11 Week 11 – Capital Structure (Chapter 16)
Purpose/Objective - Recall that the relative proportions of debt, equity and other securities that a
firm has outstanding constitute its capital structure . When corporations raise funds from outside
investors, they must choose which type of security to issue and what type of capital structure to have
The most common choices are financing through equity alone, and financing through a combination
of debt and equity.
Impact of Debt on Value of the Firm – MM1:
 Purpose – Explain capital structure and
dividend policy and their impact on the value
of a company.
 Capital structure will affect long-term debt
and shareholders equity which affect the
value of the firm and the shareholder’s
wealth
 This is a financing decision that determines
the company's capital structure, the
combination of long term debt and equity
that will be used to finance the company's
long term productive assets
Capital Structure:
 Relative proportions of debt, equity and
other securities that a firm has outstanding
constitute its capital structure.
o Always include ordinary shares
o Often include debt and preference
shares
 To be affected by financing decision made
by financial managers in a corporation
o Remember that financing decisions –
are decisions about how you are
going to finance your investment
either through debt issue or equity
issue
o How to finance? Debt issue or
Equity issue?
 Financing decision to be made consistent
with the goal of maximising shareholders’
wealth (=firm value)
There are three different worlds that demonstrate
capital structures:
Why do we need to consider the different worlds?
 To determine how different choices of MM1 =Modigliani and Miller's Proposition 1
capital structure react in different
worlds/scenarios
1. Perfect Capital Market = MM world:
 No frictions exists such as no information
asymmetry
 Perfect Capital Market is a market in which
Notations:
 MM1 =Modigliani and Miller
Proposition 1
 MM2 = Modigliani and Miller
Proposition 2
 D = Market value of debt
 E= Market value of equity
 V= Value of a firm = D+E
 RE = Cost of ordinary shares
 RD = Cost of debt
 rWACC = Weighted average cost of capital
 VL = Value of the firm with debt
 VU = Value of the firm without debt
 rU = Cost of unlevered equity (WACC of
company without debt)
 Tc = Corporate tax rate

How to measure Capital Structure:
 A firm’s debt-to-value ratio is the fractio
of the firm’s total value that corresponds t
debt:
o D /(E+D) or D/V
o Illustrates how much your capita
is financed by debt will determin
this value.
 Another common measure of capita
structure :
 Debt-to Equity ratio or leverage ratio
o Debt /Equity
 Principle - In a perfect capital market, th
total value of a firm is equal to the marke
value of the free cash flows generated b
its assets and is not affected by its choic
of capital structure.
 This means that Modigliani and Mille
argued that leverage merely changes th
 (3 assumptions exist):
 1. Securities are fairly priced.
o Therefore, Investors and firms can
trade the same set of securities at
competitive market prices equal to
the present value of their future cash
flows.
o This means that all securities are
fairly priced and there will be no
securities which are overpriced or
under-priced.
 2. There are no tax consequences or
transaction costs.
o No Tax, No transaction costs
 3. Investment cash flows are independent of
financing choices.
o Your investment decision will not be
restricted by financing choices.
Considering MM1 – Would investors prefer an
alternative capital structure?
 If the firm value (the present value of the
free cash flows given between a firm that is
allocation of cash flows between debt an
equity without altering the total cash flow
of the firm in a perfect capital market.
 Slide 13 – 14 demonstrates this principl
that:
o With a perfect capital marke
the total amount paid to a
investors still corresponds t
free cashflows generated by th
firm’s assets:
o Equity financing = distributin
cash flows only t
shareholders/equity and no
debtholders
 Unlevered = withou
debt
o Levered Financing
distributing cash flows to bot
shareholders/equity an
debtholders
 The focus is on the power of the assets, s
their focus is on the left hand side of th
balance sheet.
 And market value will be determined b
how much free cash flows will b
generated by the use of their assets, not b
how that free cash flow is divided betwee
different types of investors
 Remember meaning of Free cash flows
free cash flows is ready-to-distribute cas
flows (from a project/investment), whic
will be eventually distributed to deb
holders and shareholders, so the capita
structure is characterized as how cas
flows are divided between debtholders an
shareholders.
 The conclusion is what determines firm
value is free cash flows and not by how
is divided, not by capital structure
 Therefore:
o VL = E + D = VU
 Meaning - VL the value of levered the firm
is equal to the value of unlevered firm
there is a no difference between these tw
types of firms so that debt doesn
determine the value of firm.
In reality, the use of levered equity will increase
the risk of a firm’s equity and cost of capital
Slide 16 – In an MM1 world, after restructuring
how do we know if shareholders are happy after
the equity portion has decreased?
 If you, as a shareholder, wish to continu
 levered and unlevered) between unlevered
and levered firms are the same, the investors
would be satisfied either way
 From the investor's perspective, we like to
see how different capital structure will affect
how much cash flows they will end up with.
 Slide 15 - 16 demonstrates a firm
restructuring:
 Example – If a firm wants to change its
equity financing to a equity of $700 from
$1000 and debt of $300 structure – it can by:
o They will have to issue debt so they
can sell $300 worth of perpetual
bonds at 5%.
o And at the same time to reduce
equity, they can pay shareholders
$300 one time special dividend so
special dividend is one-off type of
dividends which they can pay out to
alter their capital structure.
 They could also, if they have
an extraordinary gain from
the sales of one part of the
business, they may be in a
position to pay special
dividends as well, but in this
case, they can use special
dividends to reduce their
equity.
Value of the firm calculation:
Value of firm = FCF/ rWACC
Conclusions on MM1:
to receive an annual income of $100 s
you don't like to receive reduced income o
$85 you want to continue to receive $10
(before restructuring), then what can yo
do to achieve that.
 Under the new restructuring $85 will b
received by shareholders.
 And the thing is he's got one-off income o
$300 and he can do something about that.
 You can use a special dividend of $300 t
purchase the bond so if you purchase th
bond, you are entitled to receive a periodi
interest.
o Special dividends is a method o
reducing your equity in th
capital structure
o Special dividends usually occu
when there is a huge inflow o
cash from e.g. a sale of an asset o
huge profitability
 and you are able to purchase the bon
worth $300.
 And you are going to get the periodi
income of $15 from bondholding.
o You therefore achieve $100 annua
income per year
 In MM1 world, tax does not exis
therefore there is not need to convert t
after tax
 Another Example in slide 17 – Where yo
can replicate the previous structure b
borrowing $300 and paying $15 interes
and still retain $85 equity, but its you
changing your portfolio (the capita
structure you invest in, not the firm):
o This involves a homemad
leverage – which is the method o
an investor to increase thei
leverage of their portfolio despit
the firm’s choice of capita
structure
o In the real world, if shareholder’
are not happy with changing o
capital structure, the value of th
firm could go down. However i
MM1, the perfect capital marke
assumes investors will be happ
regardless of changes in capita
structure because FCF will be th
same.
 In perfect market in which three condition
are met

Impact of Debt on rE – MMII:
Learning about Proposition two in a perfect world
MM Proposition 2 (MM2)
 Although capital structure DOES NOT affect demonstrates if/how WACC changes with
V ( = Value of company), it AFFECTS rE leverage)
(=cost of equity = required return on equity)
 MM2 states that the cost of (required return
on (which is on equity here)) a company's
ordinary shares is directly related to the debt-
to-equity ratio.
 We look at the impact of capital structure on
cost of equity, so your X variable remains
the same, which is the measure of capital
structure but your Y variable has changed to
cost of equity from the value of the firm.
 MM2 states that the cost of equity or
required return on ordinary shares is directly
related to the debt to equity ratio.
To see why, let's return to the WACC formula
 rWACC = rD (1 – TC) D/E+D + rE (E/E + D)
 Because in a perfect world, tax does exist, so
ignore (1 – TC)
 We first like to see whether WACC changes
with leverage so whether WACC in a levered
firm is the same as WACC in a unlevered
firm.
In the MM World – explaining how leverage/debt
 Investors can make changes in their ow
accounts that will replicate cash flows fo
any capital structure that company want
or that you desire.
 As investors can do this on their own (a
shown in the above examples), they are no
willing to place more value on companie
which change capital structure for them.
 Therefore, V will be the same regardless o
its capital structure. This is true because
 Capital structure does NOT change V if
does not affect total cash flows to security
holders
Does WACC change with leverage? (this slide
 The conclusion is that the WACC in
levered firm and unlevered firm (becaus
of perfect world does not matter on capita
structure) = equals the same
 RU = WACC (in unlevered firm)
o The demonstration of this is b
calculating the WACC formula of
 rWACC = rDD/E+D + rE (E/E + D)
o to get rE = the change between E
and E1: e.g. E1 + E0/ E0
o to get rD = the change between E
and E1: e.g. D1 + D0/ D0
 rWACC = rU = rD D/E+D + rE (E/E + D)
MM2 – in an equation form & explanation:
 Rearranging rWACC = rU = rD D/E+D + r
(E/E + D) to make rE the subject
 RE = rU + D/E (rU +rD)
 The higher the debt = the higher of equity
 Means with the increased use of deb
shareholders will require higher level o
required return.
 MM2: The cost of equity is equal to th
cost of capital of unlevered equity (=rU
plus a premium that is proportional to th
debt-equity ratio (=D/E).
 Therefore from the equation there are tw
elements which determine the require
return for shareholder rE:
o 1. first element is, rU and;
o 2. the second element is D/E(rU
rD)
 Those two terms represent two differen
types of risk.
Implication of MM Propositions MM1 & MM2 –
increase cost of capital and risk which requires more why we need to analyse MM1 & MM2 in perfect
compensation for investors for a firm that takes on world:
leverage:
 The value of MM assumptions arise whe
 WACC, rU, (where there is no you try to relax the assumptions
debt=unlevered firm) is compensation for the  The value of MM analysis is that it tells u
business risk that your company will bear exactly where we should look if we wan
and business risk exists regardless of how to understand how capital structur
much debt your company uses. affects the firm value and the cost o
 Business risk drives one part of the required equity, that means we can examine how
return for shareholders and; tax plays a role in establishing th
 Risk from debt - Another part which drives relationship between capital structure an
required return for shareholders, is to do with the value of the firm
the debt.  We can also look at the same issue b
o Risk born by shareholders is called pointing out to the transaction costs.
financial risk and it arises from the  Below MM1 will be revisited but wit
use of the debt and it increases the relaxing the assumptions of tax an
variability of shareholders' return. transaction costs:
o It increases the variability of
shareholder’s return because debt Therefore we will learn about MM1 with taxes &
holders are always paid first, and MM1 with taxes and transaction costs
with FCF’s debt holders are always
paid first, and there may not be
enough left over to pay shareholders.
Therefore there is increased
variability with taking on debt
 Therefore:
 In MM2 = rU quantifies the compensation
for business risk, and;
o Business risk is nothing to do with
the debt.
 The second term, D/E (rU-rD) compensates
for the financial risk.
o Financial risk totally to do with the
debt.
World 2 - Impact of Debt on V – MMI with tax:
 Time for us to relax the assumption slightly and we like to see the impact of the tax on influencin
relationship between capital structure and the value of the firm, so we are going to re-examine th
relationship between capital structure and the value of the firm.
 Therefore including Tax but excluding the other assumptions of costs
Impact of Corporate Tax (Tc) Benefit of interest tax Capital Structure & Corporate Taxes:
shield:  In the example, the interest paid on deb
 Firms can deduct interest payments for tax results in a tax deductibility of interes
purposes but cannot deduct dividend increases the total distributed income t
payment both bondholders and shareholders. (by th
amount of tax shield of $24)
 Interest is paid before tax is paid, so the
presence of interest expense reduces tax Impact of Tax – Benefit of interest tax shield (the
payable but dividends do not influence tax graph):
payable.  For a given debt to value ratio, the value o
 Interest tax shield - Defined as Tax savings a company with debt will be alway
resulting from deductibility of interest greater than the value of company withou
payments. debt.
  And the difference between the two value
Example: is the value of interest tax shield.
 Interest payment = cost of debt x amount  If only tax condition is violate
borrowed (meaning the assumption of no tax i
o Interest payment will reduce tax broken), the more debt it has, the mor
payment the firm is worth
 Annual tax saving on interest (= Annual tax 
shield)
o Annual tax shield = Interest payment
x corporate tax rate
 That is the long way, slide shows tax shield
can be calculated by D * Tc which is the
present value of the tax shield as long as the
tax saving is a perpetuity
Therefore in the 2nd world or MMI with taxes:

 VL = VU + PV of interest tax shield (= PV of tax savings on interest)

 VL = VU + TC * D (MM1 with taxes)
o Because VL will be greater than VU by the amount of present value of tax shield.
o And that PV can be quantified by debt times corporate tax rate (D*Tc).
 Therefore implication is that:
o Higher the Debt, the value of firm increases
 But why don’t firms borrow so much that their tax bill is reduced to zero?
o For this we consider the 3rd world where we examine two types of costs which ar
bankruptcy cost and agency cost (which shows the negative side of using debt)
World 3 Impact of Debt on V – Real World with taxes and costs:
 Look at the impact of capital structure on the value of the firm and focus on the costs associated wit
the use of the debt and how it impacts the value of the firm.
1st type of costs – Bankruptcy Costs (=financial Trade off theory:
distress costs):  Managers choose a specific target capita
 Costs associated with financial difficulties a structure based on the trade-off between th
firm might experience because it uses debt benefits of debt and costs of debt. Th
financing optimal capital structure is where the firm
 Financial distress occurs when a firm is not value is maximised.
able to make all of the interest and principal  Looking at the graph:
payments that it owes its lenders. o With the existence of bankruptc
 Situation arises when excessive debt is used costs, the value of the firm with deb
 VL= VU + PV (Interest Tax Shield) - PV the red line, will start to drop off a
(Financial distress costs) you increase your debt to value ratio
 Costs can be direct or indirect: More debt = more bankruptcy costs &
o Direct costs – fees paid to parties such as therefore value of firm decreases
lawyers, accountants and consultants  Therefore we want the Optimal capita
 Out of pocket costs which will structure or target capital structure:
have to be paid to service o Which is the capital structure tha
providers, especially when the maximizes the value of the firm an
companies are filing for trade off theory suggests that th
bankruptcy. managers will try to find this capita
o Indirect costs (more significant in structure and they will find a trade of
influencing value of firm) - The cost between the benefit of debt and cost o
arising from a change in behaviour of the debt and determine the targe
your stakeholders, when your company capital structure.
is known to be financially distressed Therefore summary of Trade-off Theory:
 Customers starting to buy the  So under the trade off theory, PV (interest ta
 competitors’ products, no
confidence in your
company/product
 Suppliers demanding cash on
delivery, & they may not provide
credit because they don’t feel
confident giving your extra time
for credit due to bankruptcy
 Employees starting to leave for
more secure job
 Sales of assets at a lower to meet
transaction needs
 Overall this will affect your FCF’s and value of
firm
2nd type of costs – Agency Cost:
 Agency costs result when there are conflicts of conflicts:
interest between stakeholders. The implication is
(when determining value of levered firm)
– VL= VU + PV (Tax Shield) - PV (Agency
costs)
 Managerial Entrenchment:
– A situation arising as a result of the
separation of ownership and control, in
which managers may make decisions that
benefit themselves at investors’ expense.
 Because of the self-interest managers
may make a decision which may not be
optimal for the shareholders
 The use of debt financing at a moderate level can
contribute to reducing agency costs. (use of some
level of debt can play a positive impact on
aligning the interest of managers and interest of
shareholders.)
How does this arise (the positive impact)?
– Under the presence of debt, using debt
financing provides managers with incentives
to focus on maximising the company’s free
cash flow in order to pay the debt holders.
FCF’s must be maximise to pay debt holders
which will contribute to stopping companies
going financially distressed
– Some debt also limits the ability of bad
managers to waste the stockholders’ money
on non-value-maximising projects.
 Because short term projects such as
expanding the business may not increase
wealth of debt holders, only you (e.g. you
want promotion and higher pay)
 Therefore having debt makes you use
your free cash flows more wisely to
service debtholders, then you've got less
shield) of interest tax shield initiall
increases as the firm borrows more
 At moderate debt levels the probability o
financial distress is low  PV(financia
distress costs) is small  tax advantage
dominate.
 At some point the probability of financia
distress increases rapidly with additiona
borrowing
o The cost of distress begins to outweig
the benefit of debt.
 Rule - Optimum (which maximises firm
value) occurs when PV(tax shield) is jus
offset by increase in PV(financial distres
costs)

Another type of Agency Cost – Equity-Debt holde
 When investors lend money to a company
they delegate authority to the shareholder
to decide how that money will be used.
 Principal = Lenders
 Agent = Shareholders
o Lenders expectation is that th
shareholders, through the managers the
appoint, will invest the money in a wa
that enables the firm to make all of th
interest and principal payments that hav
been promised. (All investors care abou
is if their interest is being paid
o HOWEVER, WHEN A FIRM i
FINANCIALLY DISTRESSED
(shareholders have a large incentive t
take big risks, because it is debt holder
who suffer & lose their investmen
whereas if its succeeds, the shareholder
benefit), Shareholders might decide tha
instead of investing the money to grow
the firm, they will distribute it t
themselves as a dividend.
 For example - shareholders migh
decide that instead of investin
the money to grow the firm, s
that they can pay debtholders, th
shareholders may distribute it t
themselves as a dividend = self
serving behaviour
o Another issue - Excessive risk-taking
Shareholders have an incentive to inves
in risky negative NPV projects that ar
=risky & high return
 Why/what is the motivatio
(why shareholders take the risk)
With risky projects, the mone
 cash flows in your hands to waste so being invested is bondholder
you've got less chance of misusing those money, so if it leads to failure,
free cash flows on a non-value is the bondholders' money tha
maximizing will be lost.
 But with a very small chance if
Therefore there is some value of debt, but once it gets becomes successful.
excessive, agency cost will be excessive as well
 The majority of the gain will go t
shareholders because bondholder
will only receive the fixed return.
 that's why if it wins, you
shareholders will be a big winner
o Under-investment problem: shareholder
have an incentive to choose NOT t
invest in a positive NPV project. =Saf
& low return
 If a new project gains a very sma
return it will accrue to th
debtholders first and if it's a low
return project.
 After servicing the debt holders
there will be nothing much left fo
shareholders.
 that's why shareholders, when th
companies are financiall
distressed, shareholders do no
have incentive in investing in
safe and low return project, the
have higher incentive to take ver
risky and high return project, s
they gamble using bondholder
money.
Pecking order hypothesis:
 Emerges under asymmetric information.
o Insiders know better and more than
outsiders.
 Theory recognises that different types of
capital have different costs and this leads to a
pecking order in financing choices that
managers make.
 Why - because of lack of information that
outsider face whenever insiders make
decisions, outsiders will watch and monitor
them carefully. So whenever insiders make
capital structure decisions, outsiders will
mimic that information
 Reasoning = Using internal funds or
obtaining more debt to raise funds does not
raise negative signals to the market
 However, selling equity/shares does send
negative signals as:
o There is an order of using/obtaining
funds:
o The pecking order - First they use
Internal funds  then issuing
 (selling) debt then finally selling
equity to raise cash
o The announcement of share issue,
leads to decline in share price (
Pshare) as investors believe managers
are more likely to issue when shares
are overpriced/overvalued (i.e. bad
signal!)
o Therefore firms prefer internal
finance since funds can be raised
without sending adverse signals.
o If external finance is required, firms
issue debt first and equity as a last
resort
Therefore summing the pecking order theory:
 There's no such thing as a target capital
structure. What they argue is companies will
issue equity or debt in a way that it doesn't
send negative signal to the market, so their
major concern is how outsiders will react to
their capital structure decision and they will
follow the order in a way that minimizes the
negative signal.

12 Week 12 – Dividend Policy (Chapter 17) A company's dividend policy dictates the amount of dividends paid o
by the company to its shareholders and the frequency with which the dividends are paid out. When a comp
makes a profit, they need to make a decision on what to do with it
Topic – concerns the payout policy and pay out policy is
the way a company chooses between the alternative ways
to pay cash out to shareholders. One of these methods is to
‘pay out’ to shareholders via 1. Repurchase Shares or 2.
Pay dividends

Calculating pay out ratio = Dividends per share/Earnings

per share

Retention rate = 1 – Pay out ratio

Method 1# - Dividends: Dividends – Important dates: (Refer to slide 9)

 1. Regular cash dividends
o Dividends are paid twice a year in
Australia
o Interim dividend & Final dividend
 2. Special dividend
o A one-off dividend payment a firm makes
that
o When do they pay special dividends:
 distribute excess cash from
operation, sale of a major asset or
business
 As a way to alter a company’s
 The Board will have to vote for it and.
 On a declaration date company will anno
its intention to pay the dividends and w
dividends are declared or, when the divide
announced to the market.
 your shares will start to trade with divid
attached and such a period is called
dividend period so shares are trading
dividends during the cum dividend period.
 So investors who want to purchase the sh
during the cum dividend period will be ent
to receive the dividend.
 capital (e.g. move from 100%
equity to 70% equity)
 Liquidating dividend (= Return of capital)
o The final dividend that is paid to
stockholders when a firm is liquidated
2# Method Share repurchase:
 An alternative way to pay cash to investors
 The firm uses cash to buy some of its outstanding
shares.
 Capital Gain - when your selling price is greater
than the initial purchase price that you paid for the
shares, the difference is known as capital gain and
it's kind of equivalent to dividend amount, and if
the dividend method was used.
 1. Open market repurchase
o Most common way a firm repurchases
shares
o A firm announces its intention to buy its
own shares on the open market
o Its price it purchases, is the market price
 2. Off-market buyback
o A firm invites its shareholders to offer to
sell their shares back to the firm by way of
a tender process
 Two ways to conduct buybacks:
o Equal-access buy-backs: A firm offers to
buy the same proportion of each
shareholder’s shares.
o Selective buyback: A firm offers to
repurchase shares directly from only one
or some of its shareholders.
 A shareholder may have a
dominant amount of ownership of
the company’s shares and
specifically buys that persons’
share
 Ex dividend date - And there is a day when
shares will trade without the dividends and
first day on which the stock trades wit
dividend is called ex dividend date and, on
day, share price will decrease
approximately dividend amount.
o So ex-dividend date is one busi
day before the record date, so
business day after the ex-divi
date, a record date will be determin
o Record date = Books closing date
o The day before the ex-dividend
is the last day you can purchase a s
with dividend
Characteristics of share repurchase:
 1. Does not we present a pro rata distribu
of the value to the shareholders because no
shareholders will participate so.
 You do not have to realise your cash and
continue to hold onto your shares, if you
sell your shares at a higher price in the futu
o For dividends example you ca
refuse dividends payments
 2. When a company conducts s
repurchase – they take those shares ou
circulation on the market & reduces
number of outstanding shares that exist
 3. Share repurchases are taxed differently
Dividends vs Share Repurchase in a perfect market MM1:

 In an MM1 world, we ignore taxes and other Dividend:

transaction costs:  You are holding 2000 shares, so the valu
o The price drop will be exactly the same as shares will be the price of the share time
the dividend amount so price will decrease number of shares that you hold and the pric
by $2 to $40. the share is $40 times 2000 will lea
 Prep = price after share repurchase, Prep would be $80,000.
calculated as market value after share purchase  So the total value for this partic
divided by the number of shares outstanding after shareholder is $84,000 And what about s
share repurchase. repurchase.
 So assume that you didn't participate in
Note that: Dividend per share = Total amount distributed share repurchase and you are holding
/ number of shares outstanding shares, as they are.
Repurchase
 And you are holding 2000 shares and bec
you didn't participate in share purchase yo
got nothing in your hands, but the value is
shares.
 So 2000 shares times the price of the s
after share purchase $42 will give you $84
and the total value that you are getting wi
$84,000.
 Therefore - there is no difference in the v
of ownership, but the location of the valu
different, between the two methods, becau
the case of dividends you've got $4,000 in
hand.
Therefore in a perfect market - there is no
difference in value between dividends and share
repurchase in a perfect capital market.
What if the firm repurchases shares but investor wants What if the firm pays a dividend and you do not wa
cash: cash?
 The investor could SELL shares to raise cash  You could use the dividend to purc
(known as homemade dividend) additional shares
 To raise $2* 2000 = how many shares would you  How many shares can you buy with the
have to sell? 4,000 / 42 = 95.24 dividend of $4,000? $4,000 / $40 = 100 sh

 Therefore – In either case, your portfolio is worth $84,000.
 In different between the firm distributing funds
 In perfect capital markets, investors are via dividends or share repurchases.
 By reinvesting dividends or selling shares, they can replicate either payout method on their own.
This illustrates the MM dividend irrelevance because:
 MM dividend irrelevance – In perfect capital market, holding fixed the investment policy, the firm’s ch
of dividend policy is irrelevant and does not affect the initial share price.
  In MM & dividend irrelevance theory, in perfect capital market, Holding fixed the investment po
company's choice of dividend policy is irrelevant and does not affect the initial share price that means
doesn't affect the initial share price that means the value remains unchanged.
 So the company's choice of dividend policy will not affect the value of the firm and that's the conclusio
MM dividend irrelevance theory.
Therefore - from here we will learn that how the world will look different if you relax the assumptions, so we hav
see the impact of dividend policy on the value of the firm under the presence of market frictions such as taxes, co
and information asymmetry and that's why from the next recording we are going to see how those market friction
play a role in influencing the relationship between dividend policy and the value of the firm.
The impact of Tax on Dividends and Share Repurchases: (the real world looking at the effect of taxation o
dividends and share repurchase)
Dividends & Taxations: (the next slide demonstrates the
two different systems)

For imputation method:

Under the Imputation Tax System:
 The imputation tax system effectively eliminates
the double taxation for Australian recipient of
franked dividends
o Franking credits (= the amount of
corporate tax prepaid) attached to franked
dividends can be sued to reduce investor’s
personal tax liabilities
 Australian shareholders with a personal tax rate
above the corporate rate will only pay the
difference between their marginal tax rate and the
 The Gross-up adjustment = gros
adjustment is the 30 cents should be adde
the 30 cents prepaid tax should be added to
cash dividend.
o And that leads to what's called
grossed-up dividends and that's
basis of the tax calculation so pers
tax would be in total 45% of $1.
 Franking credit = the amount of tax pa
a tax level
 Personal tax = person tax %
 In an imputation tax method = net p
before tax will be effectively taxed at
marginal investors tax rate and there's
double taxation.
o 45% has been taxed out of $1
FF, PF & UF (terminology):
 Dividends can be fully franked (FF), part
franked (PF), or unfranked (UF) dependin
whether dividends are paid from profits
taxed, partially taxed or untaxed
o 1. FF divs: The franking proportio
100%
 Dividends are paid ou
profits which have been t
at the full Australian corpo
 corporate tax rate tax rate Tc of 30%
 Australian shareholders with a personal tax rate o 2. UF divs: The franking proportio
lower than the corporate rate will have a surplus 0%
credit which can be used to offset their tax on  Dividends are paid ou
other income profits which have
o If there is no other income against which untaxed (i.e. profits not su
surplus credits can be offset, surplus credit to the Australian corporate
will be refunded by the ATO rate such as foreign sou
 This process explains why its important to have a income
certain dividend policy that affects a shareholder’s o 3. PF divs: The franking proportio
wealth: less than 100%
o The imputation tax system and comparing  When there is a mixtur
classical tax system and imputation tax fully franked dividends
system, you can see that how investors can unfranked dividends
be better off under the imputation tax  Companies may
system because it increases the amount of need to pay tax at
after tax dividends, that they will end up due to various
with. deductions inclu
losses made in
previous years
Grossed up dividend & Franking credit calculation: How do we incorporate the value of franking credit
into firm valuation? ( obviously franking credits se
to have a positive value, but how does it affect our
of capital, and how does it affect the value of the fi
in the end that's the question that we are trying to
answer.)
 The two main components of the mode
free cash flows and the weighted average
of capital (WACC).
 To capture the impact of dividend imputa
on firm value, we should adjust the WA
down or free cash flow up in the present v
calculation
How to calculate franking credits  The two main components of the model ar
free cash flows and the weighted average
When working out the tax amount on dividends, if of capital, so to incorporate the valu
there are unfranked credits, the grossing up dividend franking credit, you could:
process is not relevant. Therefore just tax the share at o 1. adjust your WACC downwar
the personal rate. Example look at P10 of tut questions reflect the positive value of fran
credits, or you could.
o 2. adjust your free cash flow upw
and that means you only adjust
you either change your nume
which is free cash flow or
denominator which is WACC.
 Aim - you're going to learn how to adjus
cost of capital to reflect the possible valu
Franking credits.
Adjusting the cost of capital: Don’t understand the equity part involved in this sl
 In a 1994 study, Officer shows that for valuation and the effects of equity & WACC (we understand
purposes the cost of equity (rE) should be adjusted now) on question 2 of tut questions (this is also a s
by a factor equal to in the lectures)
 where T represents the effective corporate tax rate
and gamma represents the proportion of tax Under the classical tax system: the market value of
 collected from the firm that will be rebated against equity (E) = V = d + e = value of the firm
personal tax in the hands of shareholders
Using Wacc to calculate the value of firm:

V = FCF/WACC
&
 Use this when value of a com[any under an
imputation tax system where all of its shareholders Market value of equity (E) = dividends to
can fully utilize the franking credits (this means shareholders / rE
gamma is 1) to offset their personal tax.
o When gamma = 1 all franking credits are But under the imputation system we can adjust WA
utilised to reflect the impact of franking credits through a
o When gamma = 0 no franking credits are factor of this:
utilised
 Therefore gamma = gamma can be seen as the
proportion of franking credits that can be utilized
by shareholders because:
o Not all franking credits can be used by
your shareholders.
o Not all the shareholders can utilize the
WACC reflects new re which is the cost of equity
franking credits because foreign investors which reflects the value of the firm using free cash
cannot use it. flow approach
 The impact of imputation - a reduction in cost of
equity
o Shareholders willing to accept a lower cost When gamma is greater than zero.
of equity in recognition of the benefit of
franking credits or; It will lead to reduced cost of equity and reduce the
o The return required by shareholders cost of equity will lead to higher market value of
remain unchanged. Rather the government equity.
funds a portion reducing the cost of equity
and higher market value of equity will lead to high
to the firm. market value of the firm and when all of those valu
In summary: change your WACC will be reduced.
And when there is a decrease in the WACC it will
 More franking credits results in lower r E increase the value of the firm so eventually the pos
 Less franking credits results in higher rE value of franking credits will lead to an increase in
value of the firm once again under the presence of
Your dividend policy can have an impact on the va
of the firm.
In this case, via the positive value of franking credi
Which is only available under the imputation tax
system
How share repurchase is taxed in Australia: Share repurchase structured as dividends:
 When a share holder sells a share at a higher price In Australia, off-market equal access share buyback
than that at which they purchased the share, the can be structured such that some portion of the
gain is subject to tax. repurchase price is designated as a dividend and the
 If shares were purchased after September 1999 and remainder a capital component.
held for one year or more o Dividend component subject to inc
 Shareholders can reduce their capital gain by 50% tax
before tax is applied. o Capital component subject to ca
 If held for less than one year gains tax
o No adjustments apply. o Dividend component can be fra
o The full capital gains are to be taxed. therefore making distribution
 Look at next slide for reference: franking credits possible.
 o Therefore the way your capital gain is
taxed is different to the way your dividend
is taxed
Signalling, DRP & Bonus Issues - Like to see how dividend policy can influence the value of the firm under the
presence of information asymmetry and transaction costs.
Signalling with Payout Policy:
 What would be the impact of dividend policy on
firm value under the presence of asymmetric
information?
 When managers have better information than
investors regarding the future prospects of the
 On-market buybacks
o The price cannot include a divi
component.
o The whole amount paid
shareholders is treated as proc
from the sale of shares.
o Therefore shareholders are subje
capital gains tax
Explanation:
 For example, if you are offering the repurc
price of $10 and if it's on market buyback
of the $10 will have to be capital compo
paid out of share capital.
 But if it's an off market equal access s
buyback that $10 can include the divi
component, that means part of it can be
from retained earnings.
 So, for example, $3 maybe divi
component and only the remaining $7 is
capital component and the beauty of it is.
 If you've got dividend component in this
$3 you can have franking credits attached
so having dividend component in s
repurchase price allows the company
distribute franking credits.
 which wouldn't be possible under on ma
share buyback.
 So the consequence is dividend component
$3 will be subject to income tax that mean
Australian context it's an imputation
system and the capital component wil
subject to capital gains tax so $7 wil
subject to capital gains tax.
 And dividend component can be fra
therefore making distribution of fran
credits possible.
 On market buyback, however, the price ca
include the dividend component and the w
amount paid to shareholders is considered
capital and it's treated as proceeds from
sales of the shares.
 Therefore, on market buyback shareholder
subject to capital gains tax only because.
 The entire price will only be regarded
capital component.
Dividend signalling:
 The idea that dividend changes re
managers’ views about a firm’s future earn
prospects.
o When a firm increases its dividen
sends a positive signal to investors
 firm, their payout decisions may signal this
information.
 When insiders have better information about how
companies will do in the future the way they make
dividend decision may convey or signal this
information to the market.
 That's why investors will be reacting to the
dividend decisions sensitively, in a way that moves
the prices
 How would this affect the behaviour of dividend
payment?
 Dividend Smoothing
o The practice of maintaining relatively
constant dividends.
o Recognizing this sensitivity attached to the
dividend information, and corporations
will not change dividend instantly because
they know that whenever they change the
dividend it will signal something to the
market
o Firms raise their dividends only when they
perceive a long-term sustainable and
permanent increase in the expected level
of future earnings, and cut them only as a
last resort.
 Dividend increase is taken as a positive news but
dividend decrease is taken as a negative news in
the market and because of these the insiders will
only increase the dividends when they recognize a
change in long term sustainable earning
 They wouldn't increase the dividend when they
perceive that their gain in the earnings is going to
be the temporary change.
Signalling and share repurchases:
 Share repurchases (convey information) are a
credible signal that the shares are undervalued,
because if they are over-priced a share repurchase
is costly for current shareholders.
o You can think of share repurchase as an
investment in your own company.
o And if you don't see any positive outlook
for your company you wouldn't put money
into your own company So share purchase
is like telling the market that we can't find
any better investment opportunity than
ourselves.
o Share repurchase is a sign of
undervaluation typically because if they
are overpriced, a share purchase is the
quite costly option for the current
management expects to be abl
afford the higher dividend for
foreseeable future.
o Why - because your dividends are
out of the earnings.
o For financial managers to increase
dividends, they have to have s
confidence in the level of the earn
that they will produce in the fu
time and the increase in divid
indicates.
o The insiders' perception about
ability to maintain or increase
future earnings.
 When managers cut the dividend, it may si
that they have given up hope that earnings
rebound in the near term and so need to re
the dividend to save cash.
o When there is a reduction in
dividend.
o They may put less confidence
company's future profitability, bec
when dividends are cut, inve
believe that company's fu
profitability is affected in a neg
away.
 Changes in dividends should be viewed in
context of the type of new informa
managers are likely to have: (mea
dividend cuts may be positive or neg
based on its context or purpose of it – e.g.:
o An increase of a firm’s dividend
be signal of lack of profi
investment opportunities.
o A firm might cut its dividend
exploit new positive-NPV investm
opportunities taken as positive new
Dividend Reinvestment Plans:
 Shareholders receiving dividends often hav
pay transaction costs if they want to rein
the dividends.
 To eliminate this cost, some companies
Dividend Reinvestment Plan (DRP). Wh
it?
 Shareholders choose to reinvest
dividends. Firms issue new shares instead
form of payment.
 Shareholders receive new shares wit
paying brokerage and other transaction cos
 Shares sometimes issued at a price disc
to the market price.
o Therefore - So dividend reinvestm
plan can save some money for exi
shareholders who want to reinves
 shareholders, because the future of dividends back into the s
overpriced share is a decline in the share company, so it can be
price but. shareholders in a value-maximi
o The future or the undervalued share is an way.
increase in the share price in the future, so  BUT shareholders still be liable for incom
the current shareholders can benefit from. in the same way that they would have if
o Investment in undervalued shares. had received dividends
 If investors believe that managers have better  Allows companies to retain cash to
information regarding the firm’s prospects and act investments.
on behalf of current shareholders, then investors o And it's a win, win strategy becau
will react favourably to share repurchase allows companies to retain cas
announcements. fund the investment so divi
o Share repurchase announcements tend to reinvestment plan for a corpo
lead to an increase in the share price on the perspective it's a source of capital.
announcement date, so it is taken as a  Allows companies to distribute fran
positive news in the market. credits.
 Summary - remember distinguish between share o And DRP also allows companie
issuance and share repurchase if a company issues distribute franking credits
new shares it's a typically taken as a sign of shareholders can enjoy the pos
overvaluation and share repurchase is taken as a benefit arising from having fran
sign of undervaluation. credits.
o Therefore - there are benefits for
shareholders and corporations.
Bonus Issues:
 The issue of free shares to existing shareholders,
usually in proportion to the number of shares held
by a shareholder.
 The value of the assets in a company does not
change with a bonus issue.
 After Bonus issues?
o So after bonus issue, the number of shares
outstanding will increase, but the price
will adjust downward in a way that the
value of the asset is kept constant.
o Look at slide for example in a perfect MM
world, but this is not the reality in a non-
perfect world without information
symmetry
 Lower share price can improve the affordability,
therefore increase demand.
 Bonus issue can signal better prospects ahead.
o The company expects the substantial
growth in their share price they may issue
bonus shares and they may try to decrease
the share price and to make.
o The share more affordable for the retail
investors, and it can also increase the
demand of the shares, increasing the share
price.
o and investors also believe that.
o The reason that they are trying to lower
price through bonus issue is because the
management may expect their share price
 to increase even more in the future that's
why.
o The market perceives that the investors
may have a positive outlook about the
company and expect the share price to
grow even further in the future that's why
the management is trying to reduce the
share price now to make it more
affordable.
Capital Market Efficiency:
 Whenever a company makes a decision it conveys
information to the market.
 And this information will be affecting the
investors' buying and selling or holding behavior
and whenever information is released.
 This information therefore plays a role of moving
share price into the positive direction if it's a good
news and into the negative direction if it's a bad
news.
Efficient Market Hypothesis – looks at three different
levels of information and determine the efficiency based on
how certain information is incorporated into the price
 Weak-form Efficiency
o All PAST information is reflected in
current prices & future returns
o If market is “weak-form” efficient, it
would be impossible to earn abnormally
high returns by analysing past return
o Meaning - if this is true if the market is
weak form efficient and those people who
try to find the pattern in the past price and
volumes to predict the future and their
analysis shouldn't work.
 Semi-Strong-form Efficiency
o All publicly available information is
reflected in security prices
o If publicly available information should be
reflected in the security prices.
o That means, as soon as the information is
announced to the market.
 In an efficient capital market:
o Security prices fully reflect
knowledge and expectations of
investors at a particular point in tim
o The more efficient a security ma
the more likely securities are to
priced at or near their true value
 True value: PV of CFs
investor can expect to rec
in the future
 PV in turn reflects
available information a
the size, timing and riski
of the cash flows
 We try to get as close to
value of the assets
assuming
 Assuming that the information available a
the size and timing and riskiness of the
flows are accurate and reliable and this pre
value will be closer to the true valu
intrinsic value of the firm.
 PV = C/(1+r)n
 Strong-form Efficiency
o All information, whether public
private, is reflected in security pric
o If market is “strong-form efficien
would not be possible to
abnormally high returns by tradin
private (inside) information abo
company
o In real world, insiders do make a p
by trading on private information.
 When insider trading is il
and.
 it is difficult for tra
activity to reflect
information into prices.
 And in real world, insider
make a profit by trading
private information and
indicates that the market i
strong form efficient, bec
there are people who ma
lot of money by trading
 o The share price will quickly adjust to it. and also be sent to jail.
o to the point where average investors  Concept of strong-form-market efficienc
cannot make profit out of it. rather ideal.
o If market is “semi-strong-form” efficient,
as soon as information becomes public, it
should be quickly reflected in stock prices
through trading activity.
o AND it would be impossible to earn
abnormally high returns based on publicly
available information because it would be
too quickly impounded into the share
price.

13 Week 13 – Introduction to Derivatives (Chapter 21 or Chapter 11) - deriving value from the underlying assets, when you
determine the value of the derivative contract; being able to figure out gains and losses for each contract is important,
depending on how the market moves on the actual delivery date,
Call Options & Put Options
Derivative Instruments:
 Another form of financial instrument
 What we’ve been focusing on thus far is cash instruments
o whose value is determined directly by markets
o Eg) Debt – Bond, Equity – Ordinary shares
 Another form? What is called “Derivative instruments”
o which derive their value from some other financial
instruments (i.e. from underlying assets)
o Eg) Forward, futures and options
o Used by hedgers to reduce the risk they face from
potential future price movements in a market
 Main feature - An agreement which provides that something
will be bought or sold in the future at a fixed price
o The price is determined today
o The transaction is to occur later
Option basics:
 What is it - A contract which gives the
holder the right, but not the obligation to
buy or sell an asset in the future at a price
which is determined today
o Therefore meaning – He/she has
the right to either sell or buy the
asset
 The option buyer (=option holder) holds
the right to exercise the option and has a
long position in the contract
o If you take a long position in the
option, you are the buyer of the
option.
 Two types of Options:
o Call option: gives the holder
right to buy an underlying asset at
a pre-specified price (= Exercise
price = strike price)
 Depending on where the
market is on the maturity
of the contract, you can
decide whether you will
buy the asset or not that's
why you are holding the
right, not the obligation.
o Put option: gives the holder right
to sell an underlying asset at a
pre-specified price
 The person holding the short position
funds the gain/An investor holding a
short position in an option has an
obligation
o The short position of the

Options contract slide 7:
 From the perspective of the Buyer of call option:
o $0.76 indicates the option price per share and
because there are 1000 shares in one contract.
o To buy one call option contract, you will have to pay
the price for it and the price is $760.
o So that's the call premium and that's the cost of the
option that the buyer will have to incur.
 Why do we have options?
o Investors only exercise options when they will have a
positive invement from exercising it, e.g. when
exercise price is lower than the share price.
o However the up-front payment compensates (for
purchasing the option) the writer for the risk of loss
in the event that the option holder chooses to
exercise the option.
investor takes the opposite side
of the contract to the investor
who is long who reflects the
negative value of the long
position’s investors gains.
 The option seller (=option writer) sells
(or writes) the option and has a short
position in the contract. (they have a short
position because they only have to sell it
to the option buyer) Because the long side
has the option to exercise, the short side
has an obligation to fulfil the contract
 Therefore - the buyer of the call will have
the right to buy but seller of the call will
have the obligation to sell.
 And the buyer of the put, will have the
right to sell and the seller of the put will
have an obligation to buy.
These are two types of when an option can be
exercised:
 European options: options that can be
exercised only on the expiry date
 American options
o Options that can be exercised
anytime on or before the expiry
date
o Most common kind of option
Call Option – Payout Diagram:
 XYZ call options (the right to buy): X =
$14
 Let S = the share price on the call’s expiry
date
 If S ≤ $14, would you exercise the
option?
o NO
 When would you exercise the call option?
o When you exercise the option,
you will have the incentive to
exercise the option when actual
share price on the day of expiry is
greater than the exercise price
where S> X
o Then you have the privilege to
buy the asset at a lower price than
the market price.
 Your payoff for the buyer is when for
example your actual share price was $15
That means the payoff from exercising the
option is $15 minus $14 = $1 pay off.
 Your payoff for the seller you are taking
a loss of $1 so your payoff for the seller
would be -$1 in that case.
 So the seller will lose as much as the

Call Option – Profit Diagram:
 Incorporates the cost of the options:
 XYZ call options (the right to buy) :X=$14
 Profit diagram considers the cost of option
 Y variable becomes profit
 -$0.76 represents the cost premium you had to pay as the
option buyer, and therefore to go above breakeven (which is
$14.76), you have to sell the share price above $14.76
 $0.76 represents the cost premium you had received (as a
benefit) as the option seller. That premium that he received
will start to reduce.
 And when price goes above $14.76 that's when he will start
to make a pure loss.
buyer gains.
 Note that payoff diagrams do not include
the cost of the option, only the profit
diagram does.
Remember the payoff = gain or loss that you
obtain from exercising the option.
If the price of share is less than price of purchase
of option call, then your payoff = $0 as you can
choose not to exercise it because you would incur
a loss.
^ In the same circumstance, the option seller does
not have to do or owe anything because option
holder will not exercise his right to buy the share
Understanding the payoff diagram will be
important for the exam – e.g.
1# ignoring the cost of the option, once the price
goes above $42 that's when the buyer will start to
make a positive payoff.
What if the price is between zero and $42.
You have the option of not doing anything.
2# For the option seller - once the price goes
above $42 that's when the buyers will have an
incentive to exercise the option therefore buying
the assets at exercise price, you will have to sell at
exercise price.
When the price is higher than exercise price.
So that's where your loss is coming from.
Options contract (Put Option) (slide 14):
 Buyer of put option:
o On 28th of October 2018 the buyer of the put,
decided to buy one put option contract by paying
1000 shares times 46 cents.
o That gives us $460 put premium so that's the cost of
the put option, the buyer will have to incur if he
wants to enter into the contract.
o And the buyer has the right to sell, he's buying the
put option and that gives him the right to sell the
assets.
o Be aware of the direction there you are buying the
option, but that gives the buyer the right to sell the
asset
o So you have the right to sell 1000 XYZ shares at any
time between 28th of October and 23rd of December.
 Exercise right is dependent on European & US
 Seller of put option:
o The seller would receive the premium from the buyer
so he gains $460 to start with.
o which he can keep even though nothing happens.
o So if the buyer decides to exercise the option to sell
1000 XYZ shares, the seller has the obligation to buy
1000 shares at $14.50.
o The buyer has the right to sell and to fulfil his needs,
you have the obligation to purchase the shares from
the buyer of the put option of 1000 shares at $14.50
Put Option – Profit Diagram:
 XYZ put options (the right to sell) : X =$14.50
 Profit diagram considers the cost of option.
Put Option – Payoff Diagram:
 XYZ put options (the right to sell) : X
=$14.50
 Let S = the share price on the put’s expiry
date
 If S ≥ $14.5, would you exercise the
option? NO
o The answer would be no because,
when the actual price is greater
than exercise price, you are able
to sell the assets at a higher price
in actual market
 When would you exercise the put option?
When X>S
 That's why, when would you exercise the
put option, you have an incentive to
exercise the option when actual share
price in the market is less than the
exercise price.
 Because that's when your put option
becomes valuable because you have the
privilege to sell assets at a higher price
than the actual market price.
 The buyer of the put will gain once the
price falls below the exercise price
because that's when your privilege to sell
at a higher price becomes valuable.
 And for the seller will lose as much as the
buyer gains and once again when the
price falls below the exercise price of
$14.50, you have the obligation to buy.
 N.B. Payoff diagram does not include cost
of put option
Example 3 of Put options:
 When the actual price is lower than
exercise price that's when the put option
  For the buyer of the put option: becomes valuable for the buyer because
o You will have incurred the cost of the put option, you have the privilege to sell the shares at
which was 46 cents per share. a higher price than the market price, so in
o So your break even point break-even price will be this case, your payoff will be $2 per day,
$14.04, which is the exercise price minus. ignoring the cost of the option.
o The premium per share.  And if the share is trading at $18 in six
o So if the price is between $14.50 and $14.04, you months, what will be the payoff of the
will partially recover the cost of the put option and put,
once the price falls below $14.04 and it will fully o So when the actual price is
recover the cost of the option, and you will start to greater than the exercise price the
make a pure gain. buyer doesn't have any incentive
 For the seller of the put option: to exercise the option.
o No matter what the seller can keep the put premium
of 46 cents per share that he received at the
beginning of the contract.
o And the value will start to erode once the price falls
below $14.50
o And you will partially lose your premium when the
price sits between $14.04 and $14.50 and you will
fully lose your premium that you received once the
price reaches $14.04.


Example 4 – put options as a seller: To summarise:
 Assume that you have shorted the put option in example 3 if  Call option the buyer has the right to buy
the share is trading at $10 in six months, what will you owe the assets at a predetermined price and the
 So the exercise price was $12 and if the share is trading at seller of the call has the obligation to sell
$10 the buyer of the put will have incentive to exercise the the assets at a predetermined price.
put option, therefore.  And the buyer of the put has the right to
 As a seller, you will have the obligation to buy the share at an sell underlying assets at a predetermined
exercise price of $12 when it is trading at $10 so your payoff price and the seller of the put, has the
will be -$2. obligation to buy underlying assets at a
 And if the share is trading at $18 in six months time, the predetermined price.
buyer will do nothing, because the actual price is greater than
the exercise price, so no payoff for the seller as well.
o Payoff will be zero as the option holder will not
exercise the option and pay off diagram for the seller
of the put.
 The diagram is a mirror image of the buyer's diagram and
you will make a loss.
o You will incur negative pay off once the price goes
below the exercise price, ignoring the cost of the
option.
Futures & Forwards - what each contract does and how we figure out the gains and losses from each contract:
Future contract (another form of derivative instrument):
 A contract that obligates the holder to buy or sell an asset at
a certain time in the future for a predetermined price
 Consider the position of a farmer in June of a certain year
who will harvest a known amount of corn in September
o There is uncertainly about the price the farmer will
receive for the corn
 Consider next a company that has an ongoing requirement
for corn. The company is also exposed to price risk (Price
risk which arises from uncertain price movement in the
future)
 It can make sense for the farmer and the company to get
together in June and agree on a price for the farmer’s
production of corn in September.
o The contract providing a way to eliminate the risk it
faces because of the uncertain future price of corn
Forward contract:
 A forward contract is similar to a futures contract in that it is
an agreement to buy or sell an asset at a certain time in the
future for a certain price.
 Forward contracts trade in the over-the- counter market
whereas futures contracts are traded on exchanges.
 Forward contracts on foreign exchanges are very popular.
 Unlike forwards, options involve the payment of an up-front
fee
Forward Example 1 for the buyer (slide 28-29):
 As buyer you have to use the bid quote:
 Using the predetermined and actual prices to obtain the
difference in either loss or gain
 When the exchange rate is lower than the predetermined
exchange rate
 ImportCo buys £10million for $1.5585 per pound when the
exchange rate is $1.5 per pound. The loss is £10million
Future basics:
 Future price
o The delivery price currently
applicable to a futures contract.
The lock in price
 Spot price
o The price for immediate delivery.
The price that applies today
 An investor who agrees to buy takes a
long
 position.
 An investor who agrees to sell takes a
short position.
 Futures contracts are traded on exchanges.
Forward contract example slide 27:
 Bid quote and offer quote:
o Bid quote is the quote that
financial institutions will use
when they want to buy the pounds
here.
o Offer quote - offer quote is the
quote that financial institutions
will use if they want to sell the
pound.
o That means, if you want to buy
pounds, you will have to use offer
quote.
Forward Example 1 for the seller (slide 30-31):
 As a seller the foreign currency, you want
to be able to sell at a higher exchange rate
as possible right because you want to
receive as much value as possible from
the sale.
 So you were able to lock in the exchange
rate, which was higher than the actual
 *($1.5585-$1.5) = $585,000 exchange rate on September that's why, in
 Or when the exchange rate is higher than the predetermined this case, you would have made a gain.
exchange rate: o ExportCo sells £30million for
o ImportCo buys £10million for $1.5585 per pound $1.5579 per pound when the
when the exchange rate is $1.6 per pound. The gain exchange rate is $1.5 per pound.
is £10million *($1.6-$1.5585) = $415,000 The gain is £30million
*($1.5579-$1.5) = $1,737,000
 So when you were able to lock in the
exchange rate, which was lower than the
actual exchange rate:
o You were able to lock in the
exchange rate, which was higher
than the actual
A key aspect of hedging:
 Hedging reduces the risk but it is not necessarily the case that
the outcome with hedging will be better than the outcome
without hedging
 Hedging is a method of using forward and option contracts to
reduce its liability on making payments or making gains.
Explanation in textbook on p.g. 575