and NPV of the project.

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1. The $6 million cost of the land 3 years ago is a sunk cost and irrelevant; the $6.4 million
appraised value of the land is an opportunity cost and is relevant. So, the total initial cash
flow is:
CF0 = –$6,400,000 – 9,800,000 – 825,000
= –$17,025,000

2. To find the required return for the project, we need to adjust the company’s WACC for
the level of risk in the project. We begin by calculating the market value of each type of
financing, so:
D = 25,000($1,000)(0.96) = $24,000,000
E = 400,000($89) = $35,600,000
P = 35,000($99) = $3,465,000

The total market value of the company is:

V = $24,000,000 + 35,600,000 + 3,465,000
= $63,065,000

Next, we need to find the cost of funds. We have the information available to calculate
the cost of equity, using the CAPM, so:
Re = .0520 + 1.20(.08)
= 14.80%

The cost of debt is the YTM of the company’s outstanding bonds, so:
P0 = $960 = $32.50(PVIFAR%,40) + $1,000(PVIFR%,40)
R = 3.435%
YTM = 3.435% × 2 = 6.87%

And the aftertax cost of debt is:

Rd = (1 – .34)(.0687)
= 4.53%

The cost of preferred stock is:

Rp = $6.5/$99
= 6.57%

So, the company’s WACC is:

WACC = .0453($24,000/$63,065) + .0657($3,465/$63,035) + .1480($35,600/$63,065)
= 10.44%

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 The company wants to use the subjective approach to this project because it is located
overseas. The adjustment factor is 2 percent, so the required return on this project is:
Project required return = .1044 + .02 = 12.44%

3. The annual depreciation for the equipment will be:

$9,800,000/8 = $1,225,000

So, the book value of the equipment at the end of five years will be:
BV5 = $9,800,000 – 5($1,225,000)
= $3,675,000

So, the after tax salvage value will be:

After tax salvage value = $1,250,000 + .34($3,675,000 – 1,250,000)
= $2,074,500

4. Using the tax shield approach, the OCF for this project is:
OCF = [(P – v)Q – FC](1 – t) + tCD
= [(10,000 – 9,300)(11,000) – 2,100,000](1 – .34) + .34(9,800,000/8)
= $4,112,500

5. We have calculated all cash flows of the project. We just need to make sure that in Year 5
we add back the after tax salvage value, the recovery of the initial NWC, and the after tax
value of the land in five years since it will be an opportunity cost. So, the cash flows for
the project are:

Year Cash Flows

0 –$17,025,000
1 4,112,500
2 4,112,500
3 4,112,500
4 4,112,500
5 14,012,000

Using the required return of 12.71 percent, the NPV of the project is:
NPV = –$17,025,000 + $4,112,500(PVIFA12.44%,4) + $14,012,000/1.12445
= $3,147,020.42

And the IRR is:

NPV = 0 = –$17,025,000 + $4,112,500(PVIFAIRR%,4) + $14,012,000/(1 + IRR)5
= 18.35%

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