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Brigham, Ehrhardt & Fox
Financial Management:
Theory and Practice
EMEA 2nd edition
© 2016 Cengage Learning EMEA. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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1
CHAPTER 1
Central Concepts in Finance and Financial

Management
2
Topics in Chapter
◼ Role of the financial manager
◼ Objective of the firm: Maximize wealth
◼ Determinants of fundamental value
◼ Financial securities, markets and
institutions
3
Why is the corporate financial
manager important?
4
Becoming a Limited Company
◼ A limited company is a legal entity
separate from its owners and
managers.
◼ The primary objective should be
shareholder wealth maximization, which
translates to maximizing the share
price. This is the normative goal. Is it
the observed goal?
5
Advantages and Disadvantages of
a Limited Companies
◼ Advantages:
◼ Unlimited life
◼ Easy transfer of ownership
◼ Limited liability
◼ Ease of raising capital
◼ Disadvantages:
◼ Double taxation (Corporation tax and dividends)
◼ Cost of set-up and report filing
6
Corporate Governance
◼ Corporate governance is the set of rules that
control a company’s behaviour towards its
directors, managers, employees,
shareholders, creditors, customers,
competitors, and community.
◼ Sourced from company acts, articles of
association (UK) and internal rules and
regulations
◼ Does it (should it) effectively serve the
interests of the shareholders?
7
Agency Problems and
Corporate Governance
◼ Agency: ◼ Principal (sets goals, tasks and reporting structure)
◼ Agent (sets goals, tasks and reporting structure)
◼ Examples Principal Agent; Director Senior Manager;

Senior Manager Middle manager; Middle manager
Junior manager
◼ Agency problem:
◼ Information asymmetry: the agent knows more than the principal
◼ Moral hazard: managers may act in their own interests and not on
behalf of owners (stockholders)
8
Company valuation
◼ Market Capitalization = Share price on
the stock exchange x number of shares
◼ What the shareholders think
Or (and the two values are not the same)
◼ From the balance sheet “Equity value
due to shareholders” (see chapter 2)

◼ The accountant’s view
9
What determines a firm’s
value?
The main valuation model in finance is the
sum of all the future expected free cash
flows when converted (discounted) to
today’s value:
FCF1 FCF2 FCF∞
Value = + +…+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
See “big picture” diagram on next slide.

(More . .)
10
Determinants of Company Value: The Big Picture
Sales revenues
− Operating costs and taxes
− Required investments in operating capital
Free cash flow

=
(FCF)
FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates Cost of debt Firm’s debt/equity mix
Market risk aversion Cost of equity Firm’s business risk

11
Free Cash Flows (FCF)
◼ Free cash flows are the cash flows that
are available (or free) for distribution to
all investors (stockholders and
creditors).
◼ FCF = sales revenues - operating costs
- operating taxes - required investments
in operating capital.
12
What is the weighted average
cost of capital (WACC)?
◼ WACC is the average rate of return on company’s
projects (net cash flows in total) required by the
stock market (or buyers and sellers).
◼ Also termed “the interest rate” “the cost of money” “the
discount rate”
◼ WACC is affected by:
◼ Capital structure (the firm’s relative use of debt and equity
as sources of financing)
◼ Interest rates
◼ Investors’ overall attitude toward risk
◼ The risk of the projects being undertaken by the firm
13
What four factors affect the
cost of money (interest rate)?
◼ Time preferences for consumption (e.g.1%)

◼ Risk (e.g.5%)
◼ Expected inflation (e.g.3%)
◼ Overall interest rate
◼ 1.01 x 1.05 x 1.03 -1 = 9.23%
◼ Approximately 1 + 5 + 3 = 9%
14
What economic conditions
affect the cost of money?
◼ Government monetary policies
◼ interest rates
◼ quantitative easing
◼ Budget deficits/surpluses
◼ Level of business activity (recession or boom)
15
What international conditions
affect the cost of money?
◼ Country risk. Depends on the country’s
economic, political, and social
environment.
◼ Exchange rate risk of variation affected
by:
◼ International trade deficits/surpluses
◼ Relative inflation and interest rates
◼ Country risk
16
The Capital Allocation Process
Directly
(Over
the counter)
Investors with
Capital Users borrow
Surplus Cash
from banks or issue
(Capital)
Households, Financial Stock Market financial instruments
institutions, Foreign Shares & bonds
investors, Businesses Businesses
invest money in …
Banks
17
Financial Securities (tradeable
promises of future payments issued by
governments and companies)
Debt Equity Derivatives
Financial •T-Bills •Common •Options

Markets stock (ordinary
•Eurodollars shares) •Futures
•Government bonds •Forward
•Preferred stock contract
•Corporate (preferred shares)
(company) bonds •Swaps
18
What are the advantages of
stock markets?
◼ Primary
◼ New issue (IPO or seasoned)
◼ Key factor: issuer receives the proceeds
from the sale.
◼ Secondary (the main market)
◼ Existing owner sells to another party.
◼ Issuing firm doesn’t receive proceeds and
is not directly involved.
19
What are the advantages of
stock markets?
◼ Secondary markets make primary markets attractive (as with any
good “second hand” market)
◼ Allows short term investors to invest in long term borrowers

◼ (maturity transformation: shares can be sold at any time)
◼ Allows low risk investors to invest in high risk projects

◼ (risk transformation: just buys a few shares!)
◼ A place where shares can be easily bought and sold

◼ (liquidity)
◼ A big valuation “machine” processing vast quantities of information

to arrive at a fully informed judgement as to the value of a share
◼ (valuation)
20
How are secondary markets
organized?
◼ By “location”
◼ Physical location exchanges
◼ Computer/telephone networks
◼ By the way that orders from buyers and
sellers are matched
◼ Open outcry auction
◼ Dealers (i.e., market makers)
◼ Electronic communications networks (ECNs)
21
Over the Counter (OTC)
Markets
◼ In the old days, securities were kept in a safe
behind the counter, and passed “over the
counter” when they were sold.
◼ Now the OTC market is the equivalent of a
computer bulletin board (e.g., Nasdaq Pink
Sheets), which allows potential buyers and
sellers to post an offer.
◼ No dealers
◼ Very poor liquidity
22
Financial Management
concerns
◼ preparing the accounts (Annual Report)
◼ raising finance
◼ estimating risk
◼ risk management
◼ project valuation
◼ cash flow management
◼ compliance with regulation and standards
◼ most aspects of management!
Introducing central fundamental
concepts in Finance
◼ Already addressed:
◼ Agency, Maturity transformation, risk
transformation, liquidity & valuation
◼ Homogenous expectations
◼ investors are agreed on future expected benefits
and possible variation, (behavioural finance
addresses disagreement – not mainstream!)
◼ Diversification
◼ Measuring the effect of combining differing risks,
(risk is lowered when not perfectly correlated)
concepts in Finance
◼ Market efficiency
◼ How well does a share price reflect information
about future value? This is a problem given the
volatile and ill-defined nature of such information.
◼ Law of one price
◼ If a new product can be mimicked by a set of old
products then the price of the new product must
be the same as the old products. The same
outcome cannot have two prices in an efficient
market.
concepts in Finance
◼ Arbitrage
◼ Buying and selling (a financial promise such as a
share) to make a profit without taking a risk. The
law of one price says that there should be no
difference in price for the same product which
should be true in an efficient market. To make a
profit in an efficient market, you must take a risk!
Theory and Practice
EMEA 2nd Edition
1
Chapter 2
Understanding Financial Statements
Part 1: the overall structure
2
Topics in Chapter
◼ Income statement
◼ Balance sheet
◼ Statement of cash flows
◼ Free cash flow
◼ Performance measures
◼ Corporate taxes
◼ Personal taxes
3
The General structure of Financial Statements
Annual
Report Rolls Shareholders
Royce
The General structure of Financial Statements – the accounts
Equity + Liabilities = Assets
(Shares + Profits) + (Borrowing + Creditors) = Plant + Property +

machinery +
debtors +
inventory + cash
Balance Sheet or Statement of Financial Position Rolls Royce 31/12/17
Balance Sheet terms
◼ Assets
◼ Non current assets
◼ Valuation – depreciation & net book values
◼ Conservative
◼ Current assets (less than one year)
◼ liquidity
◼ receivables
Balance Sheet terms
◼ Liabilities
◼ Non current liabilities
◼ Bonds
◼ Current liabilities (less than one year)

◼ liquidity
◼ payables
Balance Sheet terms
◼ Gearing or Leverage
◼ Window Dressing
◼ Capitalizing Expenses
◼ Asset stripping
Rolls Royce Cash Flow Statement
Equity + Liabilities = Assets
Equity + Liabilities = Non-cash Assets +

Cash Assets
Equity + Liabilities - Non-cash Assets = Cash Assets

incl. profit
1. Indirect method starts with operating profit – assumes it is all cash flows. We must therefore
add back non cash expenses (depreciation) and deduct non cash additions
2. An increase in debtors (non cash assets) reduces the left hand side and therefore must reduce
the right hand side (cash assets) - it reverses the assumption that all sales were cash.
3. A decrease in debtors increases the left hand side and therefore must be an addition to cash
assets – debtors paid up.
4. Similar reasoning for inventories.
5. An increase in creditors increases the left hand side and therefore must increase the right hand
side – cash was not paid for these supplies
6. A decrease in creditors decreases the left hand side and therefore must decrease the right
hand side – creditors were paid.
Rolls Royce Cash Flow Statement 31/12/17
An increase in
assets is a use
of cash flows
hence
NEGATIVE
a decrease is
POSITIVE
An increase in
liabilities is a
source of cash
flows hence
POSITIVE
a decrease is
NEGATIVE
What are operating current
assets (CA)?
◼ Operating current assets are the CA
needed to support operations.
◼ Op CA include: cash, inventory,
receivables.
◼ Op CA exclude: short-term investments,
because these are not a part of operations.
15
What are operating current
liabilities (CL)?
◼ Operating current liabilities are the CL
resulting as a normal part of operations.
◼ Op CL include: accounts payable and
accruals.
◼ Op CL exclude: notes payable, because this
is a source of financing, not a part of
operations.
16
Net Operating Working Capital
(NOWC) the funding required for the operations of the company
NOWC Operating Operating

= -
CA CL
From the Rolls Royce Balance Sheet:

₤1,688m = ₤14,595m - ₤12,907m
17
Return on Invested Capital
(ROIC)
ROIC = Profit / Capital

profit must be that due to the capital (equity)
From the Rolls Royce income statement and balance sheet…
ROIC = £4,208m / £6,170m
18
Auditor’s Report
19
Regulatory structure of the
accounts
◼ Companies acts of a particular country
determine what must be disclosed
◼ Stock markets also have requirements
◼ Accounts are prepared according to
accepted rules and guidance.
◼ Accountants conform to GAAP in the US
(“generally accepted accounting principles” )
◼ Elsewhere generally IFRS (“international
financial reporting standards”)
Theory and Practice
2nd EMEA edition
1
CHAPTER 3
Understanding Financial Statements
Part 2: Analysing and Managing the Accounts
2
Topics in Chapter
◼ Ratio analysis
◼ Effects of improving ratios
◼ Limitations of ratio analysis
◼ Qualitative factors
3
Overview
◼ Ratios facilitate comparison of:
◼ One company over time
◼ One company versus other companies
◼ Ratios are used by:
◼ Lenders to determine creditworthiness
◼ Stockholders to estimate future cash flows and
risk
◼ Managers to identify areas of weakness and
strength
4
Liquidity Ratios
◼ Can the company meet its short-term
obligations using the resources it
currently has on hand?
5
Balance Sheet or Statement of Financial Position Rolls Royce 31/12/17
Asset Management Ratios
◼ How efficiently does the firm use its
assets?
◼ How much does the firm have tied up in
assets for each dollar of sales?
7
Current and Quick Ratios
Current Ratio: 14,595 /10,925 = 1.37

Quick Ratio:
(14,595 – 3,660) / 9,527 = 1.15
Comparisons:
1) with other companies &
industry;
2) with previous years;
3) with production process
and particular policies.
Inventory (stock) Turnover
Ratio
COGS
Inv. Turnover = Inventories 13,134 / 3,660 = 3.59
COGS per day = 13,134 / 365 = 35.98

Stock days = 3,660 / 35.98 = 102 days
i.e. 102 days sales in stock
9
Comments on Inventory
Turnover
◼ Inventory turnover is below industry
average.
◼ Firm might have old inventory, or its
control might be poor, the measure is
only an average.
◼ Comparison over years and with other
firms
10
DSO: average number of days from
sale until cash received (Debtor days)
Debtor days = Receivables / Revenue per day

2,492 / (16307/365) = 56 days!
Type of business?
Compare with industry mean
Compare over time
11
Appraisal of DSO
◼ If firm collects too slowly, and situation
is getting worse. Cash flow problem
◼ If firm collects too quickly: goodwill and
sales are lost.
◼ Poor credit policy.
12
Debt Management Ratios
◼ Does the company have too much
debt?
◼ Can the company’s earnings meet its
debt servicing requirements?
13
Leverage
(Gearing) Ratios:
Debt Ratio
Total interest charging debt

Equity
3,406 = 37.6%
6,170
or 3,406 = 35.6%
6,170 + 3,406
= Total assets 23,063

14
Profitability Ratios
◼ What is the company’s rate of return
on:
◼ Sales?
◼ Assets?
15
Profit Margins
Rolls Royce Income Statement 31/12/17
Gross profit margin:
3,173 = 19.5%
16,307
Net operating profit margin
1,287 = 7.9%
16,307
Total Return on Total
Assets:
4,208 = 14.0%
30,002
16
Price/Earnings (P/E) ratio
Price per share / earnings per share

“How many years’ earnings are you buying”
should be Price per share / expected earnings per share
High = very safe or exceptionally low earnings
Low = risky or exceptionally high earnings
Rolls Royce:
2017 2016 2015 2014
P/E ratio 3.71 n.s. 127.38 237.36
17
Other ratios (source Osiris)
18
Explain the DuPont System
◼ The DuPont system focuses on:
◼ Expense control (PM)
◼ Asset utilization (TATO)
◼ Debt utilization (EM)
◼ It shows how these factors combine to
determine the ROE.
19
The DuPont System
( Profit
margin )( TA
turnover )( Equity
multiplier ) = ROE
NI = net operating income
NI Sales TA = ROE
Sales x TA x CE
1,287 x 16,307 x 30,002 = 7.9% x 54.4% x 4.86 = 20.9%
16,307 30,002 6,170
20
Potential Problems and
Limitations of Ratio Analysis
◼ Comparison with industry averages is
difficult if the firm operates many
different divisions.
◼ Seasonal factors can distort ratios.
◼ Window dressing techniques can make
statements and ratios look better.
◼ Different accounting and operating
practices can distort comparisons.
21
Qualitative Factors
◼ There is greater risk if:
◼ revenues tied to a single customer
◼ revenues tied to a single product
◼ reliance on a single supplier?
◼ High percentage of business is generated
overseas?
◼ What is the competitive situation?
◼ What products are in the pipeline?
◼ What are the legal and regulatory issues?
22
Theory and Practice
2nd EMEA edition
1
Chapter 4
The Time Value of Money
2
Time Value Topics
◼ Future value
◼ Present value
◼ Annuities
◼ Nominal, Spot and Forward interest
rates
3
Time lines show timing of cash
flows (CF).
0 1 2 3
i%
CF0 CF1 CF2 CF3

Tick marks at ends of periods, but CF0 is
today; CF1 is the end of Period 1; CF2 end
of period 2 etc.
4
Calculating future value
Future values
10% per year
0 1 2 3
€100 €133.1
x 1.1 x 1.1 x 1.1
Typical in
saving type
problems x 1.13
Future values - the formula
Present
Value
Present values
10% per year
0 1 2 3
€100 €133.1
∕ 1.1 / 1.1 / 1.1
Typical in
investment
type problems / 1.13
Present values – the formula
Three Ways to Find FVs
◼ Step-by-step approach using time line
◼ Solve the equation with a regular
calculator (formula approach).
◼ Use a spreadsheet.
11
Solve FVn = PV(1 + i )n for PV
FVn
PV = therefore FVn = PV (1+i )n
(1+i )n
Future value of €100 invested at 10% per year = 100 x 1.103 = €133.1
Present value of €133.1 discounted at 10% per year = 133.1 / 1.103 = €100
12
Present values of irregular
cash flows
◼ Present value is additive you can add the present
value of expected cash flows from different future time
periods.
◼ For example, a project offers annual cash flows of
€100,150,200,250 and 250 what is the present value
given an interest rate of 25%?
◼ An investment of €463 yields a return of 25%

13
Annuities
◼ Common in finance regular payments and repayments
e.g.€100 per month for 5 years as repayment for a
loan charged at 1% a month.
Present month1 month1 month1 Month1 Month

value … 60
100 100 100 100 100

4495.5 100/1.01 100/1.012 100/1.012 100/1.012 100/1.0160
= 99 = 98 = 97 = 96 = 55
14
Annuities the formula
◼ .
◼ Ai,n = Annuity ₤1 for n periods an interest rate of i
◼ i = 0.01 and n = 60 A0.01,60 = (100 – 55.045) = 44.955.

◼ Annuity of €100 has a present value of 100 x 44.955 = €4,495.5
15
Annuities the formula
◼ .
The difference between a

perpetuity starting now
and a perpetuity
starting in n periods
time
16
What’s the FV of a 5-year monthly
annuity of $100 at 1%/ month?
Previously calculated that the present value is Previously
calculated that the present value is €4,495.5
So… €4,495.5 x 1.0160 = €8,166.96
We can use the formulae to move

cash flows around in time
17
Nominal rate
◼ Stated in contracts, and quoted by banks and brokers.
◼ The rate is per year unless stated otherwise
◼ Examples:
◼ 8% Quarterly = 1.08 -1 = 1.36 – 1 = 36% AER
4
◼ AER = Annual Equivalent rate or EAR equivalent
effective rate
◼ Daily interest (365 days)
◼ Simple 36% / 365 = 0.09863%
◼ Actuarial (1+x)365= 36% so 1.361/365 -1 = x = 0.0843%
18
To solve actuarial problems
◼ find the right formula and solve for the
missing value. Solve for values (how much)
by equation and for n and i with a
spreadsheet (trial and error)
◼ Mr Y offers a ½ share in a painting to be sold in 2 years’

time for an estimated €500,000. You want a 25% return
how much would you offer now for the ½ share?
◼ 250,000/1.252 = x therefore x = €160,000
To solve actuarial problems
◼ continued
◼ You want to save €150 a month to buy a car costing €5,000.
How long will you have to save if interest rates are 0.5% a
month
moved to a future
point in time (n)
present value of
annuity… x (1+i)n = 5,000
◼ Solution
◼ We know i = 0.5% we do not know n
◼ Solve using a spreadsheet (31 months)
Spot rates
◼ Spot rates = invest now for a given “term”
(i.e. time period) at this annual rate…
◼ e.g. Barclays flexible bond rates Nov 2015
1yr 1.1%; 2yr 1.2%; 3yr 1.8%
Investment for varying spot rates and their End of term value
terms
₤1,000 for 1 year spot = ₤1,000 x 1.011 = ₤1,011
₤1,000 for 2 year spot = ₤1,000 x 1.0122 = ₤1,024
₤1,000 for 3 year spot = ₤1,000 x 1.0183 = ₤1,055

Forward rates
◼ Forward rates = annual rate to invest in x years’ time
Investment for varying end of term Implied annual forward rates

spot rates & terms value
₤1,000 for 1 year spot ₤1,011 Rate from now so only a spot
@1.1% rate of 1.1%
₤1,000 for 2 year spot ₤1,024 1 year forward rate:1024/1011
@1.2% – 1 = 1.29%
₤1,000 for 3 year spot ₤1,055 2 year forward
@1.8% rate:1,055/1,024 – 1 = 3.01%
Check ₤1,000 x 1.011 x 1.0129 x 1.0301 = ₤1055
Spot Yield curve on U.K.
Government bonds
UK commercial bank liability spot curve
21 Feb 19
1,80
1,60
1,40
1,20
Interest rate
1,00
0,80
0,60
0,40
0,20
0,00
Years
source: Bank of England website
Time value of money
◼ Values time and risk

◼ The main model for borrowing and
lending calculations (e.g. bonds)
◼ The main valuation model in finance for
projects and risky investments
(e.g.shares) but not the only model
Theory and Practice
2nd EMEA edition
1
Chapter 5
Bonds and Bond Management
2
Topics in Chapter
◼ Key features of bonds
◼ Bond valuation
◼ Measuring yield
◼ Assessing risk
3
Finance
INVESTMENTS
FINANCE
Weighted average
cost of capital
(WACC)
Market interest rates Firm’s business risk

Cost of debt
Market risk aversion Cost of equity Firm’s debt/equity mix
4
Bond outline
Timeline
How much will
you + promised
pay me now for payment
these promised of €1,000
payments? promised coupon payments
expressed as a % of €1,000
A “5% 10 year bond” is a promise of an annual payment of €50

and €1,000 in 10 years’ time.
A BOND is a financial instrument that is a standardized form of
borrowing that is easily tradable (negotiable).
Key Features of a Bond
A 5% 10 year bond is a promise of an annual payment of
€50 and €1,000 in 10 years’ time.
◼ Par value: Face amount; paid at maturity.

Assume €1,000 (₤100 in the UK).
◼ Coupon interest rate: A way of expressing
annual payments.
◼ Multiply by par value to get euros.
◼ Generally fixed.
(More…)
6
Key Features of a Bond
◼ Maturity: Years until bond must be
repaid.
◼ Issue date: Date when bond was
issued.
◼ Security or collateral: claim on assets in
the event of non payment
7
Call Provision
◼ Issuer can refund bond. That helps the
issuer but hurts the investor.
◼ Therefore, borrowers are willing to pay
more, and lenders require more, on
callable bonds.
8
What’s a sinking fund?
◼ Provision to pay off a loan over its life
rather than all at maturity.
◼ Reduces risk to investor, shortens

average maturity.
9
Sinking funds are generally
handled in 2 ways
◼ Call x% at par per year for sinking
fund purposes.
◼ Buy bonds on open market.
10
Bond Valuation
Timeline
How much will
you + promised
pay me now for payment
these promised of €1,000
payments? promised coupon payments as
a % of €1,000
Payment depends on the

required return 5%, 10%, 25%?
Value of a 10-year, 5% coupon bond
if investors want a return of 15%
0 1 2 10
5% ...
V=? 50 50 50 + 1,000
€50 €50 €1,000

VB = + . . . + +
(1 + rd) 1 (1 + rd) N (1 + rd)N
= €43.48 + €37.81… + €259.54

= €498.12
12
Bond Value and returns
10 year 5% bond
Bond Value € vs. Years
remaining to Maturity
1000.00
900.00
800.00
700.00 Annual return 15% e.g.

600.00
(714.50 + 50) / 664.78 -1
500.00
= 0.15 or 15%
400.00
1 2 3 4 5 6 7 8 9 10
14
What’s “yield to maturity”?
◼ YTM is the rate of return earned on a
bond held to maturity. Also called
“promised yield.”
◼ It assumes the bond will not default.
15
YTM on a 10-year, 9% annual coupon,
$1,000 par value bond selling for €887
0 1 9 10
rd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find rd that “works” using a spreadsheet!
16
Find rd
coupon ... coupon Par + coupon

VB = + + +
(1 + rd) 1 (1 + rd) n (1 + rd)n
90 ... 90 1,000
887 = + + +
(1 + rd) 1 (1 + rd) (1 + rd)n
n
17
What’s “yield to maturity”?
◼ If coupon rate < rd, bond sells at a
discount.
◼ If coupon rate = rd, bond sells at its par
value.
◼ If coupon rate > rd, bond sells at a
premium.
◼ If rd rises, price falls.
18
What’s “yield to maturity”
(YTM)? Trial and Error!
YTM is that discount rate that equates the cash

flows to the current value of the bond €887 i.e.
nearly 11% in this case
19
Bond Spreads
◼ A “bond spread” is often calculated as
the difference between a corporate
bond’s yield and a Treasury security’s
yield of the same maturity. Therefore:
◼ Bond’s of large, strong companies often
have very small spreads.
20
Bond Ratings % defaulting within:
S&P and Fitch Moody’s 1 yr. 5 yrs.
Investment grade bonds:
AAA Aaa 0.00 0.00
AA Aa 0.03 0.17
A A 0.09 0.74
BBB Baa 0.23 2.54
Junk bonds:
BB Ba 1.17 6.91
B B 2.14 9.28
CCC Caa 24.47 35.23
Source: FitchLearning
© 2016 Cengage RatingsEMEA. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
21
Bond Ratings and Bond
Spreads (March 2012)
Long-term Bonds Yield (%) Spread (%)
10-Year T-bond 2.18
AAA 4.11 1.93
AA 3.38 1.20
A 3.37 1.19
BBB 6.24 4.06
BB 6.28 4.10
B 7.02 4.84
CCC 9.98 7.80
22
What factors affect default risk
and bond ratings?
◼ Financial ratios
◼ Debt ratio
◼ Coverage ratios, such as interest coverage
ratio or EBITDA coverage ratio
◼ Profitability ratios
◼ Current ratios
(More…)
23
Bond Ratings Median Ratios of
companies with bond ratings (S&P)
Interest Return on Debt to
coverage capital capital
AAA 23.8 27.6% 12.4%
AA 19.5 27.0% 28.3%
A 8.0 17.5% 37.5%
BBB 4.7 13.4% 42.5%
BB 2.5 11.3% 53.7%
B 1.2 8.7% 75.9%
CCC 0.4 3.2% 113.5%
24
Other Factors that Affect Bond
Ratings
◼ Provisions in the bond contract
◼ Secured versus unsecured debt
◼ Senior versus subordinated debt
◼ Guarantee provisions
◼ Sinking fund provisions
◼ Debt maturity
(More…)
25
Other Factors that Affect Bond
Ratings
◼ Other factors
◼ Earnings stability
◼ Regulatory environment
◼ Potential product liability
◼ Accounting policies
26
Interest rate (or price) risk for
1-year and 10-year 10% bonds
Interest rate risk:
rd changes causes bond prices to fall at different rates
1-Year 10-Year
rd Price Change Price Change
5.0% €1,048 €1,386
4.8% 38.6%
10.0% €1,000 €1,000
4.5% 33.5%
15.0% €957 €749
27
Value
1 year and 10
1,500 10-year year 10% bonds
1,000 1-year
500
0 rd
0% 5% 10% 15%
28
What is reinvestment rate
risk?
◼ The risk that CFs will have to be
reinvested in the future at lower rates,
reducing income.
◼ Illustration: Suppose you just won
$500,000 playing the lottery. You’ll
invest the money and live off the
interest. You buy a 1-year bond with a
YTM of 10%.
29
What is reinvestment rate
risk?
◼ Year 1 income = $50,000. At year-end
get back $500,000 to reinvest.
◼ If rates fall to 3%, income will drop
from $50,000 to $15,000. Had you
bought 30-year bonds, income would
have remained constant.
30
The Maturity Risk Premium
◼ Long-term bonds: High interest rate
risk, low reinvestment rate risk.
◼ Short-term bonds: Low interest rate
risk, high reinvestment rate risk.
◼ Nothing is riskless!
◼ Yields on longer term bonds usually are
greater than on shorter term bonds
(see yield curve).
31
Term Structure Yield Curve
◼ Term structure of interest rates: the
relationship between interest rates (or
yields) and maturities.
◼ A graph of the term structure is called
the yield curve.
32
Yield curve UK Commercial
bank liability spot curves
Yield Curves
6,00
5,00
4,00
Spot rates
3,00
2,00
1,00
0,00
0,5
1,5
2,5
3,5
4,5
5,5
6,5
7,5
8,5
9,5
14,5
10,5
11,5
12,5
13,5
15,5
16,5
17,5
18,5
19,5
20,5
21,5
22,5
23,5
24,5
Years
31 Jan 01 31 Jan 08 31 Jan 09 31 Dec 15 01 Feb 19
source: Bank of England website
Brigham,Ehrhardt & Fox
Theory and Practice
2nd EMEA edition
1
CHAPTER 6
Risk and Return
2
Topics in Chapter
◼ Basic return and risk concepts
◼ Stand-alone risk
◼ Portfolio (market) risk
◼ Risk and return: CAPM/SML
◼ Market equilibrium and market
efficiency
3
The Focus
What are investment returns?
◼ Investment returns measure the
financial results of an investment.
◼ Returns may be historical or prospective
(anticipated).
◼ Returns can be expressed in:
◼ Money terms.
◼ Percentage terms.
5
An investment costs $1,000 and is
sold after 1 year for $1,060.
Euro return:
€ Received - € Invested
€1,060 - €1,000 = €60.
Percentage return:
€ Return/€ Invested
€60/€1,000 = 0.06 = 6%.
6
What is investment risk?
◼ Investment risk is exposure to the
chance of earning less than expected.
◼ The greater the chance of a return far
below the expected return, the greater
the risk.
7
Scenarios and Returns for a share
over the Next Year
Scenario Probability Return

Worst Case 0.10 −14%
Poor Case 0.20 −4%
Most Likely 0.40 6%
Good Case 0.20 16%
Best Case 0.10 26%
1.00
8
Discrete Probability
Distribution for Scenarios
9
Example of a Continuous
Probability Distribution
10
Continuous distribution of
returns for differing risks
-4% is…
Highly unlikely
Possible
Quite likely
-4% 6% 16%
◼
Expected value
12
Stand-Alone Risk: Standard
Deviation
◼ Stand-alone risk is the risk of each
asset held by itself.
◼ Standard deviation measures the
dispersion of possible outcomes.
◼ For a single asset:
◼ Stand-alone risk = Standard deviation
13
Variance (σ2) and Standard Deviation
(σ) for Discrete Probabilities
14
Standard Deviation of the Share’s
Return During the Next Year
15
Understanding the Standard
Deviation
◼
32%
16
Useful in Comparing
Investments
◼ Investments with bigger standard
deviations have more risk.
◼ High risk doesn’t mean you should
reject the investment, but:
◼ You should know the risk before investing
◼ You should expect a higher return as
compensation for bearing the risk.
17
Using Historical Data to
Estimate Risk
◼ Analysts often use discrete outcomes to
analyze risk for projects
◼ But for investments, most analysts normally
use historical data rather than discrete
forecasts to estimate an investment’s risk
unless it is a very special situation.
◼ Most analysts use:
◼ 48 to 60 months of monthly data, or
◼ 52 weeks of weekly data, or
◼ Shorter period using daily data.
◼ Use annual returns here for sake of simplicity.
18
Formulas for a Sample of t
Historical Returns of one share
◼
19
Formulas for a Sample of t
Historical Returns
◼
In Excel for example “=stdev(A1 : A100)”
20
Historical Data for Stock Returns
Year Market Blandy Gourmange
1 30% 26% 47%
2 7 15 −54
3 18 −14 15
4 −22 −15 7
5 −14 2 −28
6 10 −18 40
7 26 42 17
8 −10 30 −23
9 −3 −32 −4
10 38 28 75
21
Average and Standard Deviations
for Stand-Alone Investments
◼ Use formulas shown previously (tedious)
or use Excel (easy)
◼ What is Blandy’s stand-alone risk?
◼ Note: analysts often use past risk as a
predictor of future risk, but past
returns are often not a good
prediction of future returns.
Market Blandy Gourmange

Average return 8.0% 6.4% 9.2%
Standard
20.1% 25.2% 38.6%
deviation
22
How risky is the share in
Blandy?
◼ Assumptions:
◼ Returns are normally distributed, so about 16% of the time,
return will be less than the average minus σ; about 16% of
the time the return will be greater than the average plus σ.
◼ σ is 25.2%
◼ Expected return is about 6.4%.
◼ About 16% of the time, return will be:
◼ < −18.8% (6.4%−25.2% = −18.8%)
◼ > 31.6% (6.4%+25.2% = 31.6%)
◼ Stocks are very risky!
23
Portfolio Returns
◼
Share i
shares
i=1
24
Example: 2-Stock Portfolio***
Invest 75% in Blandy and 25% in

Gourmange
25
Historical Data for Stocks and Portfolio
Returns
Portfolio of Blandy and
Year Blandy Gourmange Gourmange
1 26% 47% 31.3%
2 15 −54 −2.3
3 −14 15 −6.8
4 −15 7 −9.5
5 2 −28 −5.5
6 −18 40 −3.5
7 42 17 35.8
8 30 −23 16.8
9 −32 −4 −25.0
10 28 75 39.8
26
Portfolio Historical Average
and Standard Deviation
◼ The portfolio’s average return is the
weighted average of the stocks’
share’s
average returns.
◼ BUT The portfolio’s standard
deviation is less than either stock’s σ!
◼ What explains this?
Gourmang
Blandy Portfolio
e
Average return 6.4% 9.2% 7.1%
27
22.2%
Standard deviation 25.2% 38.6%
How closely do the returns
follow one another?
◼ Notice that the
returns don’t move
in perfect unison:
Sometimes one is up
and the other is
down.
28
Correlation Coefficient (ρi,j)
◼
29
Excel Functions to Estimate the
Correlation Coefficient (ρi,j)
Est. ρi,j = Rij =Correl(A1:A100,B1:B100)
Correlation between Blandy (B) and

Gourmange (G):
Est. ρB,G = 0.11
30
In a 2-Share Portfolio
◼ r = −1
◼ 2 stocks can be combined to form a
riskless portfolio: σp = 0.
◼ r = +1
◼ Risk is not “reduced”
◼ σp is just the weighted average of the 2
stocks’ standard deviations.
◼ −1 < r < −1
◼ Risk is reduced but not eliminated.
31
Adding Shares to a Portfolio
◼ What would happen to the risk of an
average 1-stock portfolio as more
randomly selected stocks were added?
◼ sp would decrease because the added
stocks would not be perfectly
correlated.
32
Risk vs. Number of Shares in
Portfolio
sp Company Specific
35% (Diversifiable) Risk
Total Portfolio Risk, sp
20%
Market Risk
0
10 20 30 40 2,000 stocks
33
Portfolio risk
◼ The overall risk (measured as variance) of a portfolio
is the total of this matrix:
◼ Note that the individual variance of a share plays a

minor part
◼ Instead of covariance with B,C,D etc we measure A’s
risk as covariance with the Market return rm denoted
as Cov (rA,rm) or σA,m
Portfolio risk
◼ The overall risk (measured as variance of the percentage
returns) of a portfolio is the total of this matrix:
COV (B,A)
COV (C,A)
◼ Note that wA is the investment in share A as a percentage of the total value of

the portfolio
◼ Cov(B,A) = Cov(A,B)
◼ The often quoted 2 share formula is the top left hand corner i.e.
variance of an A,B portfolio = wA2varA + 2WAWB cov(A,B) + wB2varB
Portfolio risk
Stand-alone risk = Market risk
+ Diversifiable risk
◼ Market risk is that part of a security’s
stand-alone risk that cannot be
eliminated by diversification.
◼ Firm-specific, or diversifiable, risk is that
part of a security’s stand-alone risk that
can be eliminated by diversification.
37
Conclusions
◼ As more shares are added, each new share
has a smaller risk-reducing impact on the
portfolio.
◼ sp falls very slowly after about 40 stocks are
included. The lower limit for sp is about 20%
= sM .
◼ By forming well-diversified portfolios,
investors can eliminate about half the risk of
owning a single stock.
38
Can an investor holding one stock earn a
return commensurate with its risk?
◼ No. Rational investors will minimize

risk by holding portfolios.
◼ Investors bear only market risk, so
prices and returns reflect the amount of
market risk an individual stock brings to
a portfolio, not the stand-alone risk of
individual stock.
39
Market Risk Due to an
Individual Stock
◼ How do you measure the amount of
market risk that an individual stock
brings to a well-diversified portfolio?
◼ William Sharpe developed the Capital
Asset Pricing Model (CAPM) to answer
this question.
40
Market Risk as Defined by the
Capital Asset Pricing Model (CAPM)
CAPM model for firm i
41
Market Risk and CAPM
Expected return
for firm i the
discount rate
applied to value
of the firm one risk free a portion of Market risk premium
year from now return the market
risk premium
in expanded form
or Cov(ri,rm) defines
note that is constant only
the required return
of a share… as in the
variance covariance
matrix earlier.
42
Market Risk and Beta
The Security Market Line: Relating
Beta Risk and Required Return
Slope = the price

E(rm ) = 1 of risk. The
steeper it is the
more return
required to
compensate for
rf
beta risk
βm = 1
44
Required Return for Blandy
◼ Inputs:
◼ rRF = 4% (given)
◼ E(rm – rf) = 5% (given)
◼ βi = 0.60 (estimated)
◼ ri = rRF + bi (E(rm – rf) )
ri = 4% + 0.60(5%) = 7%
45
Using a Regression to
Estimate Beta
◼ Run a regression with returns on the
stock plotted on the Y-axis and returns
on the market portfolio plotted on the
X-axis.
◼ The slope of the regression line is equal
to the stock’s beta coefficient.
46
Excel: Plot Trendline Right on
Chart
y = Blandy’s returns
x = market returns
0.6027 = beta
47
Web Sites for Beta
◼ http://finance.yahoo.com
◼ Enter the ticker symbol for a “Stock Quote”,
such as IBM or Dell, then click GO.
◼ When the quote comes up, select Key
Statistics from panel on left.
◼ www.valueline.com
◼ Enter a ticker symbol at the top of the page.
◼ Most stocks have betas in the range of 0.5
to 1.5.
48
Risk and Return in the Stock
Market
Expected Expected
Expected
share price share price
share price
+ dividend + dividend
+ dividend
Share A Share C
Share B
160
discounted
discounted discounted Market
by CAPM determined
by CAPM 8% by CAPM
model return
model model
using βC
using βA using βB
160 = 148.15
1.08 Price of Share B Price of Share C
Price of Share A
Market
◼ A one period model (multiperiod a succession of

single periods)
◼ From the CAPM model, returns should not have an
expected return greater than its beta share of the
market risk premium… β i x E(rm – rf )
Market
◼ We assume that you cannot consistently get a higher
return for a given risk than that dictated by the
security market line
Market
◼ So how well does the Stock Market
value shares?
◼ see Efficient Markets Hypothesis
Market
◼ Are there any other models that explain
?
◼ In practice, yes; in theory no!
◼ Fama French adds:
◼ SMB a measure of size "small minus big"
◼ B /M book to market ratio
◼ HML "high B/M minus low“
◼ what does this tell us? Not much?!!
Theory and Practice
2nd EMEA edition
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1
Chapter 8
Valuation of Shares and
Companies
Topics in Chapter
◼ Features of ordinary shares
◼ Valuing common stock
◼ Dividend growth model
◼ Free cash flow valuation model
◼ Preferred shares
Ordinary shares – the basics
◼ Legal right of ownership
◼ Shareholder has limited liability
◼ Shares on open sale in the stockmarket
◼ Shareholders elect the directors in proportion to
shares held. Directors manage the company.
◼ Shareholders receive dividends from the company.
◼ Preferred shares limit their dividends in exchange for
being first in line for dividend payout and better
rights on insolvency.
Preferred shares – the basics
◼ Preferred shares have limited dividends
◼ non payment unlike bonds does not
give rights to sell company assets
◼ But they are first in line for dividend
payout
◼ they have better rights on insolvency.
Sources of Value
◼ Value of operations
◼ Nonoperating assets
◼ Marketable securities
◼ Ownership of non-controlling interest in
another company
◼ Value of nonoperating assets usually is
very close to figure that is reported on
balance sheets.
Claims on Corporate Value
◼ Debtholders have first claim.
◼ Preferred stockholders have the next
claim.
◼ Any remaining value belongs to
stockholders.
Total Corporate Value:
Sources and Claims
Claims: Finance Sources: Activities being
financed and generating
returns
Operations
Project
Project
Project
A share quote (Yahoo)
Share valuation – basic model
Share valuation – with growth
Share valuation – return as
dividends + future share price
◼ A: P2 is the present value of the share in 2 years’ time, which in turn

represents future dividends.
◼ B: Valuation can therefore be of the dividends before the price plus the
present value of the price.
◼ C: As the price represents dividends after 2 years B is conceptually the
same as the dividend discount model (C).
Share valuation – with different
returns & growth estimates
Taking the original valuation as €0.5722 being an annual dividend of

€0.05 a share with 3% growth and a 12% return, the table shows the
effect of varying growth and return. Brackets indicate the difference with
the €0.5722 valuation
◼ A small change in percent results in a large change in value!
◼ The higher the required return the less important the differences in growth.
◼ The higher the growth the more important the differences in return
Share valuation – Free Cash
Flow Model (FCF)
◼ The idea is that FCF represents the maximum dividends that could be
declared.
◼ We can therefore apply the basic dividend model.
FCFt
Share Value0
Weighted average cost of
capital
◼ The discount rate (rs) includes risk
◼ It is the risk of the activity
◼ Companies engage in many activities so
WACC is the average risk weighted by
the size of the net present value
hence:
Share Value0
Company valuation vs project (operation)
valuation
Firm’s debt/equity mix

Weighted average
Free cash flow
cost of capital
(FCF)
(WACC) Cost of debt
Cost of equity: The required

Dividends (D)
return on stock
WACC & separation theorem
◼ Separation theorem: The risk preferences of
shareholders are independent of the risk of the
company (as in the WACC) because…
◼ Modigliani and Miller established that shareholders

could change the risk of their personal portfolio of
investments by borrowing so as to part fund
investment or investing in a mixture of safe and less
safe assets (see the Capital Market Line)
◼ William Sharpe established that the stock market

prices risk rather than the shareholders (see the
Capital Asset Pricing Model rs = a + βs(rm – rf) )
Share valuation – value
additivity
◼ Valuation is of a “project”
◼ A company is a “portfolio of projects”
◼ What if we define the projects differently?
◼ We assume value additivity.
◼ For example:
◼ present value of A = 3, B = 4, C = 8. Total value
= 15.
◼ Or AB = 7, C = 8 Total value = 15.
◼ We assume no synergy?
Share valuation vs Stock
Market Value I
◼ The Stock Market determines the price not
the npv model.
◼ The efficient markets hypothesis tells us that
the market value is a best estimate.
◼ Academic/ research models are an attempt to
understand that process
◼ The net present value model (npv) is a
normative model (how theory says valuation
should be given certain assumptions including
a normal distribution of returns)
Share valuation vs Stock
Market Value II
◼ Is the NPV model complete? NO!
◼ NPV does not:
◼ include options (see later) e.g. opportunities that arise IF the
profits in future are higher than expected.
◼ include individual competitor reactions
◼ explain why prices change so often.
◼ explain bubbles or crashes
◼ explain the apparent high return from investing in shares (share
premium puzzle)
◼ What about empirical research into investment? We know that

judgement is aided by the accounts and ratios such as P/E ratio
but there is no clear model.
◼ There is much still to understand
Theory and Practice
2nd EMEA edition
1
CHAPTER 10
Project Cost of Capital
2
Topics in Chapter
◼ Cost of capital components
◼ Debt
◼ Preferred stock
◼ Common equity
◼ WACC
◼ Factors that affect WACC
◼ Adjusting cost of capital for risk
3
What is a project?
◼ A future cash flow.
◼ The organisational context is not an
issue
◼ a marketing campaign, building a factory
or investing in a subsidiary, a company or
a conglomerate. All are projects
◼ We choose a company to start
The basic valuation model
◼ The cash flow model
FCF is a
business
estimate
WACC is the required

return, a financial
estimate
Calculating the required return
Calculating the required return
Debt, cost lowered Share capital

Note: Interest on debt by tax relief (1-T)
(rd & rstd) is deducted
before taxable profit,
it therefore lowers the
tax bill by rd x T & rstd
x T. The net cost is
therefore rd((1-T) &
rstd(1-T)
Modigliani and Miller
proposition
WACC = wd rd + ws rs
Debt Share capital / own

money
WACC Gearing (% Overall cost of Cost of share capital

debt - wd) debt (wdrd) (WACC – wdrd) /ws
16% 0% 0% 16%
16% 25% 2% 18.66 %
16% 75% 6% 40%
Constant despite Calculated to ensure that the overall

changes in gearing cost of capital is constant WHY?
proposition
◼ Why does
the cost of
share
capital
increase
with debt?
Because returns
to shares are
more variable
compared to
proposition
◼ M&M proposition implies that:
◼ Cheaper debt does not lower the overall cost of
capital
◼ What is saved in cheaper debt is lost in riskier and
hence more expensive capital
◼ The value of the firm (project) is not affected
by gearing
◼ Shareholders need not be concerned about
the level of gearing! – why?
proposition
◼ Shareholders need not be concerned
about the level of gearing! – why?
◼ Personal gearing can adjust company
gearing
◼ If company gearing too high, invest in a
safe asset + shares
◼ If company gearing too low, borrow and
invest in the share
Modigliani and Miller proposition
n.b. probability of a high profit and a low profit 50%
proposition
◼ Suppose €1,000,000 is paid as dividends representing 16%
return i.e. share value of €6,250,000 and no gearing.
Suppose an investor wants 40% return! (and can borrow at
8%)
◼ NEW position borrow €187,500
◼ invest €62,500 + €187,500 = €250,000 a 4% holding.
◼ Dividend of 4% x €1,000,000 = €40,000
◼ Repay borrowing leaving €40,000 – 187,500 x 8% = €25,000
◼ This represents a return of 25,000/62,500 = 40%
◼ Personal gearing in new position is Debt 187.5/250 = 75%
◼ With personal gearing you can get any expected return you want
◼ Company gearing cannot therefore affect risk to shareholders and
hence the value of the company
proposition
◼ There is some benefit from taxation differences between personal and company
tax
◼ the overall no tax position is:
0.5
0.45
0.4
0.35
Shares
rate of return
0.3
Debt
0.25
0.2 Overall cost of

capital
0.15
0.1
0.05
0
0
8
16
24
32
40
48
56
64
72
% debt
What types of long-term
capital do firms use?
◼ Long-term debt
◼ Some firms also use permanent short-term
debt
◼ Other firms have temporary short-term
debt for seasonal fluctuations in inventory,
but this is usually not part of the capital
structure
◼ Preferred stock
◼ Common equity
15
Capital Components
◼ Capital components are sources of funding
that come from investors.
◼ Accounts payable, accruals, and deferred
taxes are not sources of funding that come
from investors, so they are not included in
the calculation of the cost of capital.
◼ We do adjust for these items when
calculating the cash flows of a project, but
not when calculating the cost of capital.
16
Before-tax vs. After-tax Capital
Costs
◼ Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
◼ Most firms incorporate tax effects in the
cost of capital. Therefore, focus on
after-tax costs.
◼ Only cost of debt is affected.
17
Historical (Embedded) Costs
vs. New (Marginal) Costs
◼ The cost of capital is used primarily to
make decisions which involve raising
and investing new capital. So, we
should focus on marginal costs.
18
Cost of Debt
◼ Method 1: Ask an investment banker
what the coupon rate would be on new
debt.
◼ Method 2: Find the bond rating for the
company and use the yield on other
bonds with a similar rating.
◼ Method 3: Find the yield on the
company’s debt, if it has any.
19
Component Cost of Debt
◼ Interest is tax deductible, so the after
tax (AT) cost of debt is:
rd AT = rd BT(1 – T)
rd AT = 10%(1 – 0.40) = 6%.
◼ Use nominal rate.
◼ Flotation costs small, so ignore.
20
What are the two ways that
companies can raise common equity?
◼ Directly, by issuing new shares of

common stock.
◼ Indirectly, by reinvesting earnings that
are not paid out as dividends (i.e.,
retaining earnings).
21
Why is there a cost for
reinvested earnings?
◼ Earnings can be reinvested or paid out
as dividends.
◼ Investors could buy other securities,
earning a return.
◼ Thus, there is an opportunity cost if
earnings are reinvested.
22
Cost for Reinvested Earnings
(Continued)
◼ Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
◼ They could buy similar stocks and earn
rs, or company could repurchase its own
stock and earn rs. So, rs, is the cost of
reinvested earnings and it is the cost of
common equity.
23
Three ways to determine
the cost of equity, rs:
1. CAPM: rs = rRF + (rM – rRF)b

= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Judgmental-
Risk Premium: rs = rd + RP.
24
CAPM Cost of Equity: rRF = 5.6%,
RPM = 6%, b = 1.2
rs = rRF + (RPM )b
= 5.6% + (6.0%)1.2 = 12.8%.
25
Issues in Using CAPM
◼ Most analysts use the rate on a
long-term (10 to 20 years)
government bond as an estimate
of rRF.
(More…)
26
Issues in Using CAPM
(Continued)
◼ Most analysts use a rate of 3.5% to
6% for the market risk premium
(RPM)
◼ Estimates of beta vary, and
estimates are “noisy” (they have a
wide confidence interval).
27
DCF Cost of Equity, rs:
D0 = $3.26; P0 = $50; g = 5.8%
D1 D0(1 + g)
rs = +g= +g
P0 P0
= $3.12(1.058) + 0.058
$50
= 6.6% + 5.8%
= 12.4%
28
Estimating the Growth Rate
◼ Use the historical growth rate if you
believe the future will be like the past.
◼ Obtain analysts’ estimates: Value Line,
Zacks, Yahoo!Finance.
◼ Use the earnings retention model,
illustrated on next slide.
29
Earnings Retention Model
◼ Suppose the company has been
earning 15% on equity (ROE = 15%)
and has been paying out 62% of its
earnings.
◼ If this situation is expected to
continue, what’s the expected future
g?
30
Earnings Retention Model
(Continued)
◼ Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.
This is close to g = 5.8% given earlier.
31
The Own-Bond-Yield-Plus-Judgmental-Risk-
Premium Method: rd = 10%, RP = 3.2%
◼ rs = rd + Judgmental risk premium

◼ rs = 10.0% + 3.2% = 13.2%
◼ This judgmental-risk premium  CAPM

equity risk premium, RPM.
◼ Produces ballpark estimate of rs.
Useful check.
32
What’s a reasonable final
estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
rd + judgment 13.2%
Average 12.8%
33
Determining the Weights for
the WACC
◼ The weights are the percentages of
the firm that will be financed by each
component.
◼ If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.
34
Estimating Weights for the
Capital Structure
◼ If you don’t know the targets, it is
better to estimate the weights using
current market values than current
book values.
◼ If you don’t know the market value of
debt, then it is usually reasonable to
use the book values of debt, especially
if the debt is short-term. (More…)
35
What factors influence a
company’s WACC?
◼ Uncontrollable factors:
◼ Market conditions, especially interest rates.
◼ The market risk premium.
◼ Tax rates.
◼ Controllable factors:
◼ Capital structure policy.
◼ Dividend policy.
◼ Investment policy. Firms with riskier projects
generally have a higher cost of equity.
36
Is the firm’s WACC correct for
each of its divisions?
◼ NO! The composite WACC reflects the
risk of an average project undertaken
by the firm.
◼ Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk
and capital structure.
37
The Risk-Adjusted Divisional
Cost of Capital
◼ Estimate the cost of capital that the
division would have if it were a
stand-alone firm.
◼ This requires estimating the division’s
beta, cost of debt, and capital
structure.
38
Pure Play Method for Estimating
Beta for a Division or a Project
◼ Find several publicly traded companies
exclusively in project’s business.
◼ Use average of their ungeared betas as
proxy for project’s beta.
◼ Hard to find such companies.
39
Accounting Beta Method for
Estimating Beta
◼ Run regression between project’s
ROA and S&P Index ROA.
◼ Accounting betas are correlated
(0.5 – 0.6) with market betas.
◼ But normally can’t get data on new
projects’ ROAs before the capital
budgeting decision has been made.
40
Divisional Cost of Capital
Using CAPM
◼ Target debt ratio = 10%.
◼ rd = 12%.
◼ rRF = 5.6%.
◼ Tax rate = 40%.
◼ betaDivision = 1.7.
◼ Market risk premium = 6%.
41
Divisional Cost of Capital
Using CAPM (Continued)
Division’s required return on equity:

rs = rRF + (rM – rRF)bDiv.
rs = 5.6% + (6%)1.7 = 15.8%.
WACCDiv. = wd rd(1 – T) + wsrs
= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94% ≈ 14.9%
42
Division’s WACC vs. Firm’s Overall
WACC?
◼ Division WACC = 14.9% versus

company WACC = 10.4%.
◼ “Typical” projects within this division
would be accepted if their returns are
above 14.9%.
43
What are the three types of
project risk?
◼ Stand-alone risk
◼ Corporate risk
◼ Market risk
44
How is each type of risk used?
◼ Stand-alone risk is easiest to calculate.
◼ Market risk is theoretically best in most
situations.
◼ However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
◼ Therefore, corporate risk is also
relevant.
45
A Project-Specific, Risk-Adjusted
Cost of Capital
◼ Start by calculating a divisional cost of
capital.
◼ Use judgment to scale up or down the
cost of capital for an individual project
relative to the divisional cost of capital.
46
Costs of Issuing New Common
Stock
◼ When a company issues new common
stock they also have to pay flotation
costs to the underwriter.
◼ Issuing new common stock may send a
negative signal to the capital markets,
which may depress stock price.
47
Comments about flotation
costs:
◼ Flotation costs depend on the risk of the firm
and the type of capital being raised.
◼ The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
◼ We will frequently ignore flotation costs when
calculating the WACC.
48
Four Mistakes to Avoid
◼ Current vs. historical cost of debt
◼ Mixing current and historical measures
to estimate the market risk premium
◼ Book weights vs. Market Weights
◼ Incorrect cost of capital components
◼ See next slides for details.

(More…)
49
Current vs. Historical Cost of
Debt
◼ When estimating the cost of debt, don’t
use the coupon rate on existing debt,
which represents the cost of past debt.
◼ Use the current interest rate on new
debt.
(More…)
50
Estimating the Market Risk
Premium
◼ When estimating the risk premium for the
CAPM approach, don’t subtract the current
long-term T-bond rate from the historical
average return on common stocks.
◼ For example, if the historical rM has been
about 12.2% and inflation drives the current
rRF up to 10%, the current market risk
premium is not 12.2% – 10% = 2.2%!
(More…)
51
Estimating Weights
◼ Use the target capital structure to determine
the weights.
◼ If you don’t know the target weights, then
use the current market value of equity.
◼ If you don’t know the market value of debt,
then the book value of debt often is a
reasonable approximation, especially for
short-term debt.
(More…)
52
Capital components are sources of
funding that come from investors.
◼ Accounts payable, accruals, and deferred
taxes are not sources of funding that come
from investors, so they are not included in
the calculation of the WACC.
53

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Brigham, Ehrhardt & Fox

Central Concepts in Finance and Financial

◼ Agent (sets goals, tasks and reporting structure)

◼ Examples Principal Agent; Director Senior Manager;

due to shareholders” (see chapter 2)

See “big picture” diagram on next slide.

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

FCF1 FCF2 ... + FCF∞

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

◼ Time preferences for consumption (e.g.1%)

Debt Equity Derivatives

Financial •T-Bills •Common •Options

◼ Allows short term investors to invest in long term borrowers

◼ Allows low risk investors to invest in high risk projects

◼ A place where shares can be easily bought and sold

◼ A big valuation “machine” processing vast quantities of information

Equity + Liabilities = Assets

(Shares + Profits) + (Borrowing + Creditors) = Plant + Property +

◼ Current liabilities (less than one year)

Equity + Liabilities = Non-cash Assets +

Equity + Liabilities - Non-cash Assets = Cash Assets

NOWC Operating Operating

From the Rolls Royce Balance Sheet:

ROIC = Profit / Capital

Current Ratio: 14,595 /10,925 = 1.37

COGS per day = 13,134 / 365 = 35.98

Debtor days = Receivables / Revenue per day

Total interest charging debt

= Total assets 23,063

Gross profit margin:

Net operating profit margin

Price per share / earnings per share

The Time Value of Money

CF0 CF1 CF2 CF3

◼ An investment of €463 yields a return of 25%

Present month1 month1 month1 Month1 Month

100 100 100 100 100

◼ Ai,n = Annuity ₤1 for n periods an interest rate of i

◼ i = 0.01 and n = 60 A0.01,60 = (100 – 55.045) = 44.955.

The difference between a

So… €4,495.5 x 1.0160 = €8,166.96

We can use the formulae to move

◼ AER = Annual Equivalent rate or EAR equivalent

◼ Mr Y offers a ½ share in a painting to be sold in 2 years’

₤1,000 for 2 year spot = ₤1,000 x 1.0122 = ₤1,024

₤1,000 for 3 year spot = ₤1,000 x 1.0183 = ₤1,055

Investment for varying end of term Implied annual forward rates

source: Bank of England website

◼ Values time and risk

Bonds and Bond Management

Market interest rates Firm’s business risk

A “5% 10 year bond” is a promise of an annual payment of €50

◼ Par value: Face amount; paid at maturity.

◼ Reduces risk to investor, shortens

◼ Buy bonds on open market.

Payment depends on the

€50 €50 €1,000

= €43.48 + €37.81… + €259.54

700.00 Annual return 15% e.g.

coupon ... coupon Par + coupon

YTM is that discount rate that equates the cash