2012-2013

ICHEC FINANCIAL MANAGEMENT

Eric Leurquin
eric.leurquin@cor.europa.eu
0497/23.01.61

Notes de cours + slides

 Contenu

Questions d’exam ............................................................................................................................................ 4

Part I : Introduction to the Financial Markets ...................................................................................... 5
1. Introduction to the financial market........................................................................................... 5
2. Functions performed by the financial market, both retail and wholesale ................... 6
3. Added value for the society as a whole ...................................................................................... 6
4. Other investments .............................................................................................................................. 7
5. Overview of the financial market.................................................................................................... 7
5.1.Money Market .................................................................................................................................. 8
5.2. Capital Market .............................................................................................................................. 11
5.3. The foreign exchange(FX) market ....................................................................................... 15
5.4. Commodities ................................................................................................................................. 16
5.5. Derivatives .................................................................................................................................... 17
6. Alternative investments ................................................................................................................... 18
Part II : Investment decisions .................................................................................................................. 19
1. Discounting cash flows ..................................................................................................................... 19
1.1. Reminder ....................................................................................................................................... 19
1.2. Introduction: the time value of money ............................................................................... 19
1.3. A reminder on perpetuities and annuities ........................................................................ 21
2. Making an investment decision in a project ............................................................................. 22
2.1. Project valuation and analysis ............................................................................................... 23
2.2. Decision rule ................................................................................................................................. 31
3. Exercises : NPV..................................................................................................................................... 45
3.1. Session 1 : New motor .............................................................................................................. 45
3.2. Session 2 : Salvage value .......................................................................................................... 48
3.3. Session 3 : Project A : with or without debt!  2 answers. ....................................... 50
3.4. Session 4 : The Borstal company .......................................................................................... 52
4. Capital budgeting and valuation with leverage ....................................................................... 53
4.1. Overview ........................................................................................................................................ 53
4.2. The weighted average cost of capital method (WACC) ................................................ 53
Part III : Risk & return on the stock market ....................................................................................... 56
1. Introduction .......................................................................................................................................... 56

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 2. Ratios ....................................................................................................................................................... 57
2.1. Accounting ratios ........................................................................................................................ 57
2.2. Financial ratios ............................................................................................................................ 57
3. Returns .................................................................................................................................................... 58
3.1. Investment decisions ................................................................................................................ 58
3.2. Definitions ..................................................................................................................................... 59
3.3. Examples ........................................................................................................................................ 60
3.4. Portfolios ........................................................................................................................................ 61
3.5. Conclusion on risk and return ............................................................................................... 67
4. Exercises : risk and return on stocks ........................................................................................... 68
4.1. Session 5......................................................................................................................................... 68
4.2. Session 6......................................................................................................................................... 70
5. Capital Asset Pricing Model............................................................................................................. 70
5.1. Assumptions of CAPM ............................................................................................................... 70
5.2. Risk composition ......................................................................................................................... 70
5.3. Practical uses of the CAPM ...................................................................................................... 72
5.4. CML and SML ................................................................................................................................ 72
6. Market efficiency ................................................................................................................................. 74
6.1. Introduction .................................................................................................................................. 74
6.2. Misconceptions ............................................................................................................................ 75
6.3. Forms of efficiency (important!) .......................................................................................... 75
Part IV : The capital structure of companies ( corporate finance) ............................................ 76
1. Equity vs debt financing ................................................................................................................... 76
1.1. Definition ....................................................................................................................................... 76
1.2. Exercises ........................................................................................................................................ 76
1.3. The effect of leverage on risk and return .......................................................................... 78
2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value .................................................... 80
2.1. Introduction (!) ............................................................................................................................ 80
2.2. Conditions...................................................................................................................................... 80
2.3. MM Proposition(exam!) ........................................................................................................... 80
2.4. The market value balance sheet ........................................................................................... 80
2.5. Application: A Leveraged Recapitalization ....................................................................... 81
3. Modigliani-Miller II: Leverage, Risk, and the Cost of Capital ............................................. 82
3.1. Leverage and the Equity Cost of Capital(exam!) ............................................................ 82
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 3.2. Capital Budgeting and the Weighted Average Cost of Capital ................................... 84
3.3. Levered and Unlevered Betas ................................................................................................ 85
4. Debt and taxes ...................................................................................................................................... 87
4.1. The interest tax deduction ...................................................................................................... 87
4.2. Valuing the Interest Tax Shield (!!) ...................................................................................... 89
4.3. Required return on equity ...................................................................................................... 90
4.4. Optimal Capital Structure with Taxes ................................................................................. 91
5. Session 7 exercises: Leverage, debt, capital structure .......................................................... 92
6. Default and Bankruptcy in a Perfect Market ............................................................................ 94
7. The Costs of Bankruptcy and Financial Distress.................................................................... 94
7.1. Introduction .................................................................................................................................. 94
7.2. The Bankruptcy code ................................................................................................................ 94
7.3. Direct Costs of Bankruptcy ..................................................................................................... 95
7.4. Indirect Costs of Financial Distress ..................................................................................... 95
7.5. Financial Distress Costs and Firm Value............................................................................ 96
8. Optimal Capital Structure ............................................................................................................... 96
8.1. Tradeoff Theory .......................................................................................................................... 96
8.2. Determinants of the PV of Financial Distress Costs ...................................................... 96
8.3. Optimal Leverage ........................................................................................................................ 96
9. Distributions to Shareholders ....................................................................................................... 98
9.1. Payout policy ................................................................................................................................ 98
10. Comparison of Dividends and Share Repurchases ............................................................. 98
10.1.Dividends...................................................................................................................................... 98
10.2. Share repurchases(!) .............................................................................................................. 99
10.3.Modigliani–Miller and Dividend Policy Irrelevance ..................................................100
11. The Tax Disadvantage of Dividends .......................................................................................100
11.1. ........................................................................................................................................................100
11.2. Optimal dividend policy with taxes ................................................................................101

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 Questions d’exam

1) Expliquer : Efficient market reaction, Delayed reaction, Overreaction and correction

2) Expliquer et dessiner les graphs: Capital market line + security market line
3) NPV with or without debt (if debt : only company NOT shareholders) + savoir calculer
le break even point + intérêts notionnels.
4) Exercises : market risk premium, stock risk premium, expected return.
5) Formules : Levered equity + unlevered beta
6) Définir le capital structure
7) SML + beta + expected return : faire un graph et expliquer l’influence sur l’expected
return si Beta est <1 et si Beta >1 + donner la formule.

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 Part I : Introduction to the Financial
Markets
1. Introduction to the financial market

The financial market is a market in which individuals and institutions can sell or
purchase financial instruments from other individuals or institutions.

Institution is a general word, it means any organization: bank, government, fund, public
sector, and retailer (individual people acting for their own service).

There is a difference between:

- Retail user = Individual investors, individual borrowers  private individuals
- Wholesale=users of the market: the money is managed by professional (organisations,
institutions).

Institutional share of the US equity market : 51% in 1990  80% nowadays.

FX = Foreign Exchange
Why is there a grow in FX?

1. People : nowadays people go to the bank and put some money on their account
and it is managed by the bank.
2. Program trading: computers that buy and sell automatically. It increases the
volume of financial movements.

Market participants

1° Lenders or investors
- Banks(including the Central Bank) and insurers: they receive the money of their clients
and they invest it.
- Mutual funds: collected from many investors, diversified holding, pro managed. The
funds grow in companies and when people retire, they receive an extra pension (= Unit
Trust in GB = SICAV)
- Pension funds: All employees contribute to the fund each month and when they retire,
they receive money from the company.
- Hedge funds: money received from client, pooled together (like mutual funds). But, the
differences is that companies try to increase the profit because they use a leverage effect
(it can be 2,3,4). They are speculative.
Eg : They receive 1 million and invest more than 1 million.
- Private individuals (and their brokers) : workers having a lot of money can go to the
bank but can also invest it through their bank or by themself.

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2° Borrowers: institution or people who need money.
- Sovereign institutions: Banks created by many countries. They borrow to the market
and make loans. Countries use this money for big European project for instance.
Eg: European Investment Bank, World Bank, European Bank for Reconstruction and
Development,… public sector.
- The corporations, banks : private sector. They create job, invest, sell product so they
need money to do such things. They are the most important.
- Government, countries, states, municipalities.

2. Functions performed by the financial market, both retail and

wholesale

Nb : A market is just an intermediary between those who have money and those who need
it.

a) To intermediate between investors and borrowers, nationally and

internationally.
b) To offer means of risk transferral, risk reduction or risk increase, (i.e. risk
management).
c) To offer investment management services
d) [FX Market] To intermediate between exporters and importers; To provide a
means of procuring foreign exchange. FX = Foreign Exchange : that already existed
thousands year ago (Jesus-Christ) : roman currency against Greek currency.
e) To provide a liquid secondary market.
f) To provide corporate services such as trade finance, leasing and merger and
acquisition advice.
g) To provide government with monetary policy (= to decrease interest rate. Low
interest rate encourage people to invest and that’s how growth starts(corporations and
people invest)  that stimulates loans).

Moreover, the Central Bank helps countries in debt. Usually, CB doesn’t contribute in the
market (to sell and buy). Now, it’s buying Long-Term bonds (US) and short-term bonds
(Europa) because of the crisis The monetary policy is not just about interest rates
(sometimes they buy FX too!).

3. Added value for the society as a whole

Financial markets are very important for:

a) International trade (=import & export) -> increased economic efficiency through
specialisation -> increase in productivity/decrease in price. Idea: invest in the most
profitable production.
b) Efficient capital allocation (=allocate money to where the returns are higher) ->
increase in productivity of the capital -> more investments & projects
-> Increase in productivity/decrease in price
-> Increase in well-being, GDP, economic output. -> Progress
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Listed = A listed company(= listed equities) is when you can buy its stocks (= actions)
on the market. 99% of the companies are not listed.

Market capitalization of stock = “market value”.

Facts:
• Market capitalisation of bonds: 30,000 billion $
• listed equities: 30,000 companies world-wide
• market capitalisation of stocks: 35,000 billion $
• gross capital flows (cross-border): 9% of GDP

Financial instruments

1° Short-term < 1 year = money market : deposits, T-Bills, CD’S,… = Commercial

deposits
2° Long-term > 1 year = the capital market : mainly bonds and stocks ( government
bonds(corporate bonds, supranational issues, Eurobonds), ordinary shares(preferred
shares), convertible bonds).
3° Derivatives: options, swap,… Derivatives are complex and dangerous because it
includes leverages effect.
4° Mutual funds

4. Other investments

1° Real Estate: house, apartments,…If you don’t have the money to invest in real estate,
you can have a “Real Estate investment trust”= shares from companies who own
apartments.
2° Other real assets: gold, silver, oil, antiques, art, … (commodity funds)

5. Overview of the financial market

 Most financial instruments are traded “over-the-counter” (OTC) [de gré à gré],
in an unregulated interbank marketMany investments are not listed as a stock
exchange: many financial instruments are exchanged by banks to banks.

 Commodities, Stocks, Futures and some options are listed on exchanges [bourses],
on a regulated market:
- At least 1 exchange per country
- Tightly regulated by law

Eg: NYSE = New York Stock Exchange (50% of world-wide capitalization and 36 of listed
companies). NY has a lot of influences. Stock exchanges aren’t replaced by computers for
2 reasons: a computer can’t make a proposition for you and moreover, you can
speculate for yourself. If he goes down, everybody will go down (a bit exaggerated).

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Nb : - Stock exchanges are usually segmented: Eurolist (A,B,C), Alternext, OTC
- Stock exchanges were created originally as mutual companies but many are getting listed
- Mergers are justified by economies of scale
 NASDAQ buys LSE? (this one failed… so far)
 NYSE buys Euronext? (this one succeeded)

There is a difference between the companies on the stock exchange. In fact we separate
them in 3 segments:

- Euronext is a continuous market: If you are a BIG COMPANY, your shares are moving
up and down every second because there is a lot of money and commodities.
- Alternext is a fixing market: If you are a small and mid-company: the movement will
be only once or twice per day.
- If you are coming from the free markets: maybe only once per week..

5.1.Money Market (Short-Term < 1 year) : Always about loans or extending a borrow.

“The Money Market is mostly OTC(Over the counter : trading is done directly between
two parties), and composed of short term instruments, with interest credited annually”

= loans for less than 1 year. Most of them are term deposits (it can be interbanks or
bank-clients). It’s custom–made, tailor-made. When someone deposits money, he
receives interest to have loaned his money. It is the easiest financial instruments you can
have. Usually we don’t do that because we have the savings account (= livrets
d’épargne) : for private people, not companies.

The companies have many term deposits = interbank deposits (= cash management).
 One bank has too much money, the other needs money = Interbank market. If the
difference is positive, the bank can invest. If it’s negative, the bank has to borrow.
This interbank market is essential. A bank needs all the time to manage his money.

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With the crisis, banks do it less than before because they need trust to exchange “ Not
sure they are a good bank, not sure that I’m going to have my money back…” So, they
hesitate to do it and that’s the major problem for some banks.
But, the Central Bank is the lender of the last resort (that’s what Fortis did).
Fortis reputation has been damaged. Why ?
1° They needed billions and they couldn’t find them
2° Fortis had bought toxic assets from the US.
 Reputation damaged  All Banks stop lending money to Fortis. So, they asked for
emergency assistance to the National Bank (It opened an Emergency Assistance line).
But, after a few months, this line was worth 100 billion + Fortis borrowed money from
the CB in Amsterdam: 100 billion. So the government bought Fortis (bailed out).

Exercise term-deposit

Since you have requested with us a 3-month deposit, we debit your account for 100,000€
today. “Interest rate is 4%; calculation rule is Actual/365. In 3 months, we will credit your
account with…

 They will use the actual number days divided by the interest rate.
Today = 24 sept + 3months = 24 dec  91days!!

Answer: 91/365 x 4% x 100 000 = 997.26€

 We will credit your account with 100 997.26€” (unless you are subject to the 15%
withholding tax)

Nb : They are different calculation rules! Here it’s Actual/365 but it could be :
- Actual over actual (or 365/365) : barely used
- Actual over 360 : gives you more interest than you’ll pay
- 30/360: Each month has 30 days! (even February).

EURIBOR( = EURopean InterBank Offered Rate) = daily average of each interest rate
applied by banks in the Eurozone (! Interbank )
LIBOR = London InterBank Offered Rate (same as Euribor but in England)
Spread = Interest Rate < difference between EURIBOR and LIBOR.

Libor/Euribor(interest rates or interbank deposits) change every day and have a term
structure: the interest rate is a function of the duration of the deposit: 1, 3, 6, 12 months
or any duration can be custom-made.

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EONIA = European OverNight Interest Average.

The negative interest rates are only for governments (usually). In the market rates, they
are 2 interest rates. The highest = offered rate (you want to borrow). The lowest =bid
rate (you want to deposit)

Some of the instruments are discounted securities:

- Treasury-bills(T-bills) = bonds (issued by governement) [BTF: Bons à taux fixe: 13, 26

or 52 weeks] : don’t pay rate.
- CDs (certificate of deposits issued by banks) [~short term bons de caisse]
- Commercial papers = bonds (issued by companies) [BT: billets de trésorerie] : don’t
pay rate.
All short term securities are issued at a discount (don’t pay 100% but are sold at the
price of 96%) and are later redeemed(rachetés) at par (e.g. refunded at 100% when they
mature).

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5.2. Capital Market (Long-term > 1 year)

A) Bonds
B) Stocks (and hybrids, derivatives, etc…)

Stocks & bonds are securities = financial instruments secured by physical assets.
Equity securities(titres participatifs) are represented by stocks or shares(or bonds).

The company or other entity issuing the security is called the issuer .
Securities may be represented by a certificate or, more typically, an electronic or "book
entry" form. Such Certificates may be :

- bearer, meaning they entitle the holder to rights under the security merely by holding the
security
- registered, meaning they entitle the holder to rights only if he appears on a security
register maintained by the issuer or an intermediary.

If they are traded on a market, one can buy or sell them easily. Prices may fluctuate in
function of a.o. supply & demand.

A) Bonds

=” an instrument of indebtedness of the bond issuer to the holders (or bondholders)”.

= Fixed income = will pay you an interest through coupon, expressed as a %.

Government issues 30-year bonds. Nobody would buy it if there wasn’t the possibility to
sell it at any time.

It’s a debt security : The issuer owes the bondholder a debt and is obliged to pay an
interest(coupon) and to repay the principal at a later , termed the maturity(when you
get the principal back).

How does it work? If you have a 5%-interest coupon, it is expressed per year. 99% of the
bonds are paid annually or semi-annually (sometimes monthly): payable at fixed
intervals. Now we have invented a coupon with a floating-rate note (Eg : Euribor +
0,5%). Very often the bond is negotiable, ie the ownership of the instrument can be
transferred in the secondary market.

What’s the long bond? = the name we gave to the American bond.

- The green bonds have good rates because it’s more risky.
- Discount securities = zero coupons.
- Commercial paper program = short-term bond (borrow for 3,6…months). People are
allowed to go up to a limit of borrowing. People receive 100% at maturity but people
initially bought at 99%(profit of +-1%). Those short-term bonds don’t have any interest
but you buy them at a discount.
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B) Stocks or shares

=” The original equity paid into or invested in the business by its founders or by later
investors” (much more difficult to value).

Stocks pay dividends. If there is an inflation / deflation, you don’t receive the 100% back
because there is no term (and you are not sure to receive the dividend!). So, it depends
of the profits (if the company does investments (with the profit) for its own activities)
and on the value of the stock.

Example:
- If the company is a starter (first 3 years), it doesn’t pay dividend because it buys its
own share = buy back! Moreover, there are no taxes on their own shares. So they save
money.

Many US companies distribute shares by back instead of dividends because there are
less taxes on the shares than on dividends  governments are not happy! Most of US
companies pay dividend quarterly – every 3 months >< Europe: every year.
If you don’t pay any dividends on the short-term, you can be more performing but not on
the long-term.

Shares represent a fraction of ownership in a business. A business may declare

different types (classes: A or B or…) of shares, each having distinctive ownership rules,
privileges, or share values.

Stock typically takes the form of shares of either common stock or preferred
stock(standard ones).
As a unit of ownership, common stock typically carries voting rights that can be
exercised in corporate decisions.

 Preferred stock = no right to vote but perpetual bonds= pay a dividend(coupon)

every 6 month or every year (A bit like the fixed income coupon but expressed in dollars
and not in percentage). People who like this kind of shares are pensioners because there
is a kind of stability BUT there is a risk of bankruptcy of the companies or if the
companies grow (the dividend stay the same). A preferred stock is legally entitled to
receive a certain level of dividend payments before any dividends can be issued to other
shareholders

 Common stock = right to vote + receive a constant dividend (99% of stocks are
common stock). It does continue forever and that gives people stability.

A shareholder (or stockholder) is an individual or company that owns one or more

shares of stock(=equity).
Nb : A tax-over BID = OPA

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 1. Stock Indice

A stock market Index: measures the performance of the stock market.

A benchmarked means “reference” : used to measure the performance of portfolios of
managers.
S&P 500: An American index which contains 500 American stocks, but only the biggest
ones
The total retains index = price + dividend.
The net retains index = price+ dividend- taxes

Methods to classify an index :

- Dow Jones industrial average: the price of each component stock is the only
consideration when determining the value of the index.
- Hang Seng index = market-value weighted or capitalization-weighted factors in the size
of the company  CAP= N*P (N = Number of share and P = the price of the share).

2. Euronext

Euronext is the European electronic stock exchange based in Amsterdam and with
subsidiaries in Belgium, France, Netherlands, Portugal and the United Kingdom.
In addition to equities and derivatives markets, the Euronext group provides clearing
and information services. As of December 2010, markets run by Euronext had a market
capitalization of US$2.93 trillion, making it the 5th largest exchange in the world.
Euronext merged with NYSE Group, Inc. on April 4, 2007 to form NYSE Euronext
(Euronext: NYX), the "first global stock exchange“.

Euronext manages two broad-based indices:

- The Euronext 100 Index is the blue chip index. (large capitalisation index)
- The Next 150 Index is a market capitalisation index of the 150 next largest stocks,
representing the large- to mid-capitalisation segment of listed stocks at Euronext.
- The NextEconomy and NextPrime segments have each a price index and a total return
index, weighted by market capitalisation and excluding the shares listed in the Euronext
100 Index.
They are small capitalization indices
The indices have a base date of 31 December 2001, with a starting level of 1000 points.
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Exam!!!Provide definition & formulae of the following indices: BEL20, CAC40, DAX30.

BEL20(exam!)

Q, F, f = fixed at the beginning of the year (won’t change during the year) = WEIGHT of
each company, stable overtime.
C = price of shares (change during the year)

If no company has a weight > 12 then fi = 1 Else large companies: fi < 1 and other
companies : fi > 1. Consequence: weight = 12.

If we want to buy Swiss franc: can we do it directly? In theory, we first buy US dollars 
In theory, all trades use the dollar. But, in practice, when you want to sell euros against
Swiss Franc, you call the bank and they will calculate an exchange rate = cross
exchange rate (cross because we shortcut de dollar). So we don’t have to do the
exchange twice.

Currency trading used to be a big business. But, 10 years ago, people have been laid off
because of euro (no more franc belge, français…).

Exchange control:
- You can buy shares in Thailand, Malaysia…because the economy there is booming =
emerging markets.
- 1998: big crisis after the defeat of Russia. Some currencies lost 50% from their value
within a few months. So, the countries controlled temporarily their currency: it’s
forbidden to sell the BAHT unless you have a good reason (eg : trying to stop the
depreciation). After a few months, countries will lift the control and then, they will be
allowed to do it again. What is the risk? The risk is that you are blocked.

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To decrease the risk of a loss, you can call your bank and do a forward transaction =
sell the dollars. But, we don’t have any dollar: we sell them now in settlement in
treatment. It’s not speculation, it’s to protect us from a risk, the depreciation of the
dollar (= hedging). But, the exchange rate is fixed at that moment and will not change.

Warrant is a security that entitles the holder to buy the stock of the issuing company at
a fixed exercise price until the expiry date. It’s similar to options(derivative) : special
rights to buy securities but, warrants are frequently attached to bonds or preferred
stock, allowing the issuer to pay lower interest rates or dividends.

A convertible bond is a type of bond that the holder can convert into a specified
number of shares of common stock in the issuing company or cash of equal value.

5.3. The foreign exchange(FX) market

It’s the world’s largest market with a few main currencies: $, £, €, Yen. London, NY,
Frankfurt, Zurich are the main centres. It’s a very liquid and competitive market.
The settlement is made in T + 2( intitial times + 2 working days) through corresponding
banks.

The market participants are importers, exporters, central banks (normally they don’t),
portfolio managers, FX brokers, banks…

Over the counter= no one physical location; traders are in the offices of major banks.
The deals are made over the phone or through an IT network (Bloomberg, etc…). It only
takes a few seconds.

Market makers (teneurs de marché) quote both ways, with a bid price and an ask price
He typically works for a bank. He receives two prices: it depends if he’s buying or selling.
If he’s buying, he will have the higher price and if he’s selling, he will have the lowest
price. The difference = the profit for the market maker = PIPS (around 5 pips). It’s a
small profit because there is a lot of competition (very competitive market).

A broker (courtier): in London or NY, he’s electronically in contact with the bank, he
selects for you the best price (or you’ll need 50 phone calls if you don’t have a broker).
He’s just an intermediary between market makers, he’s not the counterpoint! (Bank =
counterpoint).

Less than 5% is commercial business. When you think about tourism, it’s a bit like
import/export. What represents the 95% left? Investors,speculation on foreign
exchanges and hedge funds (from banks). What are the consequences? If 95% are
investor and speculation  there are other factors.

Factors such as purchasing power parity (relative prices) or trade balances are
irrelevant in the short run. They are relevant for import/export.

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Actions and expectations of traders and market-makers are decisive. What does
“expectation” mean? If everybody buy YEN, then we expect the YEN to appreciate 
will try to make some profit. What do expectations depend on?
The expectations are usually based on macroeconomics fundamentals (such as
inflation)and create the trend.
If I make a profit because an expectation, that means that my counterpart necessarily
makes a loss (bank or Japanese person behind).

Essentially a zero-sum game (but Central Banks intervene!). It’s a situation in which a
participant's gain (or loss) of utility is exactly balanced by the losses (or gains) of the
utility of the other participant.

Trading takes place with respect to the $:

- Using only one “vehicle currency” reduces information complexity
- And avoids triangular arbitrage (=the act of exploiting an arbitrage opportunity
resulting from a pricing discrepancy (désaccord) among three different currencies in
the foreign exchange market).
Eg : If you want to buy CHF with EURO, you need to pass by the $. It’s the cross
exchange rate that banks directly calculate and give you.

Nb : The spot rate is against $ >< the crossed spot rate (not against $).

The forward rate is the future yield on a bond.

Risk measured by the volatility of the FX rate or the Value-at-Risk. We can manage FX
risks through hedging (=how to protect you against a risk):
- Forward transaction: a commitment to sell or buy currencies at a future date but
predetermined price. It’s useful in commercial deals (when the partner is supposed to
pay you in 3 months). Most companies use the forward transaction.
- Futures contracts: commitment to sell or buy currencies at a future date but
predetermined price. It’s similar to forward transaction but more complex.
- FX options (=a right  see derivatives).

Nb : Risk of an exchange controls : risky to invest in foreign currencies (eg Thailand in

December 2006 or Asian currencies in 1998).

5.4. Commodities

“= a class of goods for which there is demand, but which is supplied without qualitative
differentiation across a market “
Commodities are not financial assets but real assets (we can touch them). Gold has
always been a possibly investment. But, there is something new = commodities fund
(fund is buying bonds for you or other things and we invest in the fund). So, it’s much
easier than buying gold by ourselves (it takes time). You can do that for silver, oil, gold
and agricultural commodities. They are not speculative.

16
There are different categories: oil, gold, gas, precious metals, agricultural commodities
(huge market). Most exchanges are London, NY and Chicago.

Commodity price index: calculate the average of selected commodity prices, which
may be based on spot or futures prices. It is designed to be representative of the broad
commodity asset class or a specific subset of commodities, such as energy or metals. It is
an index that tracks a basket of commodities to measure their performance.
Eg : Exchanges : London International Financial Futures Exchange (LIFFE).

5.5. Derivatives

A derivative is a contract between two parties that specifies conditions (especially the
dates, resulting values of the underlying variables, and notional amounts) under which
payments are to be made between the parties: options, swaps, futures, forwards, credit
derivatives. It’s a contract about the future.

Derivatives have been criticized during the crisis. All derivatives are about the future.

A) Options : you can decide whether you’ll use it or not and when.
You buy a call option on Google. The derivatives are about the future. So, a call option
will give you the right to buy Google shares. (Eg : current price : 500$/share but with a
call option, you’ll have the right to buy at 525$/share). There is a life of the option and
then the maturity of the option (option expires at maturity date). Maybe now, the option
is not very interesting. But, the interesting element is that you keep this right for one
year.
If the share price goes down, you won’t make any profit. But if the share price goes up
and down during one year, you can use your option and sell it where the price goes up.
So, we can use the option whenever we want it. In fact, we don’t have a profit but it’s the
revenue during one year (minus the investment) per share (in the real life : an option =
+- over 100 shares)  option per share.
The price of the option is called a premium based on the volatility of shares + price
(statistic model).
Call options: right to buy (at a predetermined price)
Put options: right to sell.

Nb : The American options call can only be used at the maturity.

If you don’t exercise your right, the option has been abandoned and you lose all you have
invested. You can also resell your option especially if it’s liquid. That’s an interesting tool
but it’s not advised to use it because some times, you have a loss and sometimes you
make profit.

Swap = “exchange of fixed interest rate for floating interest rate. “

17
B) Futures and forwards : about currencies. It’s different than an option with which
you have a possibility. “Futures & forwards are a commitment to buy or sell (at a
predetermined price) at a future date. It concerns indices(most of the time), shares or
commodities.

What’s the difference between futures and forwards?

Forwards: called over the counter. Custom-made, Taylor-made  not standardised, it’s
made for us. We cannot exchange it.
Futures: are standardised (the amount is typically 1,000,000 sth  = 10 futures). It’s
traded in Chicago on a exchange (not with the bank  cheaper). It’s very liquid so we
can sell it whenever we want: big advantage!
 Futures and forwards are both very useful, it depends of the needs.

Credit derivatives: linked to a bond. It’s a protection against the default of the issuer.

6. Alternative investments

With the crisis, some investors are looking for another kind of investments.
Real estate: buildings, apartments (very good: the rent pays the loans  after 20 years,
we have the apartment): through SICAV or individually.
Real estate investment trust (SICAV): fund which buys real estate
Private equity and venture capital: Funds buying shares in unlisted companies. 
That makes liquid (good for illiquid start-up) something originally illiquid. You can’t
resell a share from an unlisted company because there is no market but through a
private equity funds, you can at a certain level.
Hedge funds: they use leverage and derivatives (Ex: investment: 1M  they invest 4M).
All hedge funds speculate on banks, shares.
Closely Held Companies and Inactively Traded Securities
Distressed Securities/Bankruptcies: Buy shares of companies in difficulty because the
shares are very cheap. Sometime, they are even too cheap but it’s risky.
Commodities: gold,…
Tangible Assets with Low Liquidity.

To remind from the chapter 1 :

- Market participants
- Functions performed by financial markets
- Financial instruments
- Financial markets types
- The money market
- The FX market

18
 Part II : Investment decisions
1. Discounting cash flows
1.1. Reminder

Simple interest : interest is earned only on the original investment

- Only for money market instruments (<1y)
FV = PV (1 + n.r) with n = number of years
 We only use this when duration < 1 year  n < 1 year
Ex : 3 months = 91 days  n = 91 / 365
Compound interest: earned on both the original investment and on previous paid
interest(s)
- For Capital Markets (>1y) instruments IF the interest are capitalised, but NOT if
interests are paid to the investor.
 We only use this when n > 1 year.

Simple interest: FV = I x [1+r.n]

Compound interest: FV = I x (1+r)n
Floating rate = coupon change all the time.

A fund = a pool of money invested by many investors and managed by professionals

Most funds are incorporated = they have a legal personality, a balance sheet, etc.

Advantages of the mutual fund: In most cases, the mutual fund gets the dividend (tax
free), the coupon (tax free). Most of them keep what they have and that just grows and
when you need money, you sell it = capitalization  The investors don’t receive money
on which they have to pay taxes but just wait before selling  no taxes and that’s legal

1.2. Introduction: the time value of money

Exercises:

1° Future value (FV) problems (compounding) : Calculating the value an investment

will grow to, after earning interest: Interest rates are 5%. If I invest €4,000 today (or
every year), how much will it be worth in 8 years?

Today: FV = 4000 x (1 + 0,05)^8 = 5909, 82€

Every year: FV = 4000 x (1 + 0,05)^8 + 4000 x (1 + 0,05)^7 + 4000 x (1 + 0,05)^6 + 4000
x (1 + 0,05)^5 + 4000 x (1 + 0,05)^ 4 + 4000 x (1 + 0,05)^ 3 + 4000 x (1 + 0,05)^2 +
4000 x (1 + 0,05)
= +-38000€

19
2° Present value (PV) problems (discounting) : Calculating the value today of future
cash flows: Interest rates are 7%. If I need to have £150,000 saved in 10 years, how
much should I put aside today (or every year)?
Today : PV = 150 000 / (1 + 0,07)^10 = 76252€
Every year : 150 000 = x(1 + 0,07)^10 + x(1 + 0,07)^9 + … + x(1 + 0,07)^1
 x = 150 000 / factor = 10, 146 £ (and factor = x(1, 07)^10 +…)

3° Solving for r
r=(FV/PV)1/n -1

Ex: if you double your initial investment in 10 years, what interest rate did you get?

4° Solving for n
n=ln(FV/PV)
ln(1+r)

Ex: if you get a 5% interest rate, how long will it take to triple your initial investment?

PV and FV are related :

PV = FV x 1/(1+r)^n
Which is equivalent to FV = PV x (1 + r)^n
Where R = discount rate
And 1/(1+r)n = discount factor

The value of cash flow received at different times can never be compared -> discount
them to a common date.
Eg : assume interest rates are 10% and you have just won the lottery. You must choose
between 2 options: receive $500,000 today; or receive $1,000,000 in 5 years from now.
Which one is better?

So far, we have looked at problems involving only a single cash flow. But most business
investments will involve multiple cash flows over time. We need a method for coping
with such streams of cash flows! To calculate the PV of a multiple cash flow stream, you
need to calculate the PV of each cash flow and then add up these PVs.

An initial cash flow is usually negative. Then the project multiplies cash flows (because
you make profit).

PV and FV of multiple cash flows:

- With a flat rate curve:
PV =  FVi x 1/(1+r)i
- With a normal rate curve:
PV =  FVi x 1/(1+r i zero-coupon )i

20
In real life, interest rate is calculated with the number of years but we don’t do that in
this class. Here we simplify, we assume a flat interest rate (taux unique).

Exercises

1° Assume interest rates are 8% and you make 3 deposits to your bank account: €1,200
today; €1,400 one year later and €1,000 three years later. How much money will you
have on your account three years from now?

2° You wish to buy a car through making 3 instalments: £8,000 today; £4,000 one year
later and £4,000two years later. How much money would you have to place in an
account today to generate this stream of cash flows? (With 8% = interest rate).

PV = -8000 - 4000/(1,08) – 4000/(1,08)^2 = -15,133 £ (Attention la “,” = 1000)

1.3. A reminder on perpetuities and annuities

Annuity : Any sequence of equally spaced, level cash flows (suite de versements égaux
et équidistants : versements trimestriels, annuels,…).
Perpetuity : If the payment stream lasts forever (suite infinite de flux).
Ex : Cmb doit-on placer pour une perpétuité de 100euros à 8% : 100 / 8% = 1250

 PV of a perpetuity

PV= =

Eg: what would you pay to own a guaranteed income of $1,000 per year forever if r=4%
and payments are at the end of each year? 1000 / 4% = 25 000

!!!! Do not confuse the perpetuity formula (1/r) with the PV of a single payment (1/1+r).

 PV of an annuity

Annuity due: A level stream of payments starting immediately. Each payment is made
one period sooner  we need one period back.

21
Growing perpetuities: If the cash flows are not equal, but instead growing at a constant
rate “g”. Hint: think about a stock with growing dividend!

PV of a growing perpetuity:

Exercise

1° PV of an Annuity: Assume interest rate is 0.5% per month. You wish to buy a house
making monthly payments of $600 during 20 years. What’s the price of the house today?

2° FV of an Annuity: Assume interest rates are 10%. You decide to save $4,000 per year
for 20 years for your retirement. How much will you have saved by the time of the last
payment?

3°Annuity due. What is the PV of a stream of 5 equal annual payments starting TODAY,
each of $400, if the interest rate is 3%?

4° Growing perpetuity: An apartment which generates yearly cash flows which grow at
3% per year forever, starting at $12,000 at the end of the first year, assuming an 8%
interest rate, has a fair price of…?
12 000 / 8% - 3% = 12 000 / 5% = 240 000

2. Making an investment decision in a project

To make a well-informed decision, we need to know the cash flows (A) + to have a
decision rule (B) (+ tool : discount rate).

Financial managers discount cash flow to measure PV.

Accountant: calculate first profit, then cash flow and then, the PV. Accountant measure =
profit (= net income). They don’t take interest rates into account.

The best decision rule :

- If NPV < 0, we don’t invest.
- If NPV > 0, we invest

To remember :

PV =

NPV = PV (of future cash flows) – I (I = investment)

1° Accounting
Revenue – cost (including depreciation) = earnings net income.
2° Finance
22
Cash flows: + depreciation - investments (-ΔNWC : comes from the balance sheet =
adjust time difference)
 NPV(in euro) and IRR (in %)= 2 equivalent decision rules.
If IRR > 1 : we invest. If IRR > WACC = cost of capital.

Nb : Capital = equity + debts

2.1. Project valuation and analysis

A capital budget lists the projects and investments that a company plans to undertake
during the coming year. To determine this list, firms analyse projects and decide which
ones to accept through a process called capital budgeting. This process begins with
forecasts of the project’s consequences on the firm. Some of these consequences will
affect the firm’s revenues; other will affect its costs. Our ultimate goal is to determine the
effect of the decision on the firm’s cash flows, and evaluate the NPV of the cash flows to
assess the consequences of the decision for the firm’s value.

To derive the forecasted cash flows of a project, financial managers often begin by
forecasting earnings. Thus, we begin by determining the incremental (croissant)
earnings of a project – that is, the amount by which the firm’s earnings are expected to
change as a result of the investment decision. Then they use the incremental earnings to
forecast the cash flows of the project.

3 steps :
1. Forecasting Earnings
2. Determining Free Cash Flow and NPV
3. Analyzing the project.

1. Forecasting Earnings : looking at future costs/cash flow.

Incremental earnings forecast =

- Capital Expenditures (+- the same than your investment) and depreciation(linear)
- Taxes (We always have to know there are taxes in the exercises! Not mentioned at the
exam)
- Unlevered Net Income Calculation (unlevered = no financial charges for interests on
the debt).

BUT don’t forget :

1° indirect effects on incremental earnings :

A) Opportunity costs:
Example: We have a company and a warehouse. If we use the warehouse for the project
then, the company loses his opportunity to rent the warehouse to someone else.
If the market rate for rental is 5000€, we have to take that into account.
B) Project externalities: can decrease our revenues due to competition. It’s very
difficult to estimate. You have to take competitors into account.
23
Example: Environment: Maybe we’ll not be allowed to pollute in one year and we’ll have
to buy a machine to clean everything we are doing.
C) Cannibalization of existing product : If we launch a new product it may
decrease the sells on the existing product  of the own product.
Example: If we sell IPhone 10, it will stop the IPhone 9.
2° Common mistake: the opportunity cost of an Idle Asset
3° Sunk costs = past costs: investment you made last month or last year. We don’t have
to take them into account.
Example: Developing a new product last year with a lot of costs (research costs). Should
we sell this product? The cost of the research is done. So we are only looking at future
past costs. Those are irrelevant = sunk.
A) Fixed overhead expenses: management costs : if they are really fixed, we don’t
take them into account because it’s not incremental, they are not linked with the
project.
B) Past research and development expenditures: we only take into account future
costs.
4° Real-World Complexities
5° The Sunk Cost Fallacy (= idea that the company is more likely to continue with a
project if they’ve already invested a lot of money, time,…)
Eg : HomeNet

HomeNet’s incremental earnings forecast (see example in book p.184)

- In bracket : negative
- 4 : No overheads (frais généraux).
- 5 : Future R&D : starts now.
- 6 : Depreciation is different from cash flow, it’s a non-cash expense. We see 5 x 1500 $
= 7500$ = CapEx.
- 8 : It’s a big company, not a start up. If it was, the line would have 0 and 0 for the first
two columns.
Why do we have two positive amounts at the beginning and the end?
Beginning :existing profit of the company
End : The company pays less taxes because of the new project: the incremental negative
profit of the beginning will reduce the existing profit and so, the taxes.

24
Equations :
1°
EBIT = Earned Before Income Taxe and Tc = Tax rate of the company

2°

Eg : The opportunity cost of HomeNet’s Lab Space

40% = income tax

Table : HomeNet’s incremental earnings forecast including cannibalization and lost rent.

1 : 25% of customers buy another product from the same company : 25% x 100 000
units x 100$ = 2,5M  26,000(initially) – 2,500 = 23,500
2 : Cost of goods sold = 60$/unit  25% x 100 000 unit x 60$ = 1,5M (that costs 1,5M for
HomeNet to stop the procedure).
4 : Increases from -2800 till -3000 due to opportunity costs of 200(,000$)/year

Exam! When you have a new project, you pay less tax because you have company profit +
profit in the new project. We have to take taxes into account! We have to know at the exam
that the tax rate is 35% in Belgium!

25
We cancel the depreciation because we add it back.
We must follow the order : first : accounting table then net income…

2. Determining Free Cash Flow (= cash flow) and NPV = Net Present Value

Steps :

1. Calculating the Free Cash Flow from Earnings

- Capital Expenditures and Depreciation
- Net Working Capital (NWC)
2. Calculating Free Cash Flow Directly
3. Calculating the NPV
4. Choosing Among Alternatives
- Evaluating Manufacturing Alternatives
- Comparing Free Cash Flows for Cisco’s Alternatives
5. Further Adjustments to Free Cash Flow
- Other Non-cash Items
- Timing of Cash Flows
- Accelerated Depreciation
- Liquidation or Salvage Value
- Terminal or Continuation Value
- Tax Carryforwards

A. Calculating the Free Cash Flow from Earnings

-Capital Expenditures and Depreciation

-Net Working Capital (NWC) :

Receivables = créances
Payables = dettes

Goal of NWC: Maintain a minimum cash balance to meet unexpected expenditures.

Δ = Variation

26
Cash flow(CF) = incremental effect of the project on the firm’s available cash.
It’s different from earnings (= Unlevered Net income).

CF = earnings + non-cash charges(depreciation) – cost of capital/investment

Table: Calculation of HomeNet’s Free cash flow (including cannibalization and lost rent).

8 : 40 % EBIT
9 : Unlevered net income = EBIT – income tax (40% in that case)
11 : 7500 = 5 x 1500 (line 10).
12 : 2100 at the end : it has to be 0 except in year + 1

Table : HomeNet’s working capital requirements (spreadsheet) : NWC

In this example, assume the following balance sheet items: No cash is necessary, no
inventory is necessary, Receivables = 15% of sales, Payables = 15% of COGS (Costs of
Goods Sold)

3 : 15% of sales = 15% of 23 500

4 : 15% of COGS = 15% of 9500

27
Example 1: net working capital with changing sales(growing = increasing revenue):

4 : NWC (N + 1) – NWC (N)

B. Calculating Free Cash Flow Directly (but first calculate earnings = net income)

Equations:

C. Calculate the NPV (when we have calculated the cash flows) : book p.193

In finance, the net present value (NPV) of a time series of cash flows, both incoming and
outgoing, is defined as the sum of the present values (PVs) of the individual cash
flows of the same entity. Used for budgeting, and widely throughout economics, finance,
and accounting, it measures the excess or shortfall of cash flows, in present value terms,
once financing charges are met.

Equation:

28
The discount factor (impact of discount) starts at 0

D. Choosing Among Alternatives

-Evaluating Manufacturing Alternatives: separately + choose the one with the highest
NPV
-Comparing Free Cash Flows for Cisco‟s Alternatives

E. Further Adjustments to Free Cash Flow

-Other Non-cash Items. Eg : depreciation, amortization, goodwill, …(immaterial assets).

Firms should only include actual cash revenues or expenses.
-Timing of Cash Flows. Eg : End of each year is different from reality ( spread
throughout the year).
-Accelerated Depreciation : Firm’s interest : using the most accelerated method.
-Liquidation or Salvage Value : might be negative due to sold assets.
-Terminal or Continuation Value : can be done with a perpetuity or a annuity (the
best). Firm forecast FCF over a shouter horizon than the full horizon of the project or the
investment. Eg : Investment with an indefinite life : we add often a continuation value.
-Tax Carryforwards: Eg : start ups : apply current losses to future years profit  tax
liability is reduced.

Salvage value : suppose you have a project and at the end of the project, you sell your
assets (material, immaterial: pattern)  salvage value = estimated value that an asset
will realize upon its sale at the end of its useful life.

Terminal value or “contribution value” : you continue the project! = is the present
value at as future point in time of all future cash flows when we expect stable growth
rate forever.
So we can have stability (growth rate is zero) and it’s a perpetuity. Or a decrease (growth
rate is negative) or an increase (growth rate is positive) : it’s then a growing perpetuity.

Nb : In this class, we’ll take the linear depreciation.

3. Analysing the Project

It’s a tool ford decision-making : should we invest or not?

For a decision making, we are doing this table :

Cash flow Year 0 … Year 4 Year 5

Cap ex.
Salvage V.
Tax on…
CFFO

29
 We calculate the NPV = Net Present Value. If it’s positive, we invest. It’s not because
it’s negative that we don’t invest. It’s difficult to know the future!

A) Break-even analysis

= level for which the investment has a zero NPV.

By how much should something decrease in order to get zero MPV?
By how much should my price decrease to obtain zero MPV?
By how much should my salaries/costs increase in order to get zero MPV?

Zero MPV is still ok = I’m earning every year my discount rate  we are making a profit.
We don’t want to have a negative MPV.

B) Sensitivity analysis

This analysis shows how the NPV varies as the underlying assumptions change (only on
parameter)?
Example: If I change my price by one euro, what’s the impact on the MPV? The price is
influencing everything. The taxes will change, the cash flow also  everything will
change.
How sensitive is MPV when I decrease or increase the price by one euro?
If I decrease/increase volume/costs by 1 euro, how sensitive is MPV?

C) Scenario analysis

What if a few parameters change?

You make a meeting with your colleagues and think about 3 scenarios:
- Worst case scenario: crisis scenario + strong response of competitors (more
aggressive, hiring more sells people). During a crisis, the inflation goes down.
- Central case scenario: try to be prudent and take reasonable assumptions.
- Best case scenario : Clients love your product and competitors don’t react or go
bankrupt. There is not crisis  growth.

 So 3 different results of MPV :

Worst : MPV < 0
Central : MV = 0
Best : MPV > 0

30
Exercise : HomeNet

A) Break even analysis

Internal rate of return(IRR) measures and compares the profitability of investments.

We have to stimulate and see how far can we go to obtain a zero MPV. The IRR of an
investment is the discount rate at which the net present value of costs (negative cash
flows) of the investment equals the net present value of the benefits (positive cash
flows) of the investment.
The IRR tells you the maximal error in the cost of capital before the optimal investment
decision would change.
The internal rate of return is given by r in the equation:

Decision Criterion: If the IRR is greater than the cost of capital  accept the project.
If the IRR is less than the cost of capital  reject the project.

Table : IRR calculation (book p.200)

NPV at 12% = discount rate = Interest rate of return (IRR)

Table : Break-even levels for HomeNet

2.2. Decision rule

1. NPV and stand-alone projects : decision rule

NPV decision rule implies that we should accept the projects with positive NPV or =0,
because accepting them is equivalent to receiving their NPV in cash today, and reject
the projects with a negative NPV; accepting them would reduce the wealth of
investors, whereas not doing them has no cost (NPV = 0).
We have to measure the sensitivity with IRR.
31
Example

FFF’s New fertilizer project :

Initial investment = 250 million $; yearly cash flow = 35 million $ : perpetuity.

Make a graph of cash-flows in function of time.

The discount rate (= cost of capital ) is unknown: what is the NPV?
If the cost of capital is 10%, the project has an NPV of ?
What is your decision: invest or not?
What would be your decision if r=20?

PV = I + perpetuity = -250 +
If r = 10% (Ok) NPV = -250 + 350 = 100 > 0
If r = 5% (Not realistic) NPV = -250 + 700 = 450
If r = 20% (pessimistic) NPV = -250 + 175 = - 75 < 0 !!!

The break-even is when NPV = 0

 -250 + = 0
My perpetuity: = 0  r = 0,14  this is the IRR = Break even discount rate

When do we invest? If
- The IRR is higher than the cost of the capital.
- NPV is positive

The discount rate = cost of capital = r

R = 0,05  NPV = 450

R = 0,10  NPV = 100
R = 0,02  NPV = -75
R = 0,14  NPV = 0
If IRR(profitability in percentage) = 14%  NPV = 0

In general: r  NPV = -250 +

32
The graph shows the NPV as a function of the discount rate. The NPV is positive only for
discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of
capital of 10%, the project has a positive NPV of $100 million : - 250 + 35/0,1 = 100
The difference between the cost of capital and the IRR is the maximum estimation error in
the cost of capital that can exist without altering the original decision : 14% - 10% = 4%
Decision Criterion: If the IRR is greater than the cost of capitalaccept the project. If the
IRR is less than the cost of capital reject the project.

2. Alternative decision-rule

We have seen the NPV, but there are other “decision rules”:

A) The Payback Rule: Payback period < 5 years (for example)(book p.165)

The payback rule is not a good rule (because tomorrow is less worth than today) but is
easy to understand : In how many years do I have my money/investment back? We just
look at cash flows operations.

It doesn’t take into account :

1° The project’s cost of capital
2° The time value for money
3° Ignores CF after the payback period.

Nb : The teacher advices us not to use it.

With an initial investment of 250M and suppose to generate 35M/year.

33
 Within 5 years, 175M will not cover the initial investment (not before 8 years).

The Payback Rule is the amount of time it takes for you to recover the initial cost of an
investment that you are undertaking. Therefore, an investment is acceptable if the
Payback that results from it falls under a pre-determined # of years. Another example
would illustrate this well.

|0 |1 |2 _ |3 |4 |

-$50,000 $30,000 $20,000 $10,000 $5,000

This is a financial timeline with cash flows of $50,000 (initial investment), 30 thousand
in Year 1, 20 thousand in Year 2, 10 thousand in Year 3 and 5000 in Year 4.

What is the payback period in this case? Well the company initially invests $50,000 and
recovers $30,000 of it in the 1st year. This means it has $20,000 more left to recover
(50,000 - 30,000). In the 2nd year, the company has a cash flow of $20,000 and this is the
BREAK EVENS POINT. Thus, the Payback Period is exactly 2 years.

B) The Discounted Payback Rule: Discounted Payback

One of the limitations of the payback period rule says that the rule does not take into
account time value of money. Thus, future cash flows are not discounted and adjusted
with interest earnings, inflation, etc. However, the Discounted Payback Period Rule takes
into account time value of money and the discounting of future cash flows.

Discounted Payback < 5 years (for example) : in how many years do I have my money
back? This period has to be lower than 4 or 5 years.
Rule -> An investment is good or acceptable if its discounted payback period is less than
a few predetermined years.

For example, we are given an investment that has an initial investment of $10,000
(Year0) and cash flows from Years 1-6. We take these cash flows, and calculate their
PRESENT VALUES. We use the time value of money template in the 2nd table to perform
this calculation.

34
PV of cash-flows. Eg : Year 1 = 1500 / ( 1 + 0,8) = 1389

The Payback Period occurs in Year 4, when the cash flow turns from a Negative (-1088)
to a Positive (+954). This is always true for any cash flow analysis you do. As soon as the
cumulative cash flows turns from a negative to positive, that's your payback period.
Thus, Discounted Payback Period = 4 Years + (1088 / 2042) = 4.53 Years

C) The Internal Rate of Return Rule: IRR > 12% (for example) (book p.160)
But they are problems with IRR :

Delayed Investments
Example : Reçevoir 1M (upfront
payment) pour écrire un livre dans 3 ans.
L’auteur demande un revenu de 500 000
/ an pour écrire le livre.

NPV = 1 000 000 (upfront payment)

- 500 000/(1+r)
- 500 000 / (1+r)^2
- 500 000 / (1 + r)^3

Nonexistent IRR(p.163) Le upfront payment est augmenté de

750M.

NPV never becomes negative and it can

happen that IRR = infinite.

35
 Multiple IRRs(p.162)

Reçevoir 550 000 (upfront payment) + un

paiement après avoir écrit le livre.

NPV = 550 000 (upfront payment)

- 500 000/(1+r)
- 500 000 / (1+r)^2
- 500 000 / (1 + r)^3
+ 1 000 000 / (1+r)^4

IRR vs the IRR rule

The examples in this section illustrates the potential shortcomings of the IRR rule when
choosing to accept or reject a stand-alone project. As we said at the beginning, we can
only avoid these problems if all of the negative cash flows of the project precede the
positive cash flows (condition!) Otherwise, we cannot rely on the IRR rule. However,
even in that case, the IRR itself remains a very useful tool. The IRR measures the average
return over the life of an investment and indicates the sensitivity of the NPV to
estimation error in the cost of capital. Thus, knowing the IRR can be very useful, but
relying on it to make investment decisions can be hazardous.

Why Do Rules Other Than the NPV Rule Persist? Possible answers:

-Because managers may use the payback rule for budgeting purposes or as a shortcut to
get a quick sense of the project before calculating NPV.
-Managers may use the IRR rule because the IRR sums up the attractiveness of
investment opportunity without requiring an assumption about the cost of capital
(calculating IRR). But again, you MUST know the cost of capital when you apply the IRR
rule.
 people are using payback. But it’s not a good one! Normally people use NPV or IRR.

3. Mutually Exclusive Investment Opportunities : decision rule

Sometimes a firm must choose just one project from among several possible projects,
that is, the choices are mutually exclusive. When projects are mutually exclusive, we
need to determine which projects have a positive NPV and then rank the projects to
identify the best one:

NPV-rule: provides a straight-forward answer: pick the project with the highest NPV.
Because the expresses the value of the project in terms of cash today, picking the project
with the highest NPV leads to the greatest increase in wealth.

36
IRR rule: It has to exceed the opportunity cost of capital. Because the IRR rule is a
measure of the expected return of investing in the project, you might be tempted to
extend the IRR investment rule to the case of mutually exclusive projects by picking the
project with the highest IRR. UNFORTUNATELY, picking one project over another simply
because it has a larger IRR can lead to mistakes: in particular when projects differ in
their scale of investment (a) and/or the timing of their cash flows (b).

• Differences in Scale (too complicated : not studying!)

Identical Scale
Change in Scale
Percentage Return Versus Dollar Impact on Value
• Timing of the Cash Flows
• Incremental IRR Rule
Incremental IRR Rule Application
Shortcomings of the Incremental IRR Rule

Timing of the CF : Even when projects have the same scale, the IRR may lead you to rank
them incorrectly due to differences in the timing of the cash flows. The IRR is expressed
as a return, but the dollar value of earning a given return depends on how long the
return is earned.

Example of two projects (cost of project = 10%) with identical IRR of 50% but different
horizons:
- Short-term project: NPV = -100 + 150/(1+0,1) = $36,36
- Long-term project (5years) :

FV = 100 x (1 + 0,5)^5 = 759 375

NPV= -100 + 759 375/1,105 = $371,51  long-term project is more valuable.

!!Notice that even when projects have the same horizon, the pattern of cash flows over
time will often differ, due to their different growth rates!

Example: same scale and horizon, but different growth rate (Theory p.168, exercise
p.166)
- Music store: -400 000 + = 0 => IRR = 26% => NPV = $900 000
- Coffee shop: -400 000 + = 0 => IRR = 23%=> NPV = $1,2 million => due to higher
growth rate!

In general, if A > B  NPV A can be< B because B has a better growth rate.

Incremental IRR Rule:

Choosing between 2 projects ? Instead of comparing IRR, we compute the incremental
IRR ( = IRR of the incremental CF that would result from replacing one project with the
other).

37
The incremental IRR tells us the discount rate at which it becomes profitable to switch
from one project to another. Then, rather than compare the projects directly, we can
evaluate the decision to switch from one to the other using the IRR rule, as in the
following

Example :

Assuming the cost of capital is 10%: The IRR is 36% for project A, and 21% for project B.
Which project is the best?

Because the projects have different scales, we cannot compare their IRRs directly. To
compute the incremental IRR of switching from project A to project B, we first compute
the incremental cash flows.=> these cash flows have an IRR of
20%.

Because the incremental IRR exceeds the 10% cost of capital, switching to project B
looks attractive (its larger scale is sufficient to make up for its lower IRR). Comparing the
NPV profiles of project A and B, we can see that despite its lower IRR, project B has a
higher NPV at the cost of capital of 10%. Note also that the incremental IRR of 20%
determines the crossover point or discount rate at which the optimal decision changes.

Shortcomings of the Incremental IRR Rule: When using the incremental IRR to choose
between, projects, we encounter all of the same problems with the IRR rule:
1) Even if the negative cash flows precede the positive ones for the individual projects, it
need not be true for the incremental cash flows. If not, the incremental IRR is difficult to
interpret, and may not exist or may not be unique.

38
2) The incremental IRR can indicate whether it is profitable to switch from one project to
another, but it does not indicate whether either project has a positive NPV on its own.
3) When the individual projects have different costs of capital, it is not obvious what cost
of capital the incremental IRR should be compared to. In this case only the NPV rule,
which allows each project to be discounted at its own cost of capital, will give a reliable
answer.

4 Project Selection with Resource Constraints : decision rule

When projects are mutually exclusive, the firm can only take one of the projects even if
many of them are attractive. Often this limitation is due to resource constraints (eg :
number of engineers, capacity of buildings,…). Thus far, we have assumed that the
different projects have the same resource requirements. In this section, we develop an
approach for situations where the choices have differing resource needs.

A) Evaluating projects with different resource requirements

If there is a fixed supply of the resource so that you cannot undertake all possible
opportunities, then the firm must choose the best set of investments it can make given
the resources it has available: the manager’s goal is to choose the projects that maximize
the total NPV while staying within her budget.

Example
Table : possible projects requiring warehouse space

While project A has the highest NPV, it uses up the entire budget. Projects B and C can
both be undertaken.
NPV exceeds the NPV of project A. Thus, with a budget of $100 million, the best choice is
to take projects B and C for a combined NPV of $150 million, compared to just $110
million for project 1 alone.

Profitablity index(per unit of resource) = NPV divided by fraction of warehouse

required.

Nb : Don’t only take into account NPV when you have resource constraints! Use the
profitability index (which should be the highest possible).

39
B) Profitability index

In the table, we included the profitability index, which measures the “bang for your
buck”-that is, the value created in terms of NPV per unit of resource consumed. This ratio
tells us that for every dollar invested in Project 1, we will generate $1 in value. Both
projects 2 and 3 generate higher NPVs per dollar invested than project 1, which indicates
that they will use the available project more efficiently.
After computing the profitability index, we can rank projects based on it. Starting with
the project with the highest index, we move down the ranking, taking all projects until
the resource is consumed.

Example

Table: Profitability index with a human resource constraint.

The real solution is to hire more engineers but let’s supposed that it’s not possible.
Best project : A F  E  router  C  D  B (worst)

C) Shortcomings of the profitability index

Although the profitability index is simple to compute and use, for it to be completely
reliable, two conditions must be satisfied:
1) The set of projects taken following the profitability index ranking completely exhausts
the available resource.
2) There is only a single relevant resource constraint.

40
5 EVA or Economic Value Added : decision rule

= When your capital/investment lasts forever (profit from the difference between
cashflows and +- investment).

EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea
is that value is created when the return on the firm's economic capital employed is
greater than the cost of that capital.

In other words, Economic Value Added is a performance ratio that determines the true
economic profitability of a corporation because it factors in net operating income after
taxes & interest minus the opportunity cost of capital deployed to earn that net
operating income. In other words, Economic Value Added shows whether the financial
performance of a company exceeds or is below the minimum required rate of return for
shareholders or business lenders. Economic Value Added tells investors whether the
amount of capital they have invested in to the business is generating them higher return
than their minimum, or if it is better to invest the capital elsewhere.

Cn = Cash flow created in Year n (profit)

I = Initial investment
r = discount rate or cost of capital
RI = Cost of efficiency

A)Calculating EVA when capital is constant:

Example

1. First we calculate the profit. Here: $35 million each year;

2. Then we determine the total capital deployed in the business. Here: $250 million
3. Then we calculate the cost of capital in percentage. Here 35 / 250 = 14%

4. Finally we calculate de capital costs and the economic value added. Here: capital
cost: $35 million
($250 million x à,14) , EVA: profit – capital cost : $35million - $35 million (14% 250
000).

41
FFF should make the investment if the cost of capital is below 14%!

B) Calculating EVA when capital depreciates (= real life)

Depreciation in period n = constant amount that we substract every year.

This is an alternative methodology to calculate NPV because at last, we finally get the
same result/figure as NPV.

Example

42
6. Choosing between long- and short-lived equipment : decision rule

The Equivalent Annual Cost (EAC) of an asset is the annual cost of owning and
operating an asset over its lifetime. It is a series of equal annual payments that has the
same Present Equivalent Value (PEV) as the PEV of the actual costs of owning and
operating the asset. The EAC is often used to compare the costs associated with assets or
projects having different cost distributions or different lifetimes, and to determine the
optimum replacement time of an asset.

The EAC is calculated by finding the Present Equivalent Value of the lifetime of owning
the asset and then determining the equal, annual series of payments, basically an
annuity, having the same Present Equivalent Value (PEV):

Example

Suppose you have to choose among two machines which do exactly the same job.
- Machine A costs 15,000$ and lasts for 3 years. It costs 4000$/year to run it.
- Machine B is an “economy” model costing 10,000$ and lasting 2 years. Maintenance
costs are 6000$/year

43
A : NPV = 15 000 – 4000 x = 25 692
Annuity PV = x(1- ) = 10 692
B : NPV = 10 000 – 6000 x = 21 000
Annuity PV = x(1- ) = 10 998

B is cheaper (NPV higher) but in 3 years, the machine B will have to be replaced so it’s
not a good methodology to make a decision (because of the different durations).

When we have different durations, the solution is to use the Equivalent Annual Cost
which is the yearly cash flow of the annuity with the same PV.
Should we choose Machine B which has the lowest PV cost? Not necessarily, because this
cost is spread over 3 years (year 0, 1 and 2) while A is spread over 4 years
Machine A has the lowest equivalent annual cost  We choose machine A!

We must divide the NPV by the annuity factor, which takes the nr of years and the
discount rate into account.

A : 3 years : - 25,690 / 2.673 (annuity factor) = 9,611 cost/year

B : 2 years : - 21,000/1.833 = -11,457 cost/year
 Equivalent annual cost  compare and chose the cheapest.

Question : How to compare the annuity factor?

44
3. Exercises : NPV
3.1. Session 1 : New motor

You have just been hired as the new financial manager of a company. This company has
a great 10-year project, given the high oil price: a new, fuel-efficient motor.

What do you think: should you invest?

Project data
1. Capital expenditure: $8 million for new machinery and $1 200 000 for a
warehouse extension. We assume a salvage value for the warehouse (1 million) and
machinery (0.5 million)
2. R&D: last year, the company spent 10 million researching this new motor
2.bis. The company has a building: you don't need to buy one. (note: if rented out to
someone else: rented for 200 000$)
3. Changes in working capital: inventories in year t are assumed to be 7% of
revenues in year t+1. “Receivables less payables” amount to 3.5% of revenues in
year t.
4. Machine Depreciation is normally based on 7-year MACRS, but keep it simple and
make it linear.
5. Inflation is 2%
6. Revenues: sales are as follow- 2000 motors in year 1, 4000 motors in year 2 and
10000 motors thereafter. The sales price will decline from $4000 to $3000 per
motor as the competition enters in year 3. We add up inflation.
7. Operating costs: we assume unit costs to be $2000 in real terms ; we add up
inflation to get nominal cost.
8. No interest charge - unlevered project
8. Overhead: we assume incremental costs to be 5% of revenue (only marketing
costs) - ADMIN COSTS are a fixed overhead of 1 million/year
9. Cost of capital is 15%

- Make a clear table!

- If a project has n years, add an extra column for year 0 and also a column for year n+1
- Inflation is cumulative, it has to be compounded!! We inflate only unit price and unit
cost.

Comments :
1: Capital expenditure = 8M + 1,2M = 9,2M
2 : Sunk costs from last year.
2. bis : opportunity cost = selling, gen & admin.
3: the increase in inventory is a cash flow
4: Depreciation = capital expenditure / n = 9,2M / 10
7: Cost of goods sold

45
8: It’s not incremental! It’s essential to make a clear difference between incremental
(=costs from the project) and fixed overheads.
9: Discount rate (capital = equity + long-term debts).

Steps to solve the exercise

1° Incremental Earnings Forecast

 “Sales” to “depreciation”
 EBIT + Income tax
 Unlevered Net Income
2° Free cash flow
 +depreciation – capital expenditures - Δ NWC (= inventory + receivables –
paybles)
 CFFO
 Discounted CF
3° NPV = ∑ discounted CF (out of bord)

NWC (We must calculate it apart)

NWC Year 0 Year 1 Year 2 Year 3
+ inventory 560 1,142 2,185 2,229
+ receivables 0 280 571 1,092
- payables
= NWC 560 1,422 2,576 3,320
Δ NWC +560 +862 +1,334 3,320

560 = 7% x revenue of next year(inventory).

1,422 = 3,5% of revenue this year.

Discount factor :
Y0 Y1 Y2 Y3
1
= 0,87 =0,76 =0,66

Revenue(sales) :
Year 0 1 2 3
Unit price - 4,000 4,080 3,000x
Unit cost - 2,000 2,040 2,000 x
3,1212+2,0308= 5,202
Quantity 2,000 4,000 10,000
Revenue = sales 8,000(000) 16,320(000) 31,212

16,320(000) = 4000 motors x (4000 x 1,02)  4000 per motor and 1,02 = inflation
Marketing costs = - 5% x 8000 = - 400 + opportunity costs (-200) = -600
EBIT : 4000 – 400 – 200 – 920 = 2,480

46
 Y O 1 2 3
Incremental earning
forecast
1. Sales 8,000 16,320 31,212
2. Cost of goods sold -4,000 -8,160 -20,808
3. Gross profit - - -
4. Selling, gen & admin -600 -1,016 -1,760.6
5. R&D - - -
6. Depreciation -920 -920 -920
7. EBIT 0 2,480 6,224 7,723
8. Income tax at 35% 0 -868 -2,178 -2,703
9. Unlevered net 1,612 4,045 5,020
income
Free cash flow
10. Plus : Depreciation - 920 920 920 etc.
11. Less : Cap 9,200(920x10years)
Expenditure
12. Less : -Δ NWC -560 -862 -1,334 -565
Cash flows from -9,760 1,670 3,631 5,376
operations(CFF0) (1,612 + 920 –
(syn : free cash flow) 862)
= Net income + depreciation
+ cap expenditure +(-Δ
NWC)
Discount Factor 1
( )
14.Discounted cash -9,760 1,452 2759,56 3548,16
flows (1670 x 0,87) (2,746 : (3,534 :
arrondis !!) arrondis!!)
NPV - 2,027
(-9,760 + 1452,9 +
2759,56 + 3548,16)
Inventory (We think = 560 (7% of 8000) 1142(7% of 2,185 2,229
about the future) 7% revenue of next 16330)
year 3.5%
revenue of
this year
+ Receivables 0 571 1,092
- Payables 280 (3,5% of
(3,5% of 8,000) 16,320)
=NWC 560 1,422 2,756 3,320
(560+0) (1142+280)
Δ NWC 560 862 1,334 564
 We have the evolution (1,422-560) (3,320-2,756)

47
Nb : NWC= Net Working capital = Current Assets – Current liabilities = Cash + inventory +
receivables – payables.

Why 7% revenue of next year? Why isn’t it for this year? We are thinking in advance!
They manage their inventory proactively in this case.

 We should invest in the project because the NWC increases every year.

Why is the sign of “Δ NWC “ negative? We are increasing the inventory so we have to pay
for that, it’s not free  Negative cash flows! (Exam! Don’t forget the negative sign).

3.2. Session 2 : Salvage value

= The estimated value that an asset will realize upon its sale at the end of its useful life.

Nb : In this class, we assume that assets are fully depreciated over their useful life. In other
words they reach a book value of zero on the Balance Sheet at the end of their useful life.

We sell the project data for 1.5 M. First, we are looking at the accounting and the taxes.
After, we are looking at the cash flows.

Accounting :
If we sell a machine, it will be in “Extraordinary revenue”: 1,500.
Then, we have to pay taxes: -3,5 x 1,500(profit) = -525
Extraordinary income = 975(1,500 – 525). We have to put it normally in year 11 but
here, exceptionally in 10.
Extraordinary profit = extraordinary revenue – book value (= accounting value, what
rests in the balance sheet after depreciation = purchase price – cumulative
depreciation).
The profit is fully depreciated.

Exercise

Suppose it’s a 4-year project and the cost of capital is 10%. The asset (machinery or
computers) is purchased or 1 million euros, in year 0 (now).

1. The useful life of the asset and the cost of capital is 10%. It’s sold in year 4 for 100,000
euros. Calculate the PV of this salvage value, taking taxes into account.
2. Same question if it’s sold in year 5
3. Same question it’s it’s sold in year 5 and if the useful life is 6 years.

Suppose it’s a LT project and the cost of capital is 10%. You have made detailed forecasts
for years 0 until 4. For year 5, after-tax cash flow is estimated 200,000 euros.

4. Assume stable CF beyond year 5. Calculate this terminal value. Calculate the PV (in
year 0) of this terminal value.
48
5. Assume growing(2% per year) CF beyond year 5. Calculate the PV.
6. Assume decreasing (at -2% per year) CF beyond year 5. Calculate the PV.

Answers :

Exercises 1. and 2. The machinery(asset) has been completely depreciated.

Cash flows Year O … Year 4 Year 5

(n) (n + 1)
Cap Exp -1,000
Salvage value - 100,000 100,000
Tax on…. -35,000 -35,000
CFFO 65,000 65,000

1. PV: 4 years = = 44395.87

2. PV: 5 years = = 40359.89

Exercise 3. The asset is partly depreciated

We still have an extraordinary income = 100,000( price of the asset sold).

We have an extraordinary profit = 100,000 – book value in year 5
Extraordinary loss = 100,000 – 166,67 = -66,667. Of course, we don’t pay taxes on a loss.

IF the project is a larger company  tax credit = 3,5% x 66,667 = 23,333

Cash flows Year 0 … Year 4 Year 5

(n) (n + 1)
Cap Ex -1,000,000
Salvage V. 100,000
Tax on… 23,333* (35% x
66,667)
CFFO 123,333

* The loss decreases the profit of the company  decreases the taxes of the company.

PV : 5 years: = 76,580

IF the project is not a larger company (The company is a startup)  Tax = 0

 You reduce the value of the assets or you put on reserves.
The reduction of the value is a loss/debt moved to 4 years ( not 5 years but 4)

49
Exercise 4.

Terminal value = perpetuity = = 2M (200,000 = value of the perpetuity in year

4 = 1M / 5)

PV of terminal value = = 1,366,026 (and r=0,10)

R = 10% (v. l’énoncé)

Exercise 5.

Terminal value = growing perpetuity = = = 2,500,000 (The value of the

perpetuity in year 4).

G = 0,02 (v. énoncé)

PV of the terminal value = = 1707,533 (with r = 10%)

Exercise 6.

Terminal value = decreasing perpetuity = = 1,666,666 is the value of the

perpetuity in year 4.
PV of Terminal value = = 1,138,855 (and r = 0,10)

3.3. Session 3 : Project A : with or without debt!  2 answers.

Your company is currently considering the following investment:

Project A
- Units sold year 1: 400 000
- Units sold year 2: 700 000
- Units sold year 3 : 950 000
- unit selling price 4 euros
- unit cost (raw materials) 3 euros
- yearly inflation for price and cost above 2%
- Goods and services year 1: 100 000 euros
- Goods and services year 2: 250 000 euros
- Goods and services year 3: 230 000 euros
- Salaries year 1: 100 000 euros
- Salaries year 2: 150 000 euros
- Salaries year 3: 200 000 euros
- initial investment 1 200 000 euros
- duration of project 3 yr
- salvage value (year 4) 200 000 euros
50
On the Balance Sheet :

- Inventory year 1 200 000 euros

- Inventory year 2 300 000 euros
- Inventory year 3 250 000 euros
- Payables year 1 100 000 euros
- Payables year 2 150 000 euros
- Payables year 3 200 000 euros
- Receivables year 1 100 000 euros
- Receivables year 2 150 000 euros
- Receivables year 3 50 000 euros
- Debt to social security year 1:50 000 euros
- Debt to social security year 2:150 000 euros
- Debt to social security year 3:100 000 euros
- Depreciation linear

For calculating the discount rate, you need to know the WACC and CAPM. If it's the case
use the data below, otherwise use r=11.2% (cost of capital) : it will allow you to
calculate an unlevered net income

- risk-free interest rate 4%

- beta 1.2
- Risk Premium 6%
The bank grants you a 3-year loan at 6% but only for half the investment, and it requests
fixed (yearly) annuities. These data in blue allow you to calculate the levered NPV with the
WACC [through the enterprise cash flows also called CFFO], or the levered net income
[through the shareholders cash flows]

Question: Calculate NPV + IRR + Payback period. Do you invest? (make sure you reply
to this last question!)

What is the Payback Period?

It refers to the period of time required for the return on an investment to "repay" the
sum of the original investment. For example, a $1000 investment which returned $500
per year would have a two year payback period. The time value of money is not taken
into account: there is NO discounting. Payback period intuitively measures how long
something takes to "pay for itself." All else being equal, shorter payback periods are
preferable to longer payback periods. Payback period is widely used because of its ease
of use despite the recognized limitations ".

How to calculate it?

Let's refer back to our session 3 on NPV of Project A. There was an investment of
1,200,000 euros in year 0. It's thus a negative cash flow (CF0=-1,200,000). It is followed
by positive cash flows: CF1, CF2, CF3, CF4.
51
Starting from our negative cash position of -1.2 million, the cash position improves
every year. The cash position remains negative in year 1,2 and 3:CF0+CF1+ CF2+ CF3< 0.
The cash position becomes positive in year 4: CF0+CF1+ CF2+ CF3+ CF4 >0.
It can be concluded that: 3 <Payback Period < 4.(in this case!)

Now the only remaining question is the last fraction of year, ok?
Payback Period = 3 - (CF0+CF1+ CF2+ CF3) /CF4
The above formula is only valid in this exercise!
In the general case, replace "3" by "year of 1st positive cash position – 1".

For example, if, in another exercise, the cash position turns positive in year 3, then:
CF0+CF1+ CF2 < 0
CF0+CF1+ CF2+ CF3 > 0
It can be concluded that: 2 <Payback Period < 3
Payback Period = 2 - (CF0+CF1+ CF2)/CF3

Nb : Making a graph of the cash position in function of time will help you.

Answer: cf Ichec.campus.

3.4. Session 4 : The Borstal company

The Borstal Company has to choose between two machines which do the same job but
have different lives. The two machines have the following costs:
Year Machine A Machine B

0 $ 40,000 $ 50,000

1 10,000 8000

2 10,000 8000

3 10,000 + replace 8000

4 8000 + replace

A) Suppose you are Borstal’s financial manager. If you had to buy one or the other
machine, and rent it to the production manager for that machine economic life, what
annual rental payment would you have to charge? Assume a 6 percent real discount rate
and ignore taxes.
B) Which machine should Borstal buy ? Answer: cf Ichec.campus.
52
4. Capital budgeting and valuation with leverage

= How do we deal with debts?

Debts = bank loans, bonds,… BUT don’t take the payables into account!! (debts with I =
0%)

 rd = cost of debt
 re = cost of equity

4.1. Overview

Assumptions in this chapter:

 The project has average risk.
 The firm’s debt-equity ratio is constant.
 Corporate taxes are the only imperfection (are taken into account).

4.2. The weighted average cost of capital method (WACC)

For now, it is assumed that the firm maintains a constant debt-equity ratio and that the
WACC remains constant over time.

Because the WACC incorporates the tax savings from debt, we can compute the levered
value of an investment, by discounting its unlevered free cash flow using the WACC.
Nb : Unlevered = without the effect of debt financing.

Value of the project = PV of future cash flows :

Using the WACC to value a project :

Assume Avco is considering introducing a new line of packaging, the RFX Series.
- Avco expects the technology used in these products to become obsolete after four
years. However, the marketing group expects annual sales of $60 million per year over
the next four years for this product line.
- Manufacturing costs(25M per year) and operating expenses(9M per year).
- Developing the product will require upfront R&D and marketing expenses of $6.67
million, together with a $24 million investment in equipment. The equipment will be
obsolete in four years and will be depreciated via the straight-line method over that
period.
53
- Avco expects no net working capital requirements for the project.
- Avco pays a corporate tax rate of 40%.

Spreadsheet expected free cash flow from Avco’s RFX project :

Avco’s current market value balance sheet($ million) and cost of capital without the RFX
project.

Nb : The balancesheet doesn’t come from accounting.

- Avco intends to maintain a similar (net) debt-equity ratio for the foreseeable future,
including any financing related to the RFX project. Thus, Avco’s WACC is

Note that net debt = D=320-20=$300 million (but we don’t have to do it).

- The value of the project, including the tax shield from debt, is calculated as the present
value of its future free cash flows.

1,068 = (1 + 0,068) and 0,068 = 6,8% WACC

54
The NPV of the project is $33.25 million.
$61.25 million(value of project) – $28 million(investment with free cash flow in year 0)
= $33.25 million

Summary of the WACC method :

1. Determine the free cash flow of the investment.

2. Compute the weighted average cost of capital.
3. Compute the value of the investment, including the tax benefit of leverage, by
discounting the free cash flow of the investment using the WACC.

Condition : The WACC can be used throughout the firm as the companywide cost of
capital for new investments that are of comparable risk to the rest of the firm and that
will not alter the firm’s debt-equity ratio.

55
 Part III : Risk & return on the stock
market
Nb : Difficult part because of the statistics.

1. Introduction

Stocks are shares of the capital or equity of the company, which means that
stockholders are the owners of the company. A shareholder wants a return on his
investment. For the company, it’s the cost of equity (return on capital)same thing
but 2 different words.

Stocks return on average 10 to 15% per year over the long term, a part in income or
dividends, typically between 0 and 5% (dividends are usually in cash, sometimes in
stocks) and a part in capital gains [plus-values].

Stocks are sold to the public through a flotation called Initial Price Offering (IPO)=
primary market. An initial public offering (IPO) or stock market launch, is the first sale of
stock by a private company to the public (prix de 1ère emission sur le marché primaire =
de banque à actionnaire! Ce n’est pas la bourse).

IPO can be used by either small or large companies to raise expansion capital and
become publicly traded enterprises (transforms the private company to the public
company). When a company makes an IPO, it has to inform the possible shareholders
about all the risks. It’s a bit liability of the company lies!

Many companies that undertake an IPO also request the assistance of an Investment
Banking firm acting in the capacity of an underwriter to help them correctly assess the
value of their shares, that is, the share price. Companies can later increase their capital
through a secondary offering or reduce their capital through share buy-backs.

We are talking about listed companies (they can be big or small).

Stock return = dividends (paid in cash with some extras) + part in capital gains(wait for
a few years to get them).

Stocks are a long-term asset (of infinite duration), freely traded in a liquid secondary
market: the stock exchange. Brokerage costs (frais de courtage) vary often between
0.3% and 1.5%. (the market price of a share has no relation to the accounting value of
the share!). If we go to a normal bank, we’ll have to pay more brokerage costs (if you
open an online bank account, it costs less because there’s no physical office,…). The
future profits of the company are included in the market price.

Nb : The book value is in accounting(B&S). Often, the market price is higher than the book
value (except in periods of recession).
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2. Ratios
2.1. Accounting ratios

Earnings per share (EPS) = the amount of earnings per each outstanding share of a
company's stock.
 net accounting earnings(profit after taxes)/number of shares.
Book value of 1 share = the value of an asset according to its balance sheet account balance
(not really interesting)  accounting(book) value of equity/nb of shares.


Payout ratio = % of profit a company distributes.

 dividend/earning eg50%

Note: -In the US, EPS are published quarterly and dividends are paid quarterly.
-In Europe: EPS are published every 6 months and dividends are paid yearly

The LT capital gains comes from earnings which have been invested! It’s the difference with
financial ratios.

2.2. Financial ratios

Market Value/Book Value (for equity) = the price at which an asset would trade in a
competitive auction setting/the value of an asset according to its balance sheet account
balance.
 Stock price (on the stock exchange) / book value of 1 share.

Dividend yield = he company's total annual dividend payments divided by its market
capitalization, or the dividend per share, divided by the price per share
 yearly dividend/share price

Price-to-earning ratio (P/E) = a measure of the price paid for a share relative to the
annual net income or profit earned by the firm per share. The P/E ratio can therefore
alternatively be calculated by dividing the company's market capitalization by its total
annual earnings. It’s the one we use!
 Stock price (on the stock exchange) / earnings per share(EPS). Usually 10,12.

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3. Returns

Eg : Value of $100 invested at the end of 1925 :

It’s a logarithm scale, not linear!

$1174 = inflation. As an investor, we want to do better than inflation( but it’s already a
good start).
$2229 : Treasury bills are still a bad investment.
$85649 : Worlwide portfolio = foreign investments.

Advice : If we invest in bonds/shares, we should diversify and not take any currency risks in
bonds (If we live in Europe, we should invest in euros).

Profit is income + capital gain (or income - capital loss). It’s in $ or euros!

Return is the ratio of money gained or lost on an investment relative to the amount of
money invested. It’s profit/initial investment. It’s in % ! (daily, monthly or annual
return).

Pt = Investment, price at the beginning of the period.

Eg : The stock price for Stock A was $10 per share 1 year ago. The stock is currently
trading at $9.50 per share, and shareholders just received a $1 dividend. What return was
earned over the past year?
= 5%

3.1. Investment decisions

Under certainty : r is known in advance

Suppose you have to choose between two risk-free assets (such as 2 government bonds
of equal duration and to be held to maturity): r1, r2 the investment decision is simple:
max (r1, r2) = return on bond 1, return on bond 2. We are going to choose the highest
one (because we know it in advance)? This investment is very safe  risk free
investment.

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Under uncertainty : r is not known in advance.
If you have to choose among 2 risky assets (such as stocks stock exchanges), it is more
complicated! Investors want to maximise returns, but minimise risks (but it’s
contradictory!).

Under uncertainty, there are 2 dimensions: return r and risk s or (standard deviation).

3.2. Definitions

Returns r are modelled using the Gauss-Laplace distribution of a normal random

variable (move all the time).
 its average  = E(r) is the expected return in %/year(In statistics, we use  but
in finance, we use E(r) : what rate on return do you expect from your investment?
 its standard deviation is , also in %/year : What rate will you actually learn?
 while r is random (ie is unknown and volatile), both the expected return  and
the risk  can be measured from past observations and are supposed to be
‘relatively’ stable over time (in this class!).

Realized Return = The

return that actually occurs
over a particular time period
(historical return).
Nb : Dividend yield : generally defined over 1 year

Variance = The expected

squared deviation from the
mean. Variance has a square
unit. In practice, we’ll use
standard deviation.

Standard Deviation = σ, is a
statistical measure of the
variability of a distribution
around its mean. It’s the
square root of the variance.

The average annual return :

Arithmetic

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1 + Rtotal = (1+R1) x (1+R2) Geometric (used in finance)

For 2 periods : (1 + R geom avg)^2 = (1+R1)% x

(1+R2)% x (1+R3) if 3 years.

Variance Estimate Using

Realized Returns
The estimate of the standard
deviation (=volatility) is the
square root of the variance.

SD(R) = Volatility in finance = measure of total risk = diversifiable

risk(specific/business risk) + undiversifiable risk (=generic/market risk. Eg : inflation,
interest rate).

Risk = standard deviation of return = volatility (which measure the total risk of a stock
or portfolio of stocks).

Nb : Variance + standard deviation are measures of the risk of a probability distribution

We use the geometric average in Finance! We suppose that a first period is followed by a
second one, se we have to compound (and not simply add). The difference between
arithmetic and geometric is small but it’s ok of we use the arithmetic average (still a
good approximation).

First we calculate the average and then the returns.

3.3. Examples

On average, you earn very little (0,03% a

day) but you risk a lot (0,95%). So it
doesn’t make sense to invest on a daily
basis (= every day, very short term).

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 Huge volatility for S&P 500 and small
stocks (on a year basis).

3.4. Portfolios

Modern portfolio theory (MPT) is a theory of investment which attempts to maximize

portfolio expected return for a given amount of portfolio risk, or equivalently minimize
risk for a given level of expected return, by carefully choosing the proportions of various
assets.

What happens to Risk and Return when we combine different shares to form a
PORTFOLIO of equities?

Portfolio Weights (xi) = The fraction of the total investment in each individual
investment in the portfolio. The portfolio weights must add up to 1.00 or 100%. It’s
usually included between 0 and 1.

0 ≤ xi ≤ 1.

Example: Suppose you invest $10 000 in Ford stock, and $30 000 in Tyco International
Stock. You expect a return of 10% for Ford and 16% for Tyco. What is your portfolio
expected return?

You invested $40 000 in total, so your portfolio weights 10 000/40 000 = 0,25 in Ford
and 30 000/40 000 = 0,75 in Tyco. Therefore, your portfolio’s expected return is: E[Rp] =
xFE[RF] + xT
E[RT] = 0,25 x 10% + 0,75 x 16% = 14,5%.

From the past: realised return of a portfolio (Rp ) is the weighted average of the
returns on the investments in the portfolio, where the weights correspond to portfolio
weights.

The Future: the expected return of a portfolio is the weighted average of the expected
returns of the investments within it.
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It’s the same formula for the past or the future. The difference is that we know the
numbers for the past so the return is completely different for the future.

Example : Portfolio with 200 shares of Walt Disney Company worth $30 per share and
100 shares of Coca-Cola worth $40 per share. Total value of the portfolio = 200 x $30 +
100 x $40 = $10 000, and the portfolio weights xD(60%) and XC( 4 0 % )

We choose the portfolio with the lower volatility.

Condition of diversification : it only works when companies have a low correlation (
volatility combined is lower).

Summary
- By combining stocks into a portfolio, we reduce risk through diversification.
- The amount of risk that is eliminated in a portfolio depends on the degree to which the
stocks face common risks and their prices move together.
That’s why we insist so much on diversification ( not only different companies but also
different sectors, because a company from a same sector face the same risks).

To find the risk of a portfolio, we need to know more than the return of the component
stocks: we need to know the degree to which the stocks face common risks and their
returns move together.

Covariance: is the expected product of the deviations of two returns from their means.
The covariance between two different returns Ri and Rj

- If two stocks move together, their returns will tend to be above or below average at
the same time, and the covariance will be positive.
- If the stocks move in opposite directions, one will tend to be above average when
the other is below average, and the covariance will be negative.
If one goes up, the other goes down in exactly the same proportion. But with the
correlation, if 1 goes up, you don’t know what the other will do (because they are
independent).

Correlation = a measure of the common risk shared by stocks that doesn’t depend on
their volatility. While the sign of the covariance is easy to interpret, its magnitude is not.
It will be larger if the stocks are more volatile (and so have larger deviations from their
expected returns).

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Correlation measures how returns move in relation to each other. It is between-1
(returns always move oppositely) and +1 (returns always move together). Independent
risks have no tendency to move together and have zero correlation.

The variance of a two-stock portfolio :

Var (Rp) = x12Var(R1) + x22Var(R2) + 2x1x2 Cov (R1,R2)

Note: the volatility (SD, standard deviation) is the square foot of the variance.

Exercice : Textbook : Chapter 11, example 11.6

There is a strong correlation because Dell & Microsoft are in the same sector. Dell &
Alaska have the same volatility but lower correlation (because different sectors). In this
case, there is no advantage from diversification.

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Nb : Risk lover : really want to maximize his profitability/profit.

Volatility Versus Expected Return for

Portfolios of Intel and Coca-Cola Stock

This is what happens graphically when we

decrease the volatility.

Improving returns with an efficient portfolio : We say a portfolio is inefficient whenever it

is possible to find another portfolio that is better in terms of both expected return and
volatility.

Exercice :

The effect of correlation on volatility

and expected return

We see graphically the impact of the

correlation (Important for exercise
session 5).

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Correlation has no effect on the expected return of a portfolio. However, the volatility of
the portfolio will differ depending on the correlation. The lower the correlation, the
lower the volatility we obtain (risk).

Short sales : Portfolio of Intel and Coca

Cola.

“Risk return space”.

We have only considered portfolio’s in which we invest a positive amount in each stock
(=long position). But it is also possible to invest a negative amount in a stock (= short
position), by engaging in a short sale (=a transaction in which you sell a stock that you do
not own, with the obligation to buy it in the future)  We can include a short position as
part of a portfolio by assigning that stock a negative portfolio weight.

Intel, coca cola and Bore industries

stocks

- There are many possible portfolios where

the optimum is situated on the ‘efficient
frontier’’.
- Adding more stocks to a portfolio reduces
risk through diversification.

Combining Coca Cola and Bore stock

(+ short sales)
 We get an entire region of risk and
return possibilities rather than just a single
curve. Note that most of the portfolios are
inefficient.
- An efficient portfolio(=efficient frontier)
maximizes the return for a given risk  on
the left of the shaded region,

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Efficient frontier with 10 stocks vs 3
stocks

In general, adding new investment

opportunities allows for greater
diversification and improves the efficient
frontier (which moves on the left). More
stocks we have, closer the efficient frontier
will be to the point where we want to be as
investors.
It’s better to have 25 stocks but the marginal
gains become very small!

Combining a risk-free investment and a

risky portfolio: borrowing and buying
stocks on margins.

- We don’t know how many assets there is in

this portfolio.
- As we increase the fraction x invested in
the portfolio P from 0 to 100%, we move
along the line from the risk-free investment
to P. If we increase x beyond 100%, we get
points beyond P in the graph. In this case,
we must pay the risk-free return: in other
words, we are borrowing money at the risk-
free rate. Borrowing money to invest in
stocks is referred to as buying stocks on
margin or using leverage. => a portfolio that
consists of a short position in the risk-free
investment is known as a levered portfolio.

Tangent or efficient portfolio

- The best line : yellow because it’s efficient.

- Highest possible expected return for any
level of volatility  find the portfolio with
the steepest(raide) line when combined
with the risk-free investment. The slope of
the line through a given portfolio P is the
Sharpe ratio (measures the ratio of reward-
to-volatility provided by a portfolio). The
line of the optimal portfolio with the risk-
free investment just touches, and so is
tangent to, the efficient frontier of risky
investments.
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 Diversification reduces risk

- In practice, it also depends on sectors, not

only on the number of stocks! If we want to
get a very low volatility, we should have
stocks from different sectors, continents,…
For bonds, it’s not worth it because the
currency risk is too high.

Capital markets theory :

What happens to Risk and Return when we add a short-term government BOND (=a
risk-free asset) to a PORTFOLIO of equities?
There is another way besides diversification to reduce risk: keep some of our money in a
safe, no-risk investment like Treasury bills. Of course, it will reduce our expected return.
Conversely, we might decide to borrow money to invest even more in the stock market.

Example

*In this example, there are 4 stocks: A, F, E

and D

*All portfolios constructed with these 4

stocks are in the shaded area: for example,
portfolio T

*Efficient portfolios are on the efficient

frontier
(the curved line B-C)

3.5. Conclusion on risk and return

Summary on the relationship between Risk and Return among PORTFOLIOS and among
individual SHARES (stocks):
• What did we learn from PORTFOLIO theory?

-We learned that for their portfolio, investors prefer high return and low risk : they
prefer efficient portfolios : portfolios situated on the efficient frontier.
-Which portfolio exactly? It depends on the risk aversion of each investor.
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• What did we learn from CAPITAL MARKETS theory?

-When introducing risk-free assets (= government bonds or T-bills), the efficient frontier
becomes a straight line: the Capital Market Line (CML)
-all portfolios on the CML are a combination of x% in the risk-free asset and (1-x)% in M,
the Market portfolio of all risky securities (= the whole market of listed stocks).

• OK. And practically?

Practically, all portfolios should thus be a combination of x% in Government Bonds and

(1-x)% in a diversified set of listed stocks

-because investing in 30,000 different equities is difficult…and

-because most of the benefit from diversification is already obtained with less than 100
different equities - especially if they are spread over different industry sectors and
countries
-x% = how much? This depends on each investor’s risk-aversion (investment horizon,
experience,…)

4. Exercises : risk and return on stocks

4.1. Session 5

Question 1
Consider that Stock A with E[r]=12%, and =25% and Stock B with E[r]=18%, and
=40% are correlated with a correlation coefficient of 0.8. Calculate the expected return,
the variance and the standard deviation for an equally weighted portfolio.

Make a graph of the evolution of risk and return in function of the weight in stock A.

Taking risk and return into consideration where would you invest? In A, in B or in the
equally weighted portfolio?

Question 2
2.1. Where do we have the best benefit from diversification?
=1
<1
=0
<0
=-1
2.2. Prove what you just said:
Calculate the weights to reach a zero-risk portfolio(sigma =0) with: Stock A having an
expected return E[r]=12%, and =25%; and Stock B having an expected return
E[r]=18%, and =40%; if they have a correlation coefficient of –1.

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Question 3
If two securities have the following risks 1= 40% (which is a typical stock eg “Suez”)
and 2= 0% (which is the risk-free asset) and the following returns: r1=15% and
r2=5%.
3.1. What is the correlation coefficient: =?
3.2. Construct a portfolio with a risk of 20%: which are its weights?
3.3. What is the expected return of this portfolio?

Question 4
A mutual fund claims to have outperformed the market, with a return of 14%, while the
Dow Jones Stoxx index (Rm) made +12%.
If the current risk-free interest rate (Rf) is 5% and you discover that the Beta of this
mutual fund is 1.4, is their claim correct?
Tip: calculate the expected return of this mutual fund. Formula of CAPM.

Question 5: Suppose you consider 3 stocks for your portfolio:

Stock A B C
Beta 1.2 0.9 1.8
Weights in the portfolio 40% 30% 30%

What is the expected return of each stock and of the portfolio, according to the CAPM,
using the market data (Rf and Rm) given above in question 4?

Question 6
Using the market data (Rf(0,05) and Rm(0,12)) given above in question 4, suppose you
want to reach an expected return of 10% for your portfolio, what would be its
composition [percentage in Treasury bills and percentage in stocks] and its beta?

Question 7
Keep the same Rf as above.
7.1. What is the expected return on the stock “Carrefour” if the Expected return of the
stock market is 12.5% and Carrefour’s Beta is 0.9?

7.2. Analysts are very optimistic today: they believe that the stock market will return
20% more than its long term average of 12.5% (they mean 20% of 12.5%, or 2.5%/year
above its long term average). What is the expected return on the stock “Carrefour” if you
share their optimism?

7.3. Use the above expected return on the stock “Carrefour" as the DISCOUNT RATE to
calculate the theoretical value of the share. The dividend is 1 euro/year. Assume a
perpetuity.

Answer : ichec.campus.

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4.2. Session 6

Cov = 0,8 and correl = cov / Ϭ1Ϭ2 (sigma1sigma2)

Or that covariance = 0,046646 ?

(-4,1-10,15)^2 + (28,4-10,15)^2+(12,2-10,15)^2+(4,1-10,15)^2 = 0,01923

5. Capital Asset Pricing Model

5.1. Assumptions of CAPM

-investors use the (past) mean to measure the expected rate of (future) return
-and (past) variance to measure the risk of (future) return
-investors are risk averse
-investors can borrow or lend money at the risk-free rate rf
-all investors have the same expectations and investment horizon
-there are no taxes, no transaction costs, no inflation and interest rates do not change !!
-the capital markets are in equilibrium

5.2. Risk composition

The total risk as measured by variance or standard deviation can be split in two parts:
Total risk=systematic (non-diversifiable) risk+ unsystematic (diversifiable) risk.

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The unsystematic risk or firm-specific risk (DIVERSIFIABLE) is the risk that affects
only one stock: it is specific to the company or to its industry or sector.
-This risk disappears thanks to the diversification, as the number of stocks in the
portfolio increases

The systematic risk or the market risk (NON DIVERSIFIABLE) is a non-diversifiable

risk that affects all investments to varying extents:
-some stocks are very sensitive to market-wide changes
-other stocks are less sensitive to such market changes.
This sensitivity is what we call the Beta, which measures the sensitivity of a stock to
market risks. Beta is essential in finance!

The systematic risk is measured by the Beta or ß: the Beta measures how the return on
the stock varies in reaction to changes in the market:

It’s as statistical definition of Beta : it’s a covariance between the stock (Ri) and the
market (Rm) divided by the variance of the market.
The Beta of a portfolio measures how the return on the portfolio varies in reaction to
changes in the market:

The Beta of the MARKET PORTFOLIO M is 1. The Beta of the risk-free asset is 0. Stocks
that are riskier than average have a Beta >1. Stocks less risky than average have a
Beta <1.

Securities market line (exam!)

It’s a graphic view of the equation of Beta.

The measure of the horizontal axe is

different! It’s not Sigma anymore; it’s a
different risk/return space.

The CAPM equation states that the risk premium of any security is
equal to the market risk premium multiplied by the beta of the security. This
relationship is called the security market line, and it determines the required return for
an investment.
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Only the systematic risk(measured by Beta) should be rewarded by an extra return!
(Unsystematic risk is not rewarded since it disappears in the portfolio construction
process: it is thus NOT related to return!)

The CAPM predicts that the Expected Return on a stock is linearly related to its Beta,
where E(Rm)-Rf is the market risk premium (or the extra return expected to
compensate for taking the risk of investing in stocks). It is the Securities Market Line, the
line along which all individual securities should lie when plotted according to their
expected return and beta. (Do not confuse it with the CML => did you notice that we use
Beta here for the X-axis?)

Sensitivity depends also on sectors!

5.3. Practical uses of the CAPM

-We use the CAPM(Capital Asset Pricing Model) to determine the expected rate of
return for a risky asset (stocks,commodities, gold…)
if beta>1, the Expected return> E(Rm) > market
if beta<1, the Expected return< E(Rm) < market

We use the CAPM to calculate the VALUE of an asset: the equation gives you the
required return “r”, and you use it to discount future cash flows:

eg the Gordon-Shapiro formula for the value of a stock:

-P=DIV/r which is actually a perpetuity: a constant dividend every year
-P=DIV/(r-g) which is a growing perpetuity, where g is the growth rate of the dividend

5.4. CML and SML

a) CML = Capital Market Line : use to show the rates of return (depending on risks)

b) SML = Security Market Line : representation of the market ‘risk and return at a given
time.

There is a linear relationship between a stock’s beta and its expected return. The
security market line (SML) is graphed as the line through the risk-free investment and

72
the market. According to the CAPM, if the expected return and beta for individual
securities are plotted, they should all fall along the SML.

Exercise :

We start with the cost of equity and finish with WACC. Note : this is a simple case in
which the company has no debt.

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IF THERE IS A DEBT, we have to use the WACC (weighted average cost of capital) is
the rate that a company is expected to pay on average to all its security holders to
finance its assets.
The WACC is the minimum return that a company must earn on existing asset base to
satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

6. Market efficiency
6.1. Introduction

Normal distribution

This is not reality but it’s

our model. It’s a simplified
view of it.

Market efficiency :
- Do prices accurately reflect available information? Do they react quickly?
- If prices are efficient, then an investor cannot earn an “abnormal” or “excess” return
- This is not the same thing as not being able to earn a positive return

Theoretical example

- Efficient market reaction : strong form

- Delayed reaction : weak form
- Overreaction : semi strong form

Nb : The price doesn’t reflect the complete information of delayed reaction.

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The reaction also depends on the volume : is the share traded everyday?

What makes markets efficient?

- Many investors (thousands, millions?) are researching potential investments
- As new information becomes available, it is evaluated : If traders think that the current
price is too high (low), they will sell (buy) until the price moves to where they think it
should be.
- What happens if investors stop doing research with liquid stocks?

6.2. Misconceptions
- Efficient markets do not mean you can’t earn money: what you earn should be
appropriate for the level of risk
- While all securities should be priced correctly in an efficient market, this does not
reduce the need for diversification

6.3. Forms of efficiency (important!)

Strong form: all information, including private and public, are built into prices
Insider trading profits suggest that markets are NOT “strong form efficient”
Semistrong form: all publicly available information is built into prices
Weak form: all historic information (but not current public information) is built into
prices

Empirical studies suggest that US markets are generally at least weak form and possibly
semi strong

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 Part IV : The capital structure of
companies ( corporate finance)
Part A : Capital structure in a perfect market : no taxes
Question of a financial manager : Should increase debt or equity because of a new project?

1. Equity vs debt financing

1.1. Definition

Capital structure = The relative proportions of debt, equity, and other securities that a
firm has outstanding.

1.2. Exercises

1) Financing a firm with equity

You are considering an investment opportunity.
For an initial investment of $800 this year, the project will generate cash flows of either
$1400 or $900 next year, depending on whether the economy is strong or weak,
respectively. Both scenarios are equally likely.

Project cash flow :

The project cash flows depend on the overall economy and thus contain market risk. As
a result, you demand a 10% risk premium over the current risk-free interest rate of 5%
to invest in this project.

- What is the NPV of this investment opportunity?

The cost of capital for this project is 15%.
Expected cash flow in one year : CF1 = 0.50 x 1400 + 0.50 x 900 = 1150
NPV = -800 + 1150/1.15 = 200

- If you finance this project using only equity, how much would you be willing to pay for
the project?

If you can raise $1000 by selling equity in the firm, after paying the investment cost of
$800, you can keep the remaining $200, the NPV of the project NPV, as a profit.

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2) Financing a firm with unlevered equity
= Equity in a firm with no debt
Because there is no debt, the cash flows of the unlevered equity are equal to those of the
project.
Cash flows for unlevered equity :

When a listed company announces a new project, the value immediately goes up. Listed
companies are fully equity-financed.

Shareholder’s returns are either 40% or –10%.

The expected return on the unlevered equity is:
½ (40%) + ½(–10%) = 15%.
Because the cost of capital of the project is 15%, shareholders are earning an
appropriate return for the risk they are taking.

3) Financing a firm with debt and equity

Suppose you decide to borrow $500 initially, in addition to selling equity.
Because the project’s cash flow will always be enough to repay the debt, the debt is risk
free and you can borrow at the risk-free interest rate of 5%. You will owe the debt
holders:
$500 × 1.05 = $525 in one year.

Levered Equity(for a levered project) = Equity in a firm that also has debt outstanding

Given the firm’s $525 debt obligation, your shareholders will receive only $875 ($1400 –
$525 = $875) if the economy is strong and $375 ($900 – $525 = $375) if the economy is
weak.
First we need to calculate the debt CF.

Values and CF for debt and equity of the levered firm :

Can we create value just by taking on more debt? Apparently not…

The CF of the project don’t change.
With the levered equity, we are increasing the volatility of the shareholders.

- What price E should the levered equity sell for?

- Which is the best capital structure choice for the entrepreneur?
- What proportion of debt-equity is the best?

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With perfect capital markets, the total value of a firm should not depend on its capital
structure. The firm’s total cash flows still equal the cash flows of the project, and
therefore have the same present value.
There is no tax advantage from the debts. The value of the firm comes with the
project/assets. So, the total value is not function of the quantity of equity-debt, it doesn’t
change.

Because the cash flows of the debt and equity sum to the cash flows of the project, by the
Law of One Price the combined values of debt and equity must be $1000.
Therefore, if the value of the debt is $500, the value of the levered equity must be $500.
E = $1000 – $500 = $500.

Because the cash flows of levered equity are smaller than those of unlevered equity,
levered equity will sell for a lower price ($500 versus $1000).
However, you are not worse off. You will still raise a total of $1000 by issuing both debt
and levered equity. Consequently, you would be indifferent between these two choices
for the firm’s capital structure.
1.3. The effect of leverage on risk and return

Leverage increases the risk of the equity of a firm. Therefore, it is inappropriate to

discount the cash flows of levered equity at the same discount rate of 15% that you used
for unlevered equity. Investors in levered equity will require a higher expected return to
compensate for the increased risk.
There is no risk of bankruptcy in this case. The CF are more volatile when we have debt.

Returns to equity with or without leverage

Comment : -25% = lose 25% of your investment

The returns to equity holders are very different with and without leverage.
Unlevered equity has a return of either 40% or –10%, for an expected return of 15%.
Levered equity has higher risk, with a return of either 75% or –25%.
To compensate for this risk, levered equity holders receive a higher expected return of
25%.

The relationship between risk and return can be evaluated more formally by computing
the sensitivity of each security’s return to the systematic risk of the economy.

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Systematic Risk and Risk Premiums for Debt, Unlevered Equity, and Levered Equity

Because the debt’s return bears no systematic risk, its risk premium is zero!.
In this particular case, the levered equity has twice the systematic risk of the unlevered
equity and, as a result, has twice the risk premium.

In summary:
- In the case of perfect capital markets, if the firm is 100% equity financed, the equity(=
unlevered equity)holders will require a 15% expected return.
- If the firm is financed 50% with debt and 50% with equity, the debt holders will
receive a return of 5%, while the levered equity holders will require an expected return
of 25% (because of their increased risk).
- Leverage increases the risk of equity even when there is no risk that the firm will default.
Thus, while debt may be cheaper, its use raises the cost of capital for equity. Considering
both sources of capital together, the firm’s average cost of capital with leverage is the
same as for the unlevered firm.

Exercises :

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2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value
2.1. Introduction (!)

The Law of One Price implies that leverage will not affect the total value(=cost of
funding) of the firm. Instead, it merely changes the allocation of cash flows between debt
and equity, without altering the total cash flows of the firm.

2.2. Conditions

Modigliani and Miller (MM) showed that this result holds more generally under a set of
conditions referred to as perfect capital markets:
- Investors and firms can trade the same set of securities at competitive market prices
equal to the present value of their future cash flows.
- There are no taxes, transaction costs, or issuance costs associated with security
trading.
- A firm’s financing decisions do not change the cash flows generated by its investments,
nor do they reveal new information about them.

2.3. MM Proposition(exam!)

In a perfect capital market, the total value of a firm is equal to the market value of the
total cash flows generated by its assets and is not affected by its choice of capital structure.

Argument:
In the absence of taxes or other transaction costs, the total cash flow paid out to all of a
firm’s security holders is equal to the total cash flow generated by the firm’s assets.
Therefore, by the Law of One Price, the firm’s securities and its assets must have the
same total market value.

2.4. The market value balance sheet

A balance sheet where:

- All assets and liabilities of the firm are included (even intangible assets such as
reputation, brand name, or human capital that are missing from a standard accounting
balance sheet).
- All values are current market values rather than historical costs.
The total value of all securities issued by the firm must equal the total value of the firm’s
assets.

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The market value balance sheet of the firm :

Nb : Equity : In real life, there are more possibilities.

Using the market value balance sheet, the value of equity is computed as:

Exercise :

2.5. Application: A Leveraged Recapitalization

When a firm uses borrowed funds to pay a large special dividend or repurchase a
significant amount of outstanding shares

Example:
- Harrison Industries is currently an all-equity firm operating in a perfect capital market,
with 50 million shares outstanding that are trading for $4 per share.
- Harrison plans to increase its leverage by borrowing $80 million and using the funds to
repurchase 20 million of its outstanding shares.

This transaction can be viewed in two stages.

- First, Harrison sells debt to raise $80 million in cash.
- Second, Harrison uses the cash to repurchase shares.
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Market Value Balance Sheet after Each Stage of Harrison’s leveraged

Initially, Harrison is an all-equity firm and the market value of Harrison’s equity is $200
million (50 million shares × $4 per share = $200 million) equals the market value of its
existing assets. After borrowing, Harrison’s liabilities grow by $80 million, which is also
equal to the amount of cash the firm has raised. Because both assets and liabilities
increase by the same amount, the market value of the equity remains unchanged.
To conduct the share repurchase, Harrison spends the $80 million in borrowed cash to
repurchase 20 million shares ($80 million ÷ $4 per share = 20 million shares.) Because
the firm’s assets decrease by $80 million and its debt remains unchanged, the market
value of the equity must also fall by $80 million, from $200 million to $120 million, for
assets and liabilities to remain balanced.

The share price is unchanged.

With 30 million shares remaining, the shares are worth $4 per share, just as before
($120 million ÷ 30 million shares = $4 per share).

3. Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

3.1. Leverage and the Equity Cost of Capital(exam!)

MM’s first proposition can be used to derive an explicit relationship between leverage
and the equity cost of capital.

E : Market value of equity in a levered firm.

D: Market value of debt in a levered firm.
U: Market value of equity in an unlevered firm.
A: Market value of the firm’s assets (= PV of the enterprise’s CF).

MM Proposition I states that:

E+D=U=A
The total market value of the firm’s securities is equal to the market value of its assets,
whether the firm is unlevered or levered.
The cash flows from holding unlevered equity can be replicated using homemade
leverage by holding a portfolio of the firm’s equity and debt.

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The return on unlevered equity (RU) is related to the returns of levered equity (RE) and
debt (RD):

Solving for RE (exam!)

The levered equity return equals the unlevered return, plus a premium due to leverage.
The amount of the premium depends on the amount of leverage, measured by the firm’s
market value debt-equity ratio, D/E.

MM Proposition II(exam) : The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is proportional to the market value debt-
equity ratio.

Cost of Capital of Levered Equity (Re) : based on market value :

Recall from above:

- If the firm is all-equity financed, the expected return on unlevered equity is 15%.
- If the firm is financed with $500 of debt, the expected return of the debt is 5%.

Therefore, according to MM Proposition II, the expected return on equity for the levered
firm is:

Exercise :

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3.2. Capital Budgeting and the Weighted Average Cost of Capital

1) If a firm is unlevered, all of the free cash flows generated by its assets are paid out to
its equity holders. The market value, risk, and cost of capital for the firm’s assets and its
equity coincide and, therefore:

2) If a firm is levered, project rA is equal to the firm’s weighted average cost of capital.
Unlevered Cost of Capital (pretax WACC)

With perfect capital markets, a firm’s WACC is independent of its capital structure and is
equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its
assets.

Debt-to-Value Ratio = The fraction of a firm’s enterprise value that corresponds to

debt.

WACC and Leverage with Perfect

Capital Markets

(a) Equity, debt, and weighted average

costs of capital for different amounts of
leverage. The rate of increase of rD and
rE, and thus the shape of the curves,
depends on the characteristics of the
firm’s cash flows.
(b) Calculating the WACC for alternative
capital structures.

- The interest rate goes up because it’s

more risky
- The return on equities increases with
debts

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With no debt, the WACC is equal to the unlevered equity cost of capital.
As the firm borrows at the low cost of capital for debt, its equity cost of capital rises. The
net effect is that the firm’s WACC is unchanged.

Exercise :

3.3. Levered and Unlevered Betas

The effect of leverage on the risk of a firm’s securities can also be expressed in terms of
beta:

Unlevered Beta : A measure of the risk of a firm as if it did not have leverage, which is
equivalent to the beta of the firm’s assets.
If you are trying to estimate the unlevered beta for an investment project, you should
base your estimate on the unlevered betas of firms with comparable investments.

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Leverage amplifies the market risk of a firm’s assets, βU, raising the market risk of its
equity.

Exercises :

Beyond the Propositions :

Conservation of Value Principle for Financial Markets :
With perfect capital markets, financial transactions neither add nor destroy value, but
instead represent a repackaging of risk (and therefore return).
This implies that any financial transaction that appears to be a good deal may be
exploiting some type of market imperfection.

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Chapter Quiz :

1. How does the risk and cost of capital of levered equity compare to that of
unlevered equity? Which is the superior capital structure choice in a perfect
capital market?
2. What is a market value balance sheet?
3. In a perfect capital market, how will a firm’s market capitalization change if it
borrows in order to repurchase shares? How will its share price change?
4. With perfect capital markets, as a firm increases its leverage, how does its debt
cost of capital change? Its equity cost of capital? Its weighted average cost of
capital?
5. If a change in leverage raises a firm’s earnings per share, should this cause its
share price to rise in a perfect market?
6. Consider the questions facing Dan Harris, CFO of EBS, at the beginning of this
chapter. What answers would you give based on the Modigliani-Miller
Propositions? What considerations should the capital structure decision be
based on?

Part B : Debt and taxes : Capital structure with debts and

taxes

4. Debt and taxes

4.1. The interest tax deduction

Corporations pay taxes on their profits after interest payments are deducted. Thus,
interest expense reduces the amount of corporate taxes. This creates an incentive to use
debt.

Consider Safeway, Inc. which had earnings before interest and taxes of approximately
$1.85 billion in 2008, and interest expenses of about $350 million. Safeway’s marginal
corporate tax rate was 35%.
As shown on the next slide, Safeway’s net income in 2008 was lower with leverage than
it would have been without leverage.

Safeway’s Income with and without Leverage, 2008 ($ millions)

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Safeway’s debt obligations reduced the value of its equity. But the total amount available
to all investors was higher with leverage.

- Without leverage, Safeway was able to pay out $1,202 million in total to its investors.
- With leverage, Safeway was able to pay out $1,325 million in total to its investors.
Where does the additional $123 million come from?

Interest Tax Shield = The reduction in taxes paid due to the tax deductibility of interest.
≠net income with taxes (levered) and without taxes (unlevered)
In Safeway’s case, the gain is equal to the reduction in taxes with leverage: $648 million
− $525 million = $123 million. The interest payments provided a tax savings of 35% ×
$350 million = $123 million.

Exercise :

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4.2. Valuing the Interest Tax Shield (!!)

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
This benefit is the computed as the present value of the stream of future interest tax
shields the firm will receive.
The cash flows a levered firm pays to investors will be higher than they would be
without leverage by the amount of the interest tax shield.

The Cash Flows of the Unlevered and Levered Firm

A) MM Proposition I with Taxes

The total value of the levered firm exceeds the value of the firm without leverage due to the
present value of the tax savings from debt.

Exercise :

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B) The interest tax shield with permanent debt :
Typically, the level of future interest payments is uncertain due to changes in the
marginal tax rate, the amount of debt outstanding, the interest rate on that debt, and the
risk of the firm.
For simplicity, we will consider the special case in which the above variables are kept
constant.

The WACC with and without

Corporate Taxes

Net external financing and

capital expenditures by Us
corporations, 1975-2008.

4.3. Required return on equity

Cost of equity:
Proposition II:

Where
rE is the required rate of return on levered equity
r0 is the required rate of return on unlevered equity (noted rU in previous slides)
rD is the cost of debt or interest rate.
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Again, the cost of equity rises with leverage, because the risk to equity rises

4.4. Optimal Capital Structure with Taxes

Do Firms Prefer Debt?

- While firms seem to prefer debt when raising external funds, not all investment is
externally funded.
- Most investment and growth is supported by internally generated funds. Even though
firms have not issued new equity, the market value of equity has risen over time as firms
have grown. For the average firm, the result is that debt as a fraction of firm value has
varied in a range from 30–45%.

Debt-to-value Ratio : D / (E + D) of
US firms, 1975-2008

In the real world: Do Firms Prefer Debt?

- The use of debt varies greatly by industry.
- Firms in growth industries like biotechnology or high technology carry very little debt,
while airlines, automakers, utilities, and financial firms have high leverage ratios.

Debt-to-Value Ratio [D / (E + D)] for

Select Industries

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The low leverage puzzle
Firms worldwide have similar low proportions of debt financing. Although the corporate
tax codes are similar across all countries in terms of the tax advantage of debt, personal
tax rates vary more significantly, leading to greater variation in *.

International Leverage and Tax Rates (1990)

It would appear that firms, on average, are under-leveraged. However, it is hard to

accept that most firms are acting sub optimally.
In reality, there is more to the capital structure story than discussed so far.

A key item missing from the analysis thus far is that increasing the level of debt
increases the probability of bankruptcy.
If bankruptcy is costly, these costs might offset the tax advantages of debt financing.

5. Session 7 exercises: Leverage, debt, capital structure

1) Using the formula on slide 71:

Suppose your firm's value in 1000 (the unit is: thousands of $)
Assume you borrow only 200 to finance it.
With an interest rate of 5% on the debt and a WACC=Ru=15%, what's the cost of equity?

2) Using the formula on slide 92: SAME DATA as ABOVE.

Assume also that the Beta of the debt is close to zero and the Unlevered Beta (or Beta of
the company when it has no dent) is 1.0
What's the new (Levered) Beta?
What does it mean in terms of the sensitivity of the stock to the market movements
when comparing levered with unlevered?

Answers:

1) We use the market value balance sheet. What’s the return on levered equity? (Re).
The risk comes from the volatility of the profit/earnings : here, the risk is higher, the
shareholder will expect more than 15%!

Re = Ru + D / E (Ru- Rd) = 0.15 + 200/800 x 0.10 = 0.175 = 17,5% (that’s what the
shareholder requires).
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 2) βu = 1.0 & βd = 0  βL? What’s the levered Beta of stocks?
βe = βu + D/E x (βu – βd)  1.0 + 200/800 x (1-0) = 1.25 >< βu = 1.0 !!
It means (in terms of sensitivity) that the levered Beta is more sensitive! The stock price
of the levered company doesn’t really follow the market index, it’s more volatile so it
goes more “up and down”.
βu = 1.0 (less sensitive/volatile)
βu = 1.25 (more sensitive/volatile)

CAPITAL STRUCTURE : HOW MUCH DEBT? (EXAM!!!)

Part IV A. Capital MM1 MM2

markets with no taxes Total value Re = βe = βu + D/E(βu –βd)
= MV of CF Ru + D/E x (Ru-Rd)
= Constant, whatever D/E
Part IV B. Capital market Total Value L Re = NOT SEEN
with debt and taxes = not constant with D/E Ru + D/E x (Ru-Rd)(1-Tc)
= Vu +PV(Tax shield)
= Vu + Tc x Debt
Part IV C. Capital market Total Value L
with costly financial = Vu + PV (tax shield) – PV
distress (financial distress

 We improve the formula with each chapters!

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 Part C : Financial distress, managerial incentives and
information

6. Default and Bankruptcy in a Perfect Market

Financial Distress : When a firm has difficulty meeting its debt obligations
Default : When a firm fails to make the required interest or principal payments on its
debt, or violates a debt covenant After the firm defaults, debt holders are given certain
rights to the assets of the firm and may even take legal ownership of the firm’s assets
through bankruptcy.

An important consequence of leverage is the risk of bankruptcy : Equity financing does

not carry this risk. While equity holders hope to receive dividends, the firm is not legally
obligated to pay them.

7. The Costs of Bankruptcy and Financial Distress

7.1. Introduction

With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt, rather
bankruptcy shifts the ownership of the firm from equity holders to debt holders without
changing the total value available to all investors. In reality, bankruptcy is rarely simple
and straightforward. It is often a long and complicated process that imposes both direct
and indirect costs on the firm and its investors.

7.2. The Bankruptcy code

The U.S. bankruptcy code was created so that creditors are treated fairly and the value of
the assets is not needlessly destroyed.
U.S. firms can file for two forms of bankruptcy protection: Chapter 7 or Chapter 11.

Chapter 7 Liquidation: A trustee is appointed to oversee the liquidation of the firm’s

assets through an auction. The proceeds from the liquidation are used to pay the firm’s
creditors, and the firm ceases to exist.

Chapter 11 Reorganization: It’s the more common form of bankruptcy for large
corporations (we have the same in Belgium).
- With Chapter 11, all pending collection attempts are automatically suspended, and the
firm’s existing management is given the opportunity to propose a reorganization plan.
While developing the plan, management continues to operate the business.
- The reorganization plan specifies the treatment of each creditor of the firm.
- Creditors may receive cash payments and/or new debt or equity securities of the firm.
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The value of the cash and securities is typically less than the amount each creditor is
owed, but more than the creditors would receive if the firm were shut down
immediately and liquidated.
- The creditors must vote to accept the plan, and it must be approved by the bankruptcy
court.
- If an acceptable plan is not put forth, the court may ultimately force a Chapter 7
liquidation.
The reorganization works sometimes but when it doesn’t  liquidation.

7.3. Direct Costs of Bankruptcy

The bankruptcy process is complex, time-consuming, and costly.

- Costly outside experts are often hired by the firm to assist with the bankruptcy process.
- Creditors also incur costs during the bankruptcy process.
 They may wait several years to receive payment.
 They may hire their own experts for legal and professional advice.

(!)The direct costs of bankruptcy reduce the value of the assets that the firm’s investors
will ultimately receive. The average direct costs of bankruptcy are approximately 3% to
4% of the pre-bankruptcy market value of total assets.

(!) Given the direct costs of bankruptcy, firms may avoid filing for bankruptcy by first
negotiating directly with creditors (so you don’t have to go to the Court).
Workout = A method for avoiding bankruptcy in which a firm in financial distress
negotiates directly with its creditors to reorganize. The direct costs of bankruptcy
should not substantially exceed the cost of a workout.

7.4. Indirect Costs of Financial Distress

While the indirect costs are difficult to measure accurately, they are often much larger
than the direct costs of bankruptcy : loss of customers, loss of suppliers, loss of
employees, loss of receivables, fire sale of assets(at a low price), management time, costs
to creditors,…

Overall Impact of Indirect Costs

The indirect costs of financial distress may be substantial. It is estimated that the
potential loss due to financial distress is 10% to 20% of firm value

Who Pays for Financial Distress Costs?

- Debt holders recognize that if the firm defaults, they will not be able to get the full
value of the assets. As a result, they will pay less for the debt initially . Or in other words,
they will require a higher interest rate (up to 10 or 15%)
- If the debt holders initially pay less for the debt, there is less money available for the
firm to pay dividends, repurchase shares, and make investments. This difference comes
out of the equity holders’ pockets.
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When securities are fairly priced, the original shareholders of a firm pay the present value
of the costs associated with bankruptcy and financial distress.

7.5. Financial Distress Costs and Firm Value

The Firm Value decreases (already now!) due to expected financial costs
VL = Vu + PV (tax shield) – PV (Financial distress).

8. Optimal Capital Structure

8.1. Tradeoff Theory

Nb : It’s the conclusion of the parts A,B,C.

The firm picks its capital structure by trading off the benefits of the tax shield from debt
against the costs of financial distress and agency costs.

According to the tradeoff theory, the total value of a levered firm equals the value of the
firm without leverage plus the present value of the tax savings from debt, less the present
value of financial distress costs.

8.2. Determinants of the PV of Financial Distress Costs

Three key factors determine the present value of financial distress costs:

1) The probability of financial distress.

- The probability of financial distress increases with the amount of a firm’s liabilities
(relative to its assets).
- The probability of financial distress increases with the volatility of a firm’s cash flows
and asset values.

2) The magnitude of the costs after a firm is in distress.

Financial distress costs will vary by industry.

3)The appropriate discount rate for the distress costs

8.3. Optimal Leverage

For low levels of debt, the risk of default remains low and the main effect of an increase
in leverage is an increase in the interest tax shield.
As the level of debt increases, the probability of default increases. As the level of debt
increases, the costs of financial distress increase, reducing the value
of the levered firm.

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The tradeoff theory states that firms should increase their leverage until it reaches the
level for which the firm value is maximized (remember!)
At this point, the tax savings that result from increasing leverage are perfectly offset
by the increased probability of incurring the costs of financial distress.

The tradeoff theory can help explain :

 Why firms choose debt levels that are too low to fully exploit the interest tax
shield (due to the presence of financial distress costs)
 Differences in the use of leverage across industries (due to differences in the
magnitude of financial distress costs and the volatility of cash flows)

Optimal Leverage with Taxes and

Financial Distress Costs

- High distress costs = high probability of

bankruptcy >< low distress cost = low
probability of bankruptcy

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 Part D : Payout policy
9. Distributions to Shareholders
9.1. Payout policy

= The way a firm chooses between the alternative ways to distribute free cash flow to
equity holders
- Dividend payout ratio = div/profit
- Total Payout ratio = (dividends + stock repurchases)/profit

The uses of free CF Important Dates for Microsoft’s Special

Dividend

10. Comparison of Dividends and Share Repurchases

10.1.Dividends

Special Dividend : A one-time dividend payment a firm makes, which is usually much
larger than a regular dividend

Stock Split (Stock Dividend) : When a company issues a dividend in shares of stock
rather than cash to its shareholders

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 Dividend History for GM Stock,
1983–2008

Return of Capital: When a firm, instead of paying dividends out of current earnings (or
accumulated retained earnings), pays dividends from other sources, such as paid-in-
capital or the liquidation of assets

Liquidating Dividend: A return of capital to shareholders from a business operation

that is being terminated

10.2. Share repurchases(!)

An alternative way to pay cash to investors is through a share repurchase or buyback.

The firm uses cash to buy shares of its own outstanding stock.

Open Market Repurchase: When a firm repurchases shares by buying shares in the
open market Open market share repurchases represent about 95% of all repurchase
transactions.

Tender Offer : A public announcement of an offer to all existing security holders to buy
back a specified amount of outstanding securities at a prespecified price (typically set at
a 10%-20% premium to the current market price) over a prespecified period of time
(usually about 20 days). If shareholders do not tender enough shares, the firm may
cancel the offer and no buyback occurs.

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10.3.Modigliani–Miller and Dividend Policy Irrelevance

There is a trade-off between current and future dividends.

- If the company pays a higher current dividend, future dividends will be lower.
- If the company pays a lower current dividend, future dividends will be higher.

MM Dividend Irrelevance:
In perfect capital markets, holding fixed the investment policy of a firm, the firm’s
choice of dividend policy is irrelevant and does not affect the initial share price.

Dividend Policy with Perfect Capital Markets

A firm’s free cash flow determines the level of payouts that it can make to its investors.
- In a perfect capital market, the type of payout is irrelevant.
- In reality, capital markets are not perfect and it is these imperfections that should
determine the firm’s payout policy: see next section (taxes).

11. The Tax Disadvantage of Dividends

11.1. Taxes on Dividends and Capital Gains

- Shareholders must pay taxes on the dividends they receive and they must also pay
capital gains taxes when they sell their shares.
- Dividends are typically taxed at a higher rate than capital gains. In fact, long-term
investors can defer the capital gains tax forever by not selling.

Long-Term Capital Gains Versus Dividend Tax Rates in the United States, 1971–2009

- The higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a
dividend. When dividends are taxed at a higher rate than capital gains, if a firm raises
money by issuing shares and then gives that money back to shareholders as a dividend,
shareholders are hurt because they will receive less than their initial investment.

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 11.2. Optimal dividend policy with taxes

When the tax rate on dividends is greater than the tax rate on capital gains, shareholders
will pay lower taxes if a firm uses share repurchases rather than dividends. This tax
savings will increase the value of a firm that uses share repurchases rather than
dividends.

The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate
is to pay no dividends at all. The payment of dividends has declined on average over
the last 30 years while the use of repurchases has increased.

The Decline in Payouts and the Use of The Changing Composition of Shareholder
Dividends Payouts

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