CFA CI Full Version Updated 0407

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READING 27: INTRODUCTION TO CORPORATE

GOVERNANCE AND OTHER ESG CONSIDERATIONS
Learning outcomes
27.a. Describe corporate governance
27.b. Describe a company’s stakeholder groups, and compare interests

of stakeholder groups
27.c. Describe principal–agent and other relationships in corporate

governance and the conflicts that may arise in these relationships
27.d. Describe stakeholder management
27.e. Describe mechanisms to manage stakeholder relationships and

mitigate associated risks
27.f. Describe functions and responsibilities of a company’s board of

directors and its committees
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Learning outcomes
27.g. Describe market and non-market factors that can affect

stakeholder relationships and corporate governance
27.h. Identify potential risks of poor corporate governance and

stakeholder management, and identify benefits from effective
corporate governance and stakeholder management
27.i. Describe factors relevant to the analysis of corporate governance

and stakeholder management
27.j. Describe environmental and social considerations in investment

analysis
27.k. Describe how environmental, social, and governance factors may

be used in investment analysis
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[LOS 27.a] Describe corporate governance
Definition: Corporate governance is a system of internal controls,

processes and procedures by which individual companies are managed,
directed and controlled.
Missions: Provides a framework that defines the right, roles and

responsibilities of various groups within an organization.
Goals: Minimize and manage the conflicting interests between insiders

and external share-owners.
Under shareholder theory Under stakeholder theory
• The primary focus is the interests • The focus of corporate

of the firm’s shareholders governance is broader.
→ maximize the market value of • Concern the conflict of interest
the firm’s common equity. among several groups that have
• Concern the conflict of interest an interest in the activities and
between the firm’s manager and performance of the firm:
its shareholders. shareholders, employees,
suppliers, customers…
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[LOS 27.b] Describe a company’s stakeholder groups, and
compare interests of stakeholder groups
1. Primary stakeholders of a corporation
Internal Connected External
• Board of derectors • Shareholder • Regulators

• Senior managers • Creditors
• Employees • Suppliers
• Customers
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1. Primary stakeholders of a corporation
External
Connected
Shareholders Creditors
Loans Interest
Appoint
Internal
Board of director Senior managers

Monitor
Committees Employees
Goods, Goods,
Cash services services Cash
Suppliers Customers
Taxes
Regulators
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2. Interests and influence of stakeholder groups
Stake Interest/Influence
• Have interest in compensation, bonuses

depending on the firm’s performance
• Have a responsibility to protect the
interests of shareholders
Board of Corporation’s
• Hire, fire and set the compensation of the
directors performance
firm senior managers
• Set the strategic direction of the firm
• Monitor financial performance and other
aspects of the firm’s ongoing activities
Have interests in continuing employment

Senior Corporation’s and maximizing the total value of
managers performance compensation tied on some measure of
firm’s performance
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Have an interest in rate of pay,

Employment opportunities for career advancement,
Employees income and training, and working conditions
safety → concern the sustainability and success
of the firm
• Have a residual interest in the net

assets of the corporation after all
liabilities have been settled → concern
Financial
Shareholders about ongoing profitability and growth
returns
of the firm
• Have voting rights → effective control
of the firm and its management
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• Receive interest and principal payments,

and have a primary goal of being repaid
Financial through the company’s ability to generate
strength cash flow → concern about stability, in
Creditors
and contrast to shareholders
solvency • Have little influence on the company, other
than covenants and restrictions they can
put in place as its banks or bondholders.
• Receive payments for their services and

materials.
Financial
• Have an interest preserving an ongoing
strength
Suppliers relationship with the firm, in the
and
profitability of their trade with the firm,
solvency
and in the growth and ongoing stability of
the firm → viewed alongside creditors
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Goods and Have an interest in a good value for the

services price and standards of safety → desire
Customers
ongoing support, product guarantees, and
after-sale service → concern about stability
Taxes earnd Have an interest in having corporations act

and GDP within the guidelines of the law on a
Regulators delivered consistent basis
→ protect the economy and the interests of
the general public.
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[LOS 27.c] Describe principal–agent and other relationships in
corporate governance and the conflicts that may arise in
these relationships
1. Principal – agent conflict
When a principal hires an agent to act on its behalf, a principal-agent

relationship is created:
Delegates authority/Hire
Principal Conflict of interest Agent
Act and make decisions
The principal-agent conflict arises because an agent is hired to act in the

interest of the principal, but an agent’s interests may not coincide
exactly with those of the principal.
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these relationships
Overview of conflicts of interest between groups of stakeholders
(6) External
Connected
Minority
shareholders
(6) (5)
(4) Creditors
Controlling
shareholders
(2) Internal
Board of director Senior managers
(3)
Committees Employees
(6)
Customers Suppliers
Regulators
Principal-agent conflict Nonprincipal-agent conflict

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these relationships
Conflicts of interest between Shareholders and
2.
Managers or Directors
Managers/
Shareholders Conflict of interest
Directors
Business risks Management Information asymmetry
• The interest of managers When the board is Managers and directors have
and directors is more influenced by more and better information
dependent on firm insiders about the functioning and
performance → managers favor strategic direction of the firm
→ prefer lower of business management than shareholders → manager
risk interests at the may make strategic decisions
• The interest of shareholders expense of that are not necessarily in the
holding diversified portfolios shareholders or best interest of shareholders
is less dependent on the favor one group of → weaken the ability of
firm shareholders at the shareholders to exercise
→ may choose higher expense of another control
business risk to get more
profits
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these relationships
3. Conflicts between manager and board of director
Board of
Manager Conflict of interest
director
• Conflicts between the board of directors and management can arise

when limited information is provided to the board
→ reduce the directors’ ability to perform their monitoring function.
• It is particularly pronounced for non-executive directors who are not
involved in day-to-day operations.
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these relationships
4. Conflicts between groups of shareholders
Controlling Minority
Conflict of interest
shareholders shareholders
Controlling shareholders under different voting structure
Straight voting structure

One vote for each share owned
→ controlling shareholders is the ones who have more shares of the firm
Multiple – class structure

One class is non-voting or has limited voting rights, and the other
(founders, insiders…) holding the superior voting power even though their
shares < 50% of the firm
→ controlling shareholders is the ones who have the superior voting
power, not the ones who have more shares.
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these relationships
4. Conflicts between groups of shareholders
Controlling Minority
shareholders shareholders
The controlling shareholders act against the interests of the minority

shareholders by the following actions:
Takeover transactions Related – party transactions

Controlling shareholders may be in a Controlling shareholder that arranges a deal
position to get better terms for between the company and a third-party
themselves relative to the terms forced supplier that is owned by the shareholder’s
on minority shareholders. spouse whereby the supplier provides the
company with inventory at above-market
prices
→ benefit the controlling shareholder and
the spouse’s interests
→ harm the profitability of the company
and the interests of minority shareholders
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these relationships
5. Conflicts between shareholders and creditors
Shareholders Conflict of interest Creditors
A divergence in risk tolerance regarding the company’s investments

between shareholders and creditors → the conflicts of interest:
• Shareholders would likely prefer riskier projects with a strong
likelihood of higher return potential
• Creditors would likely prefer stable performance and lower-risk
activities
If the distribution of excessive dividends to shareholders impairs the
company’s ability to pay interest and principal → conflict with creditors’
interests
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these relationships
6. Other stakeholder conflicts
Conflicts between
Customers and Customers and Shareholders and

shareholders suppliers regulators
Shareholders When the company Reduces the tax burden

want to reduce costs extends lenient on a company
and increase profits credit terms to → benefit the
→ reduce product customers shareholders but
safety → affect the ability of detrimental to the tax
→ conflict with the company to repay base of the government
customers’ interest as suppliers on time → conflict of interest.
customers want a safe → conflict with
product. suppliers’ interest
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[LOS 27.d] Describe stakeholder management
Stakeholder management involves identifying, prioritizing, and

understanding the interests of stakeholder groups, and, on that basis,
managing the company’s relationships with these groups.
Stakeholder management frameworks is built to reflect a legal,

contractual, organizational, and governmental infrastructure that
defines the rights, responsibilities, and powers of each group.
Legal Identify the laws relevant to and the legal recourse of

infrastructure stakeholders when their rights are violated.
Contractual Refer to the contracts between the company and its

infrastructure stakeholders that spell out the rights and responsibilities
of the company and the stakeholders.
Organizational Refer to a company’s corporate governance procedures,

infrastructure including its internal systems and practices that address
how it manages its stakeholder relationships.
Governmental Comprises the regulations to which companies are

infrastructure subject.
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[LOS 27.e] Describe mechanisms to manage stakeholder
relationships and mitigate associated risks
1. General meetings
Mechanism
a. General meetings
• Require board of director to address about the company’s performance and
other matters involved in.
• Enable shareholders to participate in discussions and to vote on major corporate
matters and transactions that are not delegated to the board of directors.
Managers/
Shareholders
Directors
• Elect the directors at the general meetings

• Approve the financial statements, discharge directors of their duties,
appoint external auditors.
• Exercise their voting rights (*) on important matters of the company
• Present shareholders with the annual audited financial statements of the

company.
• Provide an overview of the company’s performance and activities.
• Address shareholder questions.
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1. General meetings
(*)
Proxy voting Cumulative voting
When shareholders are unable to Shareholders have the ability to

attend a meeting → they can authorize accumulate and vote all their shares
their voting rights to another one for a single candidate in an election
→ proxy voting. involving more than one director.
b. Extraordinary general meetings may be called and could include

special resolutions that will require larger voting margins to pass,
typically including amendments to bylaws, mergers,...
Implications
• Shareholders can better monitor the company through a direct

exchange of information.
• Mitigating agency problems and their associated risks.
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2. Board of Directors
Mechanism
The board is accountable primarily to shareholders and is responsible for the

proper governance of the company; in this regard, the board is the link between
shareholders and managers.
Shareholders
Board of (1)
Manager
director
(1)
• Guide managers on the company’s strategic direction, oversee and monitor
management’s actions in implementing the strategy.
• Evaluate and rewards or disciplines management performance.
• Supervise the company’s audit, control, and risk management functions
Implications
• Ensure the proper governance of the company → act in the best value for the
shareholders.
• Mitigating agency problems and their associated risks.
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3. Audit function
Mechanism
• Provide assurances that financial statements are properly reported.

• Provides a service that evaluates the control environment within a
company:
o Reviews and analyses the various systems, controls, and
policies/procedures that are in place
→ Examine the operations and the manner in which financial
information is accumulated.
• External auditors are independent from the company and elected by
the shareholders (though recommended by the audit committee).
Implications
• Limits insiders’ discretion with regard to the use of company resources

and to its financial reporting.
• Mitigate incidents of fraud or misstatements of accounting and
financial information
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4. Reporting and Transparency
Mechanism
• Sources of information for shareholders include, but aren’t limited to,

required filings such as quarterly and yearly reporting, as well as
information from social media.
• Require disclosure of any potential or actual situations, whether
direct or indirect of the handling of related-party transactions
potential issues.
Implications
• Reduces information asymmetry for shareholders.

• Reduce issues related to transparency, risk, and management of
potential issues.
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5. Remuneration policies
Mechanism
• Design incentive plans for remuneration policies that discourage either

“short-termism”, including: granting shares, rather than options, to
managers and restricting their vesting or sale for several years or until
retirement.
• A long-term incentive plan delays the payment of remuneration, either
partially or in total, until company strategic objectives (typically
performance targets) are met.
• Adopt clawback provisions → recover previously paid remuneration if
certain events, such as financial restatements, misconduct, breach of
the law, or risk management deficiencies, are uncovered.
Implications
Mitigate the risk of short-termism: the most common potential issues

arise when executives act in the short term to increase their own pay or
take on excessive risk rather than the interest of shareholders
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6. Say on Pay
Mechanism
Say on pay is a concept that helps to decrease potential conflicts with

shareholders by gaining their insights on the company’s remuneration
policy.
Give insights on the company’s

remuneration policy Managers/
Shareholders
Directors
Have actions (*) upon the shareholders’
feedback on renumeration policy
Implications
Limit the discretion of directors and managers in granting themselves

excessive or inadequate remuneration → reduce a critical agency conflict
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6. Say on Pay
(*)
• Nonmandatory and nonbinding say on pay systems (e.g., Canada):
the board is required to ask for feedback, rather than their imposition
on renumeration policies and is not required to act upon it.
• Mandatory and nonbinding system: the board is required to enable
shareholders to vote on remuneration plans, but the board does not
have to abide by the result of the vote.
• Mandatory and binding system: the board is required to enable
shareholders to vote on remuneration plans, but the board has to
abide by the result of the vote.
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7. Contractual agreements with creditors
Mechanism
Indenture A legal contract that describes the structure of a bond, the

obligations of the issuer, and the rights of the bondholders.
Covenants Are the terms and conditions of lending agreements within

the indenture, specify the actions an issuer is obligated to
perform (Affirmative covenants) or prohibited from
performing (Restrictive covenants). (Explained in Reading 24)
Collaterals Are another way to further increase the likelihood of

repayment through the offering of assets or financial
guarantees.
Implications
Protect their rights of creditors

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8. Employee Laws and Contracts
Mechanism
• Labor law: The framework that outlines employee rights such as working hours,
hiring and firing, pensions, and other employee benefits.
• Employment contracts: for the individual and outline the employee’s rights and
responsibilities; they are not all-encompassing, leaving some discretion within
the relationship.
• Other items such as the code of ethics and human resources documents are
intended to outline the relationship in order to manage and mitigate any legal
or reputational risks.
Implications
Employers and employees can determine clearly about their rights and
responsibilities:
• A company seeks to comply with employees’ rights and mitigate legal or
reputational risks in violation of these rights
• Ensure that employees are fulfilling their responsibilities toward the company
and are qualified and motivated to act in the company’s best interests
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8.
9. Employee Laws
Contractual and Contracts
agreements with customers and suppliers
Mechanism
Customers and suppliers have contractual agreements that:

• Specify the products and services underlying the relationship, the
prices or fees and the payment terms, the rights and responsibilities of
each party, the after-sale relationship, and any guarantees.
• Specify actions to be taken and recourse available if either party
breaches the terms of the contract
Implications
• Mitigate legal risks and reputational risks in violation of these rights

and responsibilities
• Ensure the customers and suppliers to comply with their
responsibilities toward the company
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10. Laws and Regulations
Mechanism
The government and regulators seek to protect the public through

developing laws and monitoring compliance. Regulations vary by
industry and increase with the level of risk that the public is exposed to.
Implications
Companies normally seek to adopt internal governance and compliance

procedures and adhere to the relevant financial reporting and
transparency requirements imposed by regulators
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[LOS 27.f] Describe functions and responsibilities of a
company’s board of directors (BOD) and its committees
1. Board structures
(1) There is a single board of directors that includes both internal and
external directors.
• Internal (executive) directors: senior managers employed by the
firm.
• External (non-executive) directors: are not company managers,
provide objective decision making, monitoring, and performance
One-tier
assessment.
board
• Independent directors: are non-executive directors who have no
other relationship with the firm regard to employment, ownership
or remuneration.
(2) Lead independent director has the ability to call meetings of the
independent directors, separate from meetings of the full board.
(3) The general practice is for all board member elections to be held at
the same meeting and each election to be for multiple years
(1) There is a supervisory board that typically excludes executive

directors.
Two-tier • The supervisory board and the management board (made up of
board executive directors) operate independently.
(2) The general practice is for all board member elections to be held at
the same meeting and each election to be for multiple years
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1. Board structures
Two-tier board
One-tier board
Board of director
Non-executive Direct supervision Executive

directors directors
Report for
monitoring Supervision
purpose
Supervisory board/commitee
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1. Board structures
(1) Elections for some board positions are held each year
(2) Board of directors are typically divided into three classes
that are elected separately in consecutive years - one class
every year:
• Negative aspect: need several years to replace a full board
Staggered
→ limit the ability of shareholders to replace board
board
members in any one year → limits their ability to effect a
major change of control at the company.
• Positive aspect: provides continuous implementation of
strategy and oversight without constantly being reassessed
by new board members thereby bringing short-termism into
company strategy.
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2. Functions and responsibilities of a board
Duty of the board member is to act in the interest of the company and
shareholders → prevent individual board members from acting in their
own interest, or the interest of another individual or group, at the
expense of the company and all shareholders
BOD’s role in the company’s management
• Manage the company through managers, who are given the

responsibility for the day-to-day operations of the company.
• Establish milestones for the company based on the strategic direction it
oversees.
• In monitoring progress, the board will select, appoint, and terminate
the employment of senior management.
→ They thereby play a key role in ensuring leadership continuity.
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2. Functions and responsibilities of a board
BOD’s role in the company’s internal control and audit system
• Set the overall structure of these systems and oversee their

implementation, including oversight of the financial reporting practices
and review of the financial statements for fairness and accuracy.
• Oversee reports by internal audit, the audit committee, and the external
auditors and proposes and follows up on remedial actions.
• Ensure that the company adopts and implements proper corporate
governance principles and complies with all applicable internal and
external laws and regulations, including ethical standards.
BOD’s role in the company’s risk management system
• Regular receive reviews and reports from both management and the
company’s risk function
• Review any proposals for corporate transactions or changes, such as
major capital acquisitions, divestures, mergers, and acquisitions, before
they are referred to shareholders for approval, if applicable.
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3. Responsibilities of board committees
Strategy
Internal control
Board of director Management
Risk management
Support
Audit committee
Governance committee
Nominations committee
Remuneration committee
Risk committee
Investment committee
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company’s board of directors and its committees
Audit committee
• Oversight of the financial reporting function and implementation of

accounting policies
• Effectiveness of the company’s internal controls and the internal audit
function
• Recommending an external auditor and its compensation
• Proposing remedies based on their review of internal and external
audits.
Governance committee
• Oversight of the company’s corporate governance code.

• Implementing the company’s code of ethics and policies regarding
conflicts of interest
• Monitoring changes in relevant laws and regulations
• Ensuring that the company is in compliance with all applicable laws and
regulations, as well as with the company’s governance policies.
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Nominations committee
• Proposes qualified candidates for election to the board

• Manage the search process and attempt to align the board’s
composition with the company’s corporate governance policies
Remuneration committee
• Recommend to the board the amounts and types of compensation to be

paid to directors and senior managers
• Oversight of employee benefit plans and evaluation of senior managers
Risk committee
• Informs the board about appropriate risk policy and risk tolerance of the
organization
• Oversees the enterprise-wide risk management processes of the
organization.
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Investment committee
Reviews and reports to the board on management proposals for large

acquisitions or projects, sale or other disposal of company assets or
segments, and the performance of acquired assets and other large capital
expenditures.
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[LOS 27.g] Describe market and non-market factors that can
affect stakeholder relationships and corporate governance
1. Market factors
Shareholder engagement
The engagement of companies with shareholders—called shareholder engagement

— has traditionally involved certain events, such as the annual shareholder meeting
and analyst calls, the scope of which was limited to financial and strategic matters.
The additional transparency and information sharing tend to increase management

support → reduce the potential for efforts by shareholders to more actively pursue
other means to influence outcomes such as short-term activist investors, countering
negative recommendations from proxy advisory firms.
Shareholder Activism
Shareholder activism refers to strategies used by shareholders to attempt to compel

a company to act in a desired manner to increase shareholder value:
• Initiate shareholder lawsuits or seek to compel the company to act in particular
manner.
• Propose shareholder resolutions for a vote and raising their issues to all
shareholders or the public to gain wider support.
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1. Market factors
Competition and Takeover
• If the company is underperforming a competitor → senior managers

may lose their positions and directors can be voted out by shareholders.
• Proxy contest, tender offer and hostile takeover can be pursued to
replace the directors from board of directors or fire senior managers
→ effect on the board structure → effect on corporate governance
Proxy shareholders are persuaded to vote for a group

contest seeking to take positions that will control the company’s
(proxy fight) board of directors.
an activist group that attempts to persuade shareholders to

Tender offer
sell their shares to the group seeking to gain control.
Hostile results when an entity acquires a company without the

takeover consent of company management.
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2. Non-market factors
The legal environment
The legal environment varies around the world and offers different
protections to the shareholder or creditor:
• Common-law system: judges’ rulings become law in some instances
→ shareholders’ and creditors’ interests are considered to be better
protected
• Civil law system: judges are bound to rule based only on specifically
enacted laws → the rights of creditors are more clearly defined
→ creditors generally have a better protected position
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Media
• The media have played an important role in bringing attention to

various topics and its ability to spread information quickly and shape
public opinion to raise the awareness of stakeholders over the years.
• Negative media attention can adversely affect the reputation or public
perception of a company → reputational risk to the company
• Shareholders use social media to protect interests or enhance their

influence on corporate matters
• Companies has an advantage in distributing information thanks to
relationships with traditional media organizations.
• Cost less for shareholders to get more information and are thus better
able to compete with company management in influencing public
sentiment
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The Corporate governance industry
The demand for external corporate governance services increases

→ an industry that provides corporate governance services, including
governance ratings and proxy advice, has developed.
These external corporate governance services have considerable influence

on corporate governance practices
→ corporations are generally compelled to pay attention to ratings and
recommendations produced by the corporate governance industry.
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[LOS 27.h] Identify potential risks of poor corporate
governance and stakeholder management, and identify
benefits from effective corporate governance and stakeholder
management
Risks of poor corporate governance and stakeholder
1.
management
Weak control systems
Corporate governance is weak → the control functions of audits and board

oversight may be weak as well → accounting fraud, or simply poor
recordkeeping → lack of confidence in financial information, an inability to
obtain financing or producing poor information internally
→ negative implications for company performance and value
Ineffective decision making
Corporate governance is weak → information asymmetry → ineffective

decision making:
• Management may have incentive compensation that causes them to
pursue their own benefit rather than the company’s benefit.
For example: related-party transactions that benefit their friends/family
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management
Risks of poor corporate governance and stakeholder
1.
management
Legal, regulatory, and reputational risk
Corporate governance is weak → various legal, regulatory, and

reputational risks:
• Violating stakeholder rights can lead to stakeholder lawsuits
• Company’s reputation can be damaged by failure to comply with
governmental regulations.
Default and bankruptcy risks
Corporate governance is weak and failure to manage creditors’ rights

→ poor decision making from management → affect the company’s
financial position → debt default and bankruptcy.
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management
Benefits from effective corporate governance and
2.
stakeholder management
Operational efficiency
A good governance structure balanced with adequate internal control

mechanisms → ensure that corporate decisions and activities are properly
monitored and controlled to mitigate risk → improve the operational
efficiency of the company
Improved control
• Effective control → identify and manage risk at early stages

• Adopt procedures for monitoring compliance with internal policies and
external regulations and for reporting any violations → better mitigate
regulatory or legal risks and their associated costs.
• Adopt procedures with regard to conflicts of interest and related-party
transactions → ensure fairness in its relationships with those parties.
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management
Benefits from effective corporate governance and
2.
stakeholder management
Better operating and financial performance
• Good governance and stakeholder management → improve its

operating performance and reduce the costs associated with weak
control systems.
• Good governance → improve its decision-making process and respond
faster to market factors → increase corporate value.
Lower default risk and cost of debt
• Good corporate governance → manage conflicts of interest with

creditors protect creditor rights → reduce a company’s cost of debt and
default risk
• Proper functioning of audit systems, improved transparency and the
control of information asymmetries → mitigate default risk
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[LOS 27.i] Describe factors relevant to the analysis of
1. Company ownership and Voting structure
Straight voting structure: one vote per share → any shareholder’s voting
power is equal to the percentage of the company’s outstanding shares
owned by that shareholder.
Dual class structure: common shares may be divided into two classes, one
of which has superior voting rights to the other.
There are two mechanism in dual class structure:
• A share class carries one vote per
Each share has equal voting rights, but:
share and is publicly traded
• One share class (held by insiders)
• Another share class (held exclusively
elects a majority of the board
by company insiders or family
• Another share class would be entitled
members) carries several votes per
to elect only a minority of the board
share
For example: Alibaba
For example: Facebook
The founders/insiders can still control The insiders retain substantial power
board elections and all other major over the affairs of the corporation
voting matters even when their because they control a majority of the
ownership level < 50%. board.
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1. Company ownership and Voting structure
Considerations and Implications
If a company has a dual class voting structure:

• Negative effects: Economic ownership becomes separated from voting
control → investors can face significant potential risks of interest conflict
with management
• Positive effects: promote company stability and enable management to
make long-term strategic investments, insulated from the short-term
pressures of outside investors.
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2. Board of Directors representation
Analysts may want to consider carefully the make-up of a company’s

board of directors to determine whether the experience and skill sets on
the board match the current and future needs of the company.

Important considerations are whether directors:
(1) Are executive, non-executive, or independent directors?
(2) Are involved in related-party transactions with the company?
If the board has multiple directors engaging in related-party transactions
→ investors may have cause for concern about any conflicts of interest
that arise.
(3) Have the diversity of expertise that suits the company’s current
strategy and challenges?
If the board composition is dominated by such long-tenured members
→ negative effect on the board’s diversity and adaptability.
(4) Have served for many years and may have become too close to the
company’s management?
Directors with long tenure clearly offer valuable experience and
expertise
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3. Management incentives and remuneration
Remuneration is one way to incentivize management to act in the long-

term interests of the company.
Various warning signs could present themselves, including:

• The lack of equity incentives to align with shareholders
→ a misalignment of incentives between executives and investors
unless management already owns a significant stake in the company
• Little variation in results over multiple years due to inadequate hurdles
If an award is described as performance-based but still pays in full every
year regardless of the company’s results
→ investors may have concerns about the rigor of the performance
hurdles underlying the awards.
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3. Management incentives and remuneration
• Excessive payouts relative to comparable companies with comparable

results
→ Investors may want to understand the cause of the anomaly and
whether it is a temporary issue or a result of flawed remuneration plan
design.
• Strategic implications of incentives that may not be appropriate
→ the milestones driving the incentive plan align do not comply with
the company’s objectives.
• Plans that have not changed with the company’s life cycle change
The company communicates to the investor community a more returns-
oriented strategy when the company’s business has matured, but the
financial incentives in remuneration plan may still be based purely on
revenue growth → misalignment of interests
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4. Composition of shareholders
Understanding the investor composition gives insights into control and

directionality of decisions:
• If there is a concentrated holding that controls voting → can dictate
how the company is run for the immediate future, and potentially
longer.
• If the shareholder group has a significant number of experienced
activists → lean toward a short-term-oriented investor mentality, which
can create substantial turnover in a very short period of time.
55

5. Relative strength of shareholders’ rights
The strength of shareholders’ rights is another aspect to consider. The framework of

the rights will help determine whether:
(1) Could be structural obstacles to certain transactions in the company’s charter or
bylaws?
Some transactions may not be undertaken due to bylaws restraints
(2) Can shareholders remove board members or convene special stockholder
meetings?
If shareholders can not to remove directors from the board or to convene special
stockholder meetings → be difficult for external initiatives to be successful.
6. Management of long-term risks
Analysts should be concerned if a company does not manage the risks of

stakeholder conflicts well over time:
A failure to manage stakeholder issues well or to manage other long-term risks to
the company’s sustainability → disastrous consequences for shareholders and other
stakeholders
56

[LOS 27.j] Describe environmental and social considerations
in investment analysis
The use of environmental, social, and governance factors in making

investment decisions is referred to as ESG investing.
Example of ESG factors
Environmental Issues Social Issues Governance Issues
• Climate change and • Customer satisfaction • Board composition

carbon emissions & product (independence &
• Air and water responsibility diversity)
pollution • Data security and • Audit committee
• Biodiversity privacy structure
• Deforestation • Gender and diversity • Bribery and
• Energy efficiency • Occupational health corruption
• Waste management & safety • Executive
• Water scarcity • Treatment of workers compensation
• Community relations • Shareholder rights
& charitable activities • Lobbying & political
• Human rights contributions
• Labor standards • Whistleblower
schemes
57

[LOS 27.j] Describe environmental and social considerations
in investment analysis
ESG investment strategies
Sustainable investing
A term used in a similar context to responsible investing, but its key focus is on
factoring in sustainability issues while investing.
Responsible investing
The broadest term used to describe investment strategies that incorporate
environmental, social, and governance (ESG) factors into their approaches.
Socially responsible
ESG investing Impact investing
investing (SRI)
Refer to the exclusion

Use material ESG
of investments in Refer to investment
factors in investment
companies whose that meet an
analysis, which has a
products are contrary investor’s specific
potential impact on
to the ethical and social and
the firm’s ability to
moral values of an environmental goals
generate sustainable
investor, such as with identifiable
returns in the long
weapons and tobacco financial returns.
term.
in investment process.
58

[LOS 27.k] Describe how environmental, social, and
governance factors may be used in investment analysis
Some approaches to integrating ESG factors into the portfolio
management process
Refers to excluding specific companies or industries from

consideration for the portfolio based on their practices
Negative
regarding human rights, environmental concerns or
screening
corruption.
approach
For example: exclude mining, oil extraction and transport,
and tobacco firms/industries.
Excluded companies
x x x
59

management process
Positive Refers to including specific companies or industries that

screening have positive ESG practices.
approach
Identify companies within each industry group with the

Relative/best-
best ESG practices → preserve the index sector weightings
in-class
in the portfolio while still taking advantage of
approach
opportunities to profit from positive ESG practice
Included companies under Included companies under

Positive screening Best-in-class approach
60

management process
Refers to the inclusion of ESG factors or ESG scores in

traditional fundamental analysis.
ESG
For example: a company’s ESG practices are considered as
integration
fundamental variables such as cost of capital, future cash
flow,…
Refers to investing in sectors or companies in an attempt

to promote specific ESG-related goals
Thematic For example: more sustainable practices in agriculture,
investing greater use of cleaner energy sources, improved
management of water resources, or the reduction of
carbon emissions.
Engagement/ Refers to using ownership of company shares or other

active securities as a platform to promote improved ESG practices
ownership → promote reduction in a company’s carbon footprint,
investing increased wages, or other social and environmental goals…
61

management process
• Refers to producing economic growth in a more

sustainable way by reducing emissions and better
Green finance managing natural resource use.
• Green bonds: the funds raised are used for projects with
a positive environmental impact.
Are used by fund and portfolio managers to manage the

ESG characteristics of their overall portfolios.
Overlay/
For example: a fund manager may seek to reduce the
portfolio tilt
environmental pollution or carbon footprint of their
portfolio stocks as a whole.
Risk factor/ Refers to the treatment of ESG factors as an additional

risk premium source of systemic factor risk, along with such traditional
investing risk factors as firm size and momentum.
62
READING 28: USES OF CAPITAL
Learning outcomes
28.a. Describe the capital allocation process and basic

principles of capital allocation
28.b. Demonstrate the use of net present value (NPV) and internal rate
of return (IRR) in allocating capital and describe the advantages
and disadvantages of each method.
28.c. Describe expected relations among a company’s investments,

company value, and share price.
28.d. Describe types of real options relevant to capital investment.
28.e. Describe common capital allocation pitfalls

63

[LOS 28.a] Describe the capital allocation process and basic
principles of capital allocation.
1. Capital allocation process
Definition
The capital allocation process is identifying and evaluating capital projects,
that is, projects where the cash flows to the firm will be received over a
period longer than a year.
The steps typically involved in the capital budgeting process are as follows:
Step 1: Idea Generation
Step 2: Investment Analysis
Step 3: Capital Allocation Planning
Step 4: Monitoring and Post-Audit

64

Step 1: Idea Generation
The generation of investment ideas can originate from anywhere within

the organization or from outside the company.
Having good investment ideas for management consideration is the

most important step in the capital allocation process.
Step 2: Investment Analysis
The collection of information needed to forecast the timing, duration,

and volatility of each investment’s expected cash flows and to evaluate
the investment’s profitability.
65

Step 3: Capital Allocation Planning
The organization of the profitable proposals that together best fit the
company’s strategy. Financial and real resource constraints mean the
scheduling and prioritizing of capital investments are key considerations.
Project 1 18%
36% Project 3
18%
Project 2
28% Project 4
Like other business activities, the capital allocation activity is a cost–

benefit exercise for the company.
Benefits from the improved

decision making > Costs of the capital
allocation efforts
66

Step 4: Monitoring and Post-Audit
It is important to follow up on all capital allocation decisions

Monitoring
An analyst should compare the actual results to the projected results,
and project managers should explain why projections did or did not
match actual performance.
Post-audit
Because the capital allocation process is only as good as the estimates

of the inputs into the model used to forecast cash.
A post-audit should be used to identify systematic errors in the

forecasting process and improve company operations.
67

Conclusion
Planning for capital investments can be very complex, often involving

many persons inside and outside the company. Information across
multiple disciplines such as marketing, technology, engineering,
regulation, taxation, finance, production, and behavioral issues must
be systematically gathered and evaluated by the company.
Management’s authority to make capital decisions depends on the size

and complexity of the investment in question
Make larger and complex decisions, some are so

Top
significant that the company’s board of directors
management
ultimately has the decision-making authority.
Make decisions that involve less than a given

Lower-level
amount of money or that do not exceed a given
managers
capital allocation
68

2. Basic categories of capital allocation projects
Investment projects
Investment projects may be sub-divided
into:
• Replacement projects to maintain the
business;
• Replacement projects for cost
reduction
Example:
• Replacing existing equipment with newer
c. New technology
Products • The decision whether to replace a piece
and Services
of equipment becomes obsolete
Replacement projects to maintain the business: The only issues

Without detailed
are whether the existing operations should continue and whether
analysis
existing procedures or processes should be maintained.
Replacement projects for cost reduction: determine whether With a fairly

equipment that is obsolete, but still usable, should be replaced. detailed analysis
69

Expansion projects
Investment projects that expand
business size and often involve greater
uncertainty and management
consideration than replacement
projects.
c. New Example:
Products Vietcombank opens a representative office
and Services in New York (2019).
70

New Products and Services

New products or services development
also entails a complex decision-making
process that will require a detailed
analysis due to the large amount of
uncertainty involved.
Example:
c. New TH true milk introduces “TH true juice”
Products and product line.
Services
71

Regulatory, Safety, and Environmental

Projects
These projects are sometimes made
mandatory by a governmental agency or
some external party. The company will
accept the required investment and
continue to operate.
c. New
Products and Occasionally, however, the cost of such
Services projects is sufficiently high that the
company would be better off to cease
operating altogether or to shut down
any part of the business that is related to
the project.
Example: Due to new standards in wastewater treatment brought out by the

government, the company has to build new nastewater collection and treatment
system.
72

Others
Some projects are not easily analyzed
through the capital allocation process.
Such projects may include a pet project

of senior management or a high-risk
endeavor that is difficult to analyze with
typical capital allocation assessment
c. New methods.
Products You can read more about pet project
and Services
here.
Example: A senior manager of a architecture firm wants the most qualified designers
to involve in a smart greenhouse project just because he is interested in gardening.
73

3. Some important capital budgeting concepts
Sunk cost
A sunk cost is one that has already been incurred. One cannot change a sunk
cost. Decisions made today, however, should be based on current and future
cash flows and should not be affected by prior, or sunk, costs.
Opportunity cost
An opportunity cost is the value of the next best alternative that is foregone in
making the decision to pursue a particular Project.
For example, if we invest $1 million in a piece of equipment, the opportunity cost
of investing in that piece of equipment is the amount that $1 million would have
earned in its next-most-profitable use. Opportunity costs should be included in
project costs.
Incremental cash flow
An incremental cash flow is the cash flow that is realized because of an

investment decision: the cash flow with a decision minus the cash flow without
that decision.
74

Externality
An externality is the effect of an investment on things other than the
investment itself.
An investment affects the cash flows of other parts of the company, and these
externalities can be positive or negative.
A positive externality occurring within The primary one is a negative

the company would be expected externality called cannibalization
synergies with existing projects or
business activities that result from
making the investment. Cannibalization
Note: Cannibalization occurs when an

• Companies should consider investment takes customers and
externalities in the investment sales away from another part of the
decision. company.
• Sometimes externalities occur
outside the company.
75

Conventional cash flows versus nonconventional cash flows
A conventional cash flow pattern is one with an initial outflow followed by a

series of inflows.
A project has a conventional cash flow pattern if the sign on the cash flows
changes only once, with one or more cash outflows followed by only cash
inflows.
Cash inflows
0 1 …
2 3 4 Cash outflows
Initial outlays Cash flows change signs once

76

Conventional cash flows versus nonconventional cash flows
In a non-conventional cash flow pattern, the initial outflow is not followed

by inflows only, but the cash flows can flip from being positive (inflows) to
negative (outflows) again or possibly change signs several times.
An unconventional cash flow pattern has more than one sign change.
Cash inflows
0 1 3 …
2 4 Cash outflows
Cash flows change signs

Initial outlays several times
77

4. Principles of Capital Allocation
• Decisions are based on cash flows, not accounting income

The relevant cash lows to consider as part of the capital allocation process
are incremental cash flows, the changes in cash flows that will occur if the
project is undertaken.
• Cash flows are based on opportunity costs

Key assumptions
Opportunity costs are cash flows that a firm will lose by undertaking the
project under analysis. These are cash flows generated by an asset the firm
already owns that would be forgone if the project under consideration is
undertaken.
→ Opportunity costs should be included in project costs.
• Cash flows are analyzed on an after-tax basis
The impact of taxes must be considered when analyzing all capital

allocation projects.
78

4. Principles of Capital Allocation
• Timing of cash flows is crucial

Capital allocation decisions account for the time value of money, which
means that cash flows received earlier are worth more than cash flows to
be received later.
This is true because the money that you have right now can be invested
and earn a return, thus creating a larger amount of money in the future.
Key assumptions
The time value of money occurs for three reasons:

o Potential for earning interest/cost of finance;
o Impact of inflation;
o Effect of risk.
• Financing costs are ignored

Financing costs are reflected in the required rate of return and thus
ignored in cash flows to avoid double-counting.
Only projects that are expected to return more than the cost of the capital
needed to fund them will increase the value of the firm.
ROIC > COC (cost of capital) (refer to LOS28.c.1)
79

5. Project interactions
Independent projects versus mutually exclusive projects
Independent projects are capital investments whose cash flows are independent
of each other.
Example:
If projects A and B are independent, and both projects are profitable, the firm
could accept both project.
Mutually exclusive projects compete directly with each other. Multiple projects
are mutually exclusive if only one of them can be accepted so that profitability
must be evaluated a among the projects.
Example:
If Projects A and B are mutually exclusive, either Project A or Project B can be
accepted, but not both. Making a capital allocation decision to select one of two
different stamping machines, each with different costs and outputs, is an example
of ranking two mutually exclusive projects.
80

Project sequencing
Many capital projects are sequenced over time, so that investing in a project
creates the option to invest in future projects
Example:
The company might invest in a project today and one year later invest in a second
project:
• If the financial results of the first project or new economic conditions are
favorable, the company would undertake the second project.
• If the results of the first project or new economic conditions are not favorable,
the company would not invest in the second project.
0 t=1
Yes
Invest in project 2
Favorable
Invest in Project 1
result?
Not invest in project 2
No
81

Unlimited funds versus capital rationing
An unlimited funds environment Capital rationing exists when the

assumes that the company can raise company has a fixed amount of funds
the funds it wants for all profitable to invest.
projects simply by paying the required
rate of return.
Explanation:
If a firm’s profitable project
opportunities exceed the amount of
funds available, the firm must ration,
or prioritize, its capital expenditures
with the goal of achieving the
maximum increase in value for
shareholders, given its available
capital.
82

[LOS 28.b] demonstrate the use of net present value (NPV)
and internal rate of return (IRR) in allocating capital and
describe the advantages and disadvantages of each method.
1. Net present value (NPV)
Net present value (NPV) is the sum of the present values of all the expected
incremental cash flows if a project is undertaken.
n
CF1 CF2 CF3 CFn CFt
NPV = CF0 + + + +…+ = ෍
(1+k)1 (1+k)2 (1+k)3 1+k n (1+k)t
t=0
Where:
▪ CF0 = initial investment outlay (a negative cash flow),
▪ CFt = after-tax cash flow at time t ( can be positive and negative),
▪ k = required rate of return for project.
83

Decision rule:
Because the NPV is the amount by which the company’s wealth increases as a
result of the investment, the decision rule for the NPV is as follows:
If NPV > 0 → Invest

Positive-NPV investments are wealth increasing for the company and its
shareholders,
if NPV < 0 → Do not invest
Negative-NPV investments are wealth decreasing for the company and its
shareholders.
Note: In the rare case that NPV turns out to be zero, the project could be
accepted because it meets the required rate of return.
84

Example: Assume that Gerhardt Corporation is considering a capital investment

of €500 million that will return after-tax cash flows of each year as follows:
Year 1: €100 mil; Year 2: €170 mil; Year 3: €230 mil; Year 4: €260 mil.
The company’s required rate of return is 10%.
Required: calculate NPV of this investment project.

Solution:
230 260
170
100 Cash inflows
0
1 2 3 4 Cash outflows
The NPV would be:

500
100 170 230 260
NPV = −500 + + + + = €81.7
1.101 1.102 1.103 1.104
85

1. Net present value (NPV) - using financial calculator
Use this function to enter the cashflows at each

period
What would be shown on the screen:

CF0 : Enter the cashflow at t=0
C01 : Enter the cashflow at t=1
F01 : Enter the frequency of C01 , for example, if
the cashflow C01 also appears at t=2, we can
say C01 appear twice and we enter F01 =2
…
C0n : Enter the cashflow at t=n
F0n : Enter the frequency of C0n
Press CPT & NPV to calculate the the present

value of cash flows

I: Enter the discount rate.
86

Example: Back to the example calculating the present value

Step 1: Entering the cashflows
Keystrokes Display Input value
CF0 -500
C01 100
F01 1
C02 170
F02 1
C03 230
F03 1
C04 260
F04 1
87

Example: Back to the example calculating the present value of an uneven cashflow
Step 2: Enter the discount rate and calculate the cashflow
• Press
• The screen displays “ I=“
• Enter the discount rate 10
• Press to show the result: NPV = 81.7909

88

2. Internal Rate of Return (IRR)
Internal rate of return (IRR) is the discount rate that makes the present
value of the expected incremental after-tax cash inflows just equal to the
present value of the project’s estimated cash outflows.
PV (inflows) = PV (outflows)
Alternatively, the IRR is also the discount rate for which the NPV of a project is
equal to zero: n
CF1 CF2 CF3 CFn CFt
NPV = 0 = CF0 + + + +…+ = ෍
(1+k)1 (1+k)2 (1+k)3 1+k n (1+k)t
t=0
NPV
Discount rate
0
IRR NPV graph

89

Decision rule:
if IRR > the required rate of return* → Invest

if IRR < the required rate of return* → Do not invest
if IRR = the required rate of return* → the project is theoretically acceptable
because it meets the required return.
*The required rate of return for a given project is usually the firm’s cost of capital.
→ The required rate of return is often called the hurdle rate, the rate that a
project’s IRR must exceed for the project to be accepted by the company.
Note: the required rate of return may be higher or lower than the firm’s cost of
capital to adjust for differences between the project’s risk and the average risk of
all of the firm’s projects (which is reflected in the firm’s current cost of capital).
Required rate
of return
Firm’s cost of capital
Projects with higher than avg. risk
Projects with lower than avg. risk
90

Example: Back to the example for NPV.

In the Gerhardt Corporation example, we want to find a discount rate that makes
the total present value of all cash flows, the NPV, equal zero.
In equation form, the IRR is the discount rate that solves the following equation:
100 170 230 260
−500 + + + + =0
(1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)4
Comment: Algebraically, this equation would be difficult to solve. Without the use
of a financial calculator, we would have to resort to trial and error, systematically
choosing various discount rates until we find one, the IRR, that satisfies the
equation. This process can be long and tedious.
The next slides will show how to use financial calculator to compute IRR.
91

2. Internal Rate of Return (IRR) – using financial calculator
Use this function to enter the cashflows at each

period

CF0 : Enter the cashflow at t=0
C01 : Enter the cashflow at t=1
F01 : Enter the frequency of C01 , for example, if
the cashflow C01 also appears at t=2, we can
say C01 appear twice and we enter F01 =2
…
C0n : Enter the cashflow at t=n
F0n : Enter the frequency of C0n
Press CPT & IRR to calculate the the present

value of cash flows

I: Enter the discount rate.
92

Step 1: Entering the cashflows
Action Display Input value
CF0 -500
C01 100
F01 1
C02 170
F02 1
C03 230
F03 1
C04 260
F04 1
93

Step 2: Enter the discount rate and calculate the cashflow
• Press
• Press to show the result: IRR = 16.300%

94

3. Using NPV and IRR to rank projects
a. NPV and IRR Applied to Independent Projects
NPV and IRR criteria will usually indicate the same investment decision for a given
capital investment (Acceptance or rejection of the investment).
Example:
If Project A and Project B were independent projects and the cost of capital were
7%, the company would accept both projects, as they both have positive NPVs
and their IRRs exceed the cost of capital (7%).
95

b. NPV and IRR Applied to Mutually Exclusive Projects
If the projects are mutually exclusive, NPV criterion is strongly preferred
▪ The NPV shows the amount of gain, or wealth increase in company value,
as a currency amount.
▪ The NPV assumes reinvestment of cash flows at the required rate of
return, while the IRR assumes reinvestment at the IRR. The reinvestment
assumption of the NPV is the more economically realistic measure.
▪ Another issue is that when the cash flows are nonconventional (i.e., they
change sign more than once), there are multiple IRRs.*
(*) This is one of IRR problems that will be mentioned in the next slide
If NPV is always preferred over IRR for selecting projects, why do companies
even bother with IRRs?
Answer: The reason is that many people find it easy to understand a rate of return.
96

c. Problems with IRR
The Multiple IRR Problem
A project has a nonconventional cash flow pattern
There are Multiple IRRs No IRRs

NPV
NPV
Discount rate (%)

0 0
No IRRs
Multiple IRRS
Discount rate (%)
97

d. Advantages and disadvantages of each method (additional)
Net present value – NPV
Advantages Disadvantages
• Considering the time value of • It is difficult to explain to managers

money • It requires knowledge of the cost of
• An absolute measure of return capital
• Based on cash flows, not profits • It is relatively complex.
• Considering the whole life of the • It does not include any
project consideration of the size of the
• Should lead to the maximization of project.
shareholder wealth.
98

d. Advantages and disadvantages of each method (additional)
Internal rate of return – IRR
Advantages Disadvantages
• Considering the time value of • It is not a measure of absolute

money profitability
• It is a percentage and easy to • Interpolation only provides an
understand estimate
• Based on cash flows, not profits • Non-conventional cash flows may
means a firm selecting projects give rise to multiple IRRs
where the IRR exceeds the cost of • Contains an inherent assumption
capital should increase that cash returned from the
shareholder’s wealth project will be reinvested at the
• Considering the whole life of the project’s IRR, which may be
project unrealistic.
99

[LOS 28.c] describe expected relations among a company’s
investments, company value, and share price.
1. Return on invested capital (ROIC)
One way to approach the question of whether a company is creating value for its
shareholders is to compare the return on the company’s investment in assets to
its cost of capital.
The return on invested capital (ROIC) is a measure of the profitability of a company

relative to the amount of capital invested by the equity- and debtholders. ROIC reflects
how effectively a company’s management is able to convert capital into profits.
After−tax net profit
ROIC =
Average book value of invested capital
OR
Net oporating profit After tax
ROIC =
Average book value of invested capital
Numerator:
▪ Using after-tax net profit to measure the return to all sources of capital (both debt
& equity) = net income + after-tax interest expense.
▪ Using net operating profit after tax = net income + after-tax interest expense -
after-tax non-operating income
Denominator: Average book value of invested capital is the sum of the average book
values of debt, common stock, and preferred stock.
100

1. Return on invested capital (ROIC)
The ROIC measure is often compared with the associated cost of capital
(COC), the required return used in the NPV calculation and the company’s
associated cost of funds.
The company is generating a higher return for

ROIC > COC investors compared with the required return, thereby
increasing the firm’s value for shareholders
The company is generating a lower return for investors

ROIC < COC compared with the required return, thereby
deteriorating the firm’s value for shareholders
101

2. NPV criterion and stock prices
NPV criterion Stock prices
If a corporation invests in
positive-NPV projects
Adding to the wealth of the company and

the corresponding wealth of its shareholders
Note: In actuality, the effect of a capital investment’s positive or negative

NPV on share price is very complicated.
102

2. NPV criterion and stock prices
Example:
Freitag Corporation is investing €600 million in distribution facilities. The present
value of the future after-tax cash flows is estimated to be €850 million.
Freitag has 200 million outstanding shares with a current market price of €32.00
per share. This investment is new information, and it is independent of other
expectations about the company. What should be the investment’s effect on the
value of the company and the stock price?
Solution:
The NPV of the investment = PV of the future after-tax cash flows – Initial outlay
= €850 million − €600 million = €250 million.
The total market value of the company prior to the investment is
€32.00 × 200 million shares = €6,400 million.
→ The value of the company should increase by €250 million, to €6,650 million.
→ The price per share should increase by the NPV per share, or €250 million/200
million shares = €1.25 per share.
→ The share price should increase from €32.00 to €33.25.
103

[LOS 28.d] describe types of real options relevant to capital
investment
1. Real option’s definition
Real options are options that allow companies to make decisions in the
future that alter the value of capital investment decisions made today.
At time zero At future dates

Not making Company can wait and make additional decisions at
all capital investment future dates when these future decisions are
decisions now contingent on future economic events or information
0 t=1
Waiting for
a period of time
Yes
Invest now Take actions
Would the contingent on
Making all capital
future economic events or
investment
information be incurred?
decisions now Reject
No
104

investment
1. Real option’s definition
Real options are options that allow companies to make decisions in the
future that alter the value of capital investment decisions made today.
At time zero At future dates

Instead of making Company can wait and make additional decisions at
all capital investment future dates when these future decisions are
decisions now contingent on future economic events or information
0 t=1
Rather than one-time decisions, it is more reasonable to assume that a company

is making decisions sequentially, some now and some in the future.
A combination of optimal current and future decisions is what will

maximize company value.
105

investment
2. Types of real options
a. Timing Options
b. Sizing Options
c. Flexibility Options
d. Fundamental Options
106

investment
a. Timing options allow a company to delay making an investment because

they expect to have better information in the future.
Project sequencing options allow the company to defer the decision to

invest in a future investment until the outcome of some or all of a current
investment is known.
107

investment
a. Timing options allow a company to delay making an investment because

they expect to have better information in the future.
Example: We use an example of a rental car company that is considering the

purchase of a new car for its rental fleet. Management is trying to decide
whether to buy a hybrid vehicle. Within this decision context we illustrate
the embedded options the company should consider given uncertainty of a
new energy bill offering income-tax credits for the purchase of commercially
operated hybrid vehicles.
0 1
Wait one year
At T = 0, Management At T =1, it will be If profitability, company will

estimates that the new known for certainty purchase hybrid car
energy bill has a 40% chance whether the new bill If not profitability, company
of being passed has passed will not buy any car
108

investment
b. Sizing Options are sub-divided by two categories of options as follows
Abandonment options Expansion options

(growth option)
They allow management to They allow a company to make
abandon a project if the present additional investments in future
value of the incremental cash flows projects if the company decides
from exiting a project exceeds the they will create value.
PV of the incremental cash flows
from continuing the project.
Example: A company prefers to Example: Companies tend to build

outsource its research and facilities with a certain amount of
development (R&D) function to an slack (or “cushion”) because the
external party rather than keep its slack provides a valuable growth
own in-house scientists. option
109

investment
b. Sizing Options are sub-divided by two categories of options as follows
Abandonment options
If after two years investing, the financial results are

disappointing, the company can abandon the investment.
0 1 2 … n n+1
… …
If the future financial results are strong , the company can make
additional investments.
Expansion options
110

investment
c. Flexibility options give managers choices regarding the operational

aspects of a project.
Price-setting options Production-flexibility options
They allow the company to change They offer the operational flexibility
the price of a product. to alter production when demand
varies from what is forecast.
111

investment
The whole investment is essentially an option
d. Fundamental options are projects that are options themselves because

the payoffs depend on the price of an underlying asset
Is the project profitable?

No Yes
Exit project Perform project
Example:
The payoff for a copper mine is dependent on the market price for copper:
- If copper prices are low, it may not make sense to open a copper mine,
- If copper prices are high, opening the copper mine could be very profitable.
→ The operator has the option to close the mine when prices are low and
open it when prices are high.
112

[LOS 28.e] Describe common capital allocation pitfalls.
Although the principles of capital allocation may be easy to understand,

applying the principles to real-world investment opportunities can be
challenging for companies.
Some of the common capital allocation mistakes that companies make:
1. Not incorporating economic responses into the investment analysis

Economic responses to an investment often affect its profitability, and these
responses have to be correctly anticipated by companies.
For example, if a profitable project is in an industry with low barriers to entry,
competitors will likely undertake similar projects, reducing future
profitability.
2. Misusing capital allocation templates

Since managers may evaluate hundreds of projects in a given year, they
often create templates to streamline the analysis process. However, the
template may not be an exact match for the project, resulting in estimation
errors.
113


3. Pushing pet projects

Pet Projects are project that have the personal backing of influential
members of senior management.
Pet projects are often selected at companies without undergoing normal
capital allocation analysis. Or the pet project receives the analysis, but overly
optimistic projections are used to inflate the investment’s profitability.
4. Basing investment decisions on EPS, net income, or ROE

Paying too much attention to short-run accounting numbers can result in a
company choosing investments that are not in the long-run economic
interests of its shareholders.
114


5. Using IRR to make investment decisions*

The IRR criterion is sound for companies undertaking independent
investments with conventional cash flow patterns.
However, for investment opportunities that are mutually exclusive, or
competitive with each other, using only IRR may have some problems that
result in suboptimal investment decisions.
(*) The reasons why should not use only IRR to make investment decisions
are mentioned above in LOS 28.b.
6. Incorrectly accounting for cash flows

Individuals assessing the investment for the company may erroneously omit
relevant cash flows, double-count cash flows, and mishandle taxes.
115


7. Misestimating overhead costs

The cost of a project should include only the incremental overhead costs
related to management time and information technology support. These
costs are often difficult to quantify, and over- or underestimation can lead to
incorrect investment decisions.
8. Using the incorrect discount rate

The required rate of return on the project should reflect the project’s risk.
Simply using the company’s WACC as a discount rate without adjusting it for
the risk of the project may lead to significant errors when estimating the NPV
of a project.
116


9. Overspending and underspending the capital allocation

Spending all the investment allocation just because it is available is another
common mistake made by companies.
In a company with a culture of maximizing shareholder value:
• Profitable investments cost < allocation: Managers will return excess
funds.
• Profitable investments cost > allocation: Managers will make a sound
case for extra funds.
10. Failing to consider investment alternatives or alternative states

Generating investment ideas is a crucial step in the capital allocation
process. However, once a manager comes up with a “good” idea, they may
go with it rather than searching for an idea that is “better.”
117


11. Incorrectly handling sunk costs and opportunity costs

• Ignore sunk costs
Managers should not consider sunk costs in the evaluation of a project
because they are not incremental cash flows.
However, in practice, ignoring sunk costs is difficult for companies to do.
• Include opportunity costs
Managers should always consider opportunity costs because they are
incremental. Not identifying the economic alternatives that are the
opportunity costs is probably the biggest failure by companies in their
analyses.
However, in practice, many managers do this incorrectly.
118
READING 29: SOURCES OF CAPITAL
Learning outcomes
29.a. Describe types of financing methods and considerations in their

selection
29.b. Describe primary and secondary sources of liquidity and factors

that influence a company’s liquidity position
29.c. Compare a company’s liquidity position with that of peer

companies
29.d. Evaluate choices of short-term funding

119

[LOS 29.a] Describe types of financing methods and
considerations in their selection
Types of financing
External
Internal
Financial Capital
Other
intermediaries markets
• Operating cash • Uncommitted • Commercial • Leasing
flows • Committed paper
• Accounts • Revolving • Debt
payable • Secured loans • Equity
• Accounts • Factoring • Hybrid
receivable
• Inventory
• Marketable
securities
The main difference between internal and external sources of finance is

the origin:
• Internal financing comes from the business
• External financing comes from outsider investors (include
shareholders or lenders)
120

[LOS 29.a] describe types of financing methods and
1. Internal financing
Internal financing is the process of a firm using its profits or assets as a

source of capital to fund a new project or investment.
Company
Generate more Increase working

Convert liquid
after-tax operating capital efficiency
assets to cash (1.3)
cash flows (1.1) (1.2)
• Extending payable’s
The higher after-tax Converting
period
operating cash flows receivables,
• Reducing
are the greater ability inventories and
receivable's period
to internally finance marketable securities
• Shortening asset
itself to cash
conversion cycle
Internal financing
121

1.1. Generating more after-tax operating cash flows
Operating cash flows (OCF) is cash for operation before investing in

working capital and financial capital (*)
Dividend
Net income Depreciation
Payments
Operating cash flows

Used to
Invest in working capital Invest in financial capital
The higher OCF, the greater ability to internally finance itself
(*) Note that the term “operating cash flow” mentioned here is different from the
“operating cash flow” that appears on the Cash flow statement in the FRA topic.
122

1.2. Increasing working capital efficiency
• Extending payable’s period
Accounts payable period measures the average number of days it takes

a business to pay its accounts payable.
Transaction Supplier Payment date
date (Account receivable)
Accelerate cash Delay cash

receipt payment
The company
(Account payable)
The longer a company delays its payment, the more it can finance its
daily purchase
123

• Reducing receivable's period
Account receivable period measures the average number of days that

credit customers usually make the payment to the company
Transaction Customers Payment date
date (Account payable)
Accelerate cash Delay cash

receipt payment
The company
(Account receivable )
The sooner a company can collect what it is owed, the less its need to
finance its operations in some other way
124

• Shortening asset conversion cycle
Asset conversion cycle is the process by which cash is used to create

goods and services, deliver them to customers, and then collect cash
Asset conversion Inventory
AR days AP days
cycle days
Shortening
Shortening inventory days
AR days
Goods Cash Goods’ Cash’

Extending
AP days Shortening asset conversion cycle (Cash’ > Cash)
Shortening asset conversion cycle means that company receives cash

sooner → the less its need to finance its operations in some other way
125

1.3. Converting liquid assets
• Converting receivables to cash
Trade receivables arise when a business makes sales or provides a

service on credit.
The sooner receivables are collected, the higher liquidity they have
By reducing account receivable period (like section 1.2),

the company can convert receivables to cash quickly
126

• Converting inventories to cash
Inventories are goods that are waiting to be sold and hold by the
company
Invest in and holding inventory costs money
The longer the inventory remains unsold , the longer that

money is tied up and not usable for other purposes
127

• Converting marketable securities to cash
Marketable securities are financial instruments, such as stocks and

bonds, that can be quickly sold and converted to cash
The company intends to liquidate them within a year and earn a

rate of return that is greater than they would earn by holding cash
The company can sell marketable securities if they need

funds
128

2. External financing
2.1. Financial intermediaries
2.1.1. Line of credit 2.1.2. Secured loans
2.1.3. Factoring 2.1.4. Web-based lenders

129

2.1.1. Line of credit (LOC)
A line of credit is a preset borrowing limit that a borrower can draw on

at any time.
Lends money up to a limit

Company Bank
Pays interest
The main types of lines of credit
Uncommitted Committed Revolving
Reliability
130

Committed or
Types Definition Period
not?
Uncommitted
Form of bank borrowing in which a bank

extends an offer of credit for an
Uncommitted N/A
extended period of time but may refuse
to lend if circumstances change.
Committed
Legal agreement outlining the conditions

of the credit line between a bank & the Less than
Committed
borrower, and cannot be suspended 365 days
without notifying the borrower.
Agreement that permits an account

Revolving
holder to borrow money repeatedly up

Multiple
to a set money limit while repaying a Committed
years
portion of the current balance due in
regular payments.
131

Can be listed in
Types Cost
the footnotes?
Uncommitted
Do not require any compensation other than

No
interest
• Require compensation, usually in the form of a

Committed
commitment fee to the lender

• The fee is a fractional percent of the full Yes
amount or unused amount of the line,
depending on bank-company negotiations
• Similar to committed LOC with respect to

Revolving
borrowing rates, compensation and interest

• Revolving credit can come with variable Not mentioned
interest rate that may be adjusted and
typically higher than regular lines of credit
132

2.1.2. Secured loans
Secured loans are loans in which the lender requires the company to
provide collateral in the form of an asset.
Provide collateral
Company Bank
Lend money
• Collateral is usually a fixed asset owned by the company or high-

quality receivables and inventory.
• These assets are pledged against the loan, and the lender files a lien
(*) against them. This lien becomes part of the borrower’s financial
record and is shown on its credit report.
(*) A lien is a claim or legal right against assets that are typically used as
collateral to satisfy a debt.
133

2.1.3. Factoring
Factoring refers to the actual sale of receivables at a discount from their face
value. Debt factoring involves three parties: a business, a client, and a debt
factoring company.
(1) The company sells goods to the

Company Customer
customer payable in 30 days
(2) The company sells (3) The customer pays

the debt to the factor the factor after 30 days
Factor
In a factoring arrangement, the company shifts the credit granting and collection
process to the factor. The cost of this credit (i.e., the amount of the discount)
depends on the credit quality of the accounts and the costs of collection.
134

2.1.4. Web-based lenders
Web-based lenders operate primarily on the internet, offering loans in

relatively small amounts, typically to small businesses in need of cash.
Non-bank lenders also lend to businesses, but unlike typical banks,

which make loans and take deposits, these lenders only make loans.
135
READING 29: SOURCE OF CAPITAL

2.2. Capital markets
The company can finance funds on capital markets by using three kinds
of financial instruments
Capital markets
Debt instruments Hybrid securities Equity instruments
Commercial paper Preferred shares Common shares
Convertible debts
Long-term debts and convertible
preferred stocks
136

2.2.1 Capital markets – Debt instruments
a. Commercial paper (CP)
• Commercial paper is a commonly used type of unsecured, short-

term debt instrument issued by corporations.
• Typically used for the financing of payroll, accounts payable and
inventories, and meeting other short-term liabilities.
Issuing CP for
▪ Holding for
Issuer A Holder B maturity;
Lending money to ▪ Trading
CP enables corporations to raise short-term funds

directly from end investors (holders) through:
▪ Their own in-house CP sales team; or
▪ Arranged placing through bank dealers
137

a. Commercial paper (CP)
Characteristics of commercial paper:

• Typically issued by large and well-rated companies
• Short-term debt, (mostly) unsecured instrument (with no specific
collateral)
• Maturities on commercial paper range from a few days to one year
(272 days in U.S.)
• Can be sold directly to investors or through dealers
• Typically issued by large and well-rated companies;
The credit quality of the issuer is important for the investor
(because of its unsecured nature)
• The backup line of credit (LOC) protects investors in the event that a
company defaults on its commercial paper
• The short-term nature of CP Offer a cheaper

• The creditworthiness of the borrower form of financing
• The backup line of credit to corporation
138

b. Long-term debt
Long-term debt is debt that matures in more than one year
Characteristics of long-term debt:

• Has a maturity of at least one year
• Lenders (investors) and borrowers (companies) agree to covenants
that are detailed contracts specifying the rights of the lender and
restrictions on the borrower
• Often carries a fixed interest rate through maturity, which may be
decades after issuance
• Interest rates on a company’s debt depend on its creditworthiness
and the collateral, if any, pledged for repayment of the debt
Note: Debt payments have priority over payments to equity holders and
the interest paid on debt is typically tax deductible
139

b. Long-term debt
Long-term debt is divided into two categories:
Public debt Private debt

(debt owed by national, state, and (debt owed by households,
local governments) businesses, and nonprofits)
• Negotiable instrument* • Private debt does not trade on a

• Approved for sale on open market → more difficult to sell
markets • Private debt issued by businesses
can usually be sold by one party
to another but some are not (e.g.:
savings bonds and certificates of
deposit)
(*) A negotiable instrument is a written document describing the promise to pay

that is transferable and can be sold to another party.
140

2.2.2 Capital markets – Equity instrument
Common Equity (Common stock/Common shares) :

• Represents ownership in a company;
• Considered as a more permanent source of capital.
Issue shares
Shareholders Company
• Receive dividends
• Elect board of directors
• Have control
• Entitled to residual value of
assets in case of bankruptcy
141

Common equity is divided into two categories:
Public equity Private equity
Public Ownership Private
Access to
All material
information about Confidential
information
the company
Investor Direct involvement

Relatively passive
involvement in key decisions
142

Common equity is divided into two categories:
Influenced by short- Management Likely to take long-

term factors focus term view
Generally large and May be at any stage

Maturity stage
mature in the lifecycle
Readily traded on
Illiquidity
public stock More difficult to sell
premium
exchanges
143

2.2.3 Capital markets – Hybrid securities
a. Preferred shares (Preferred stock)
Preferred shares are hybrid securities that are issued by companies and
have characteristics of both bonds and common equity
Characteristics:
• Dividends on preferred shares are often fixed but can be variable
• No maturity date
• Not a tax-deductible expense for the company
• Can choose to defer or decline to pay dividends on preferred equity
• Priority of payments:
Debt → Preferred shares → Common equity
• In case of business failure, preferred shareholders have similar
seniority over common shareholders
144

2.2.3 Capital markets – Hybrid securities
b. Convertible debt and convertible preferreds are hybrid securities

which are convertible into a fixed number of the companies’ common
shares
Convertible instruments
Debt component Equity component
If the company’s share price If the share price rises

remains low sufficiently
May retain ownership to receive May convert to common stock,

its dividend or interest given the appreciation
145

Businesses are generally financed longer term using a combination of

debt and equity securities. Their key differences include:
Debt Equity
Legal Company has a Shareholders are

Agreement contractual obligation residual owners of the
to debtholders company
Claim Priority Debtholder interest and Residual claimants to

principal payments have distributions and
priority corporate assets
Distributions Periodic, contractual Discretionary dividend

interest payments and payments declared by
repayment of principal the Board of Directors
at maturity
146

Debt Equity
Taxation Interest payments are Dividend payments and

tax- deductible share repurchases are
expenses not tax-deductible
expenses
Term Stated term to maturity No finite term
Voting rights No voting rights Voting rights
Cost to Lower cost Higher cost

company
Investor risk Lower risk Higher risk

147

2.3. Other Financing
Leasing Obligations
The lease is a debt instrument where the asset owner (the lessor) gives
another party (the lessee) the right to use the asset. In return, the lessee
makes make regular lease payments.
Leasing contract’s components:
• A set of contractually fixed payments
• Specifies the length of time the lessee can use the asset
• Specifies whether the lessee is responsible for maintenance of the
asset
• Specifies whether the lessee can buy the asset at the end of the
leasing period and if so, at what price
The leasing might offer lower joint costs for the company and for
suppliers of capital than buying and financing separately
148

3. Considerations affecting financing choices
Financing choices are affected by firm-specific considerations and

macroeconomics considerations
3.1. Macroeconomic considerations
Monetary policy
The company
3.2. Firm-specific
Inflation Taxation
considerations*
Government policy
(*) There are ten firm-specific considerations, that will be mentioned in section 3.2.
Firm-specific considerations
149

3.1.1. Taxation
Taxation typically affects cost of debts through tax-deduction
Interest payments on debt

financing are tax-deductible
After-tax cost of debt
financing is more attractive
Distributions on equity
financing are not
150

3.1.2. Inflation
Inflation affects financing choice through interest rate
Borrower Lender
Expected increases Prefer to borrow at Prefer to lend at a

in inflation a fixed rate variable rate
Expected decreases Prefer to borrow at Prefer to lend at a

in inflation a variable rate fixed rate
Uncertainty over inflation rates can make

longer-term, fixed-rate contracts unattractive
to the borrower or lender
151

3. Considerations affecting finanaing choices
3.1.3. Government Policy
Fiscal policy refers to the use of government spending and tax policies to
influence economic conditions, especially macroeconomic conditions
Can be used to stimulate the economy or to subsidize specific industries
Governments may make below-market rate debt or debt guarantees

available to specific companies or industries, making available greater
amounts of debt financing
152

3.1.4. Monetary Policy
Monetary policy aims to influence monetary variables such as the

interest rate and the money supply to achieve macroeconomic targets,
such as targets for the rate of inflation.
Expansionary monetary policy Contractionary monetary policy

The government decrease The government increase
interest rate or decrease reserve interest rate or increase reserve
requirements. requirements.
Low (or even negative) real rates of

High real rates of interest
interest
More attractive for companies to Less attractive for companies to

issue debt and invest in their issue debt and invest in their
businesses. businesses.
153

3.2. Firm-specific considerations
3.2.1. Company size 3.2.2. Riskiness of assets
3.2.4. Public & private

3.2.3. Assets for collateral
equity
3.2.5. Asset liability 3.2.6. Debt maturity

management structure
3.2.7. Currency risks 3.2.8. Agency costs
3.2.9. Bankruptcy costs 3.2.10. Flotation costs

154

3.2.1. Company size
Large companies with strong operating cash flows can rely more heavily
on internal financing
Be easier to access to funding Equity financing is usually the

sources predominant source of financing.
Establish optimal capital structure Debt financing may not be

mixed both equities and debts available or is too expensive
Small companies, especially those that are younger and faster growing,
or without cash flow, must rely more on external financing
155

3.2.2. Riskiness of assets
High levels of uncertainty or volatility in operating cash flows can make

servicing debt obligations challenging
Companies with higher volatility of operating cash flows rely primarily on

equity financing and tend to use little if any debt financing.
156

3.2.3. Assets for collateral
• Real property and equipment are good collateral for mortgages and
asset-backed bonds
• Assets that are unique, highly specialized, and intangible might not be
valuable as collateral
Sound collateral can increase a company’s access to debt financing as

well as reduce its costs.
157

3.2.4. Public & private equity

For companies that have issued For companies that finance
public equity, shares are available through private equity, shares are
and easily traded through public available directly from the
stock markets. company or from non - public
transactions.
Publicly traded companies ’s Private company claims are not

securities are liquid and trade liquid and do not trade in
frequently secondary markets
158

3.2.5. Asset liability management
• Businesses tend to match the maturity structures of their assets and

liabilities
• A mismatch of asset and liability maturity structures can be
problematic
If a company finances its long-term assets with short-term obligations, its

profitability might be threatened if the cost of its short-term financing
increases
159

3.2.6. Debt maturity structure
• If interest rates on short-term debt are less than those on long-term

debt, the company would be to finance with short-term debt and
continually refinance with new short-term debt whenever current debt
matures
• This risk, sometimes called rollover risk, materializes when interest
rates go up or when company-specify or general economic conditions
cause the company to be unable to refinance or issue new debt
160

3.2.7. Currency risks
A company’s business revenues and its financing can be in different

currencies
→ The company has to face the risk that: If the domestic currency
declines in value, the company might not be able to repay its debts.
Short-term debt contracts can be hedged in derivatives markets,

however, the market for these derivatives is relatively small.
• The company’s best option to hedge currency risks is to execute its

debt and equity financing in the same currency as its business
operations
• Multinational companies will finance themselves in different
currencies to match the currency exposure of their local operations
161

3.2.8. Agency costs
Debtholders can suffer losses if the borrowing company increases its

riskiness beyond its original expectations. This can occur in several
ways:
• Asset substitution: wherein the company replaces assets that were
fairly safe with much riskier assets
• Cash distribution: company distributes too much cash to owners or
managers
• Using more financial leverage: replacing equity financing with
increased levels of new debt financing, pledges significant assets to
secured creditors
Debtholders try to protect their interests by having bond covenants that

restrict the company from taking certain actions that would be
detrimental to bondholders
162

3.2.9. Bankruptcy Costs
Bankruptcy introduces additional costs

Company resources being consumed by third parties, the legal system,
and other administrative costs of bankruptcy.
Suppliers of capital might be averse to financial structures that risk

bankruptcy
163

3.2.10. Flotation Costs
A publicly traded company incurs flotation costs when it issues new debt
or equity securities. Flotation costs include various expenses that are
company specific:
• Legal fees
• Registration fees
• Audit fees
• Underwriting fees
Flotation costs as a percentage of the capital raised are generally lower

for debt offerings than for equity offerings
Flotation costs increase the cost of financing and can affect a company’s
financing decisions
164

[LOS 29.b] Describe primary and secondary sources of liquidity
and factors that influence a company’s liquidity position
1. Managing liquidity
Liquidity is the extent to which a company is able to meet its short-term

obligations using cash flows and those assets that can be readily
transformed into cash.
Liquidity management refers to the ability of a company to generate

cash when required.
Cash balances
Ability to convert other

assets into cash Keeping
Liquidity the entity
solvent
Borrowing capacity
Ability to extend liability

maturity
165

To develop, implement, and maintain a liquidity policy effectively,

Company must manage all its key sources of liquidity efficiently
Key sources of liquidity generally include
Primary sources of liquidity Secondary sources of liquidity

represent the most readily includes liquidating short-term
accessible resources available. or long-lived assets,
renegotiating debt agreements,
or filing for bankruptcy and
reorganizing the company.
The use of secondary sources can

The use of primary sources is
change the company’s financial
unlikely to change the company’s
structure and operations
normal operations
significantly
Might signal a company’s

deteriorating financial health
166

Primary sources of liquidity Secondary sources of liquidity
• Free cash flow • Negotiating debt contracts

• Ready cash balances • Liquidating assets
• Short-term funds • Filing for bankruptcy
• Cash flow management protection and reorganization
167

Primary sources of liquidity
Free cash flow

Free cash flow = After-tax operating cash flow - Planned investments
• For a profitable firm, free cash flow provides substantial liquidity
• A rapidly growing firm has less free cash flow
Ready cash balances

Ready cash balances is cash available in bank accounts, resulting from:
• Payment collections
• Investment income
• Liquidation of near-cash securities
• Other cash flows.
168

Primary sources of liquidity
Short-term funds
Short-term funds include items such as:
• Trade credit
• Bank lines of credit
• Short-term investment portfolios.
Cash flow management

Cash flow management is the company’s effectiveness in its cash
management system and practices, and the degree of decentralization of
the collections or payments processes.
Example: The more decentralized the system of collections, the more likely
the company will be to have cash tied up in the system and not available
for use.
169

Secondary sources of liquidity
Negotiating debt contracts

Relieving pressures from high interest payments or principal repayments,
and negotiating contracts with customers and suppliers.
Liquidating assets
This depends on how both short-term and long-term assets can be
liquidated and converted into cash without substantial loss in value
Filing for bankruptcy protection and reorganization

When a company fills for bankruptcy protection & reorganization, it is
temporarily protected from claims by creditors for full repayment of
outstanding debts → Can use operating CF to continue business.
170

Cash flow transactions—that is, cash receipts and disbursements—have

significant effects on a company’s liquidity position.
A drag on liquidity occurs when there is a delay in cash coming into the
company, creating pressure from the decreased available funds
Company
A pull on liquidity occurs when cash leaves the company too quickly,
requiring companies to expend funds before they receive funds from
sales that could cover the liability.
171

A drag on liquidity
Major drags on receipts involve pressures from credit management and
deterioration in other assets and include the following:
The longer receivables are outstanding, the greater the

Uncollected risk that they will not be collected at all.
receivables Indication: a large number of days of receivables and
high levels of bad debt expenses.
If inventory stands unused for long periods, it might be

Obsolete an indication that it is no longer usable.
inventory Indication: Slow inventory turnover ratios
Adverse economic conditions can make it difficult for

Tight credit companies to arrange short-term financing
172

A pull on liquidity
Major pulls on payments include the following:
Making By paying vendors, employees, or others before the

payments early due dates, companies forgo the use of funds.
Reduced If a company has a history of making late payments,

credit limits suppliers might cut the amount of credit they will
allow to be outstanding at any time.
 Squeeze the company’s liquidity.
Limits on short- If a company’s bank reduces the line of credit it

term lines of offers the company, a liquidity squeeze might
credit result.
Low liquidity Many companies face chronic liquidity shortages,

positions often because of their particular industry or from
their weaker financial position.
173

[LOS 29.c] Compare a company’s liquidity position with that of
peer companies
1. The needs of liquidity measurement
Liquidity contributes to a company’s creditworthiness
Creditworthiness allows the company to obtain:

• Lower borrowing costs and,
• Better terms for trade credit,
• Contributes to the company’s investment flexibility, enabling it to
exploit profitable opportunities.
We should consider a reasonable level of liquidity
If liquidity is too low If liquidity is too high

there are the risk that company that means the company have too
will suffer financial distress or, in much invested in low- and non-
the extreme case, insolvency or earning assets  low earning
bankruptcy relative to the long-term
174

peer companies
2. Liquidity ratios
Liquidity ratios
• Measure a company’s ability to meet short-term obligations to
creditors as they mature or come due,
• Analyze the relationship between:
o Current assets and current liabilities;
o The rapidity with which receivables and inventory can be
converted into cash
Liquidity ratios
Current ratios Quick ratios Cash ratios

175

peer companies
2. Liquidity ratios
Current assets
Current ratio =
Current liabilities
Current Usage: Expresses current assets in relation to current liabilities.
ratio
Interpretation: A high current ratio is desirable as it indicates a
higher level of liquidity.
Cash + Short−term investment + AR

Quick ratio =
Current liabilities
Usage: Expresses “quick” assets in relation to current liabilities.
Quick ratio Quick assets excludes items in current assets that cannot be
converted into cash such as prepaid expenses, taxes, inventory.
Interpretation: A high quick ratio indicates greater liquidity.
Cash+Short−term investment
Cash ratio =
Current liabilities
Usage: Represents a reliable measure of an entity’s liquidity in a
Cash ratio crisis situation. Only highly marketable short-term investments
and cash are included.
Interpretation: A high cash ratio is desirable as it indicates greater
liquidity.
176

peer companies
2. Activity ratios
Activity ratios measure how well key current assets are managed over time
Purchases Sales
Days of inventory on hand Days of sales outstanding
Number of days Cash conversion cycle

of payables
Pay cash Receipt cash
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peer companies
2. Activity ratios
Activity ratios measure how well current assets are managed over time
Days of sales outstanding
Purchases Pay cash Sales Receipt cash
Receivables Turnover and days of sales outstanding (DSO)

Revenue
Receivables turnover = Average receivables
365
DSO = Receivable turnover
• Usage: The number of DSO represents the elapsed time between a sale and cash
collection, reflecting how fast the company collects cash from customers.
• Interpretation:
o A high receivables turnover might indicate that the company’s credit
collection are highly efficient or result from overly stringent credit or
collection policies, which can hurt sales if competitors offer more lenient
credit terms to customers and vice versa
o A high DSO means that the company’s credit collection are highly inefficient.
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peer companies
2. Activity ratios
Number of Days of
Payables
Payables Turnover and the Number of Days of Payables

Purchase∗
Payables turnover = Average payables
365
Number of days of payables =
Payables turnover
(*) with Purchases = Ending inventory + COGS - Opening inventory
• Usage: The number of days of payables reflects the average number of days the
company takes to pay its suppliers, and the payables turnover ratio measures
how many times per year the company theoretically pays off all its creditors.
• Interpretation:
o A high payables turnover might indicate that the company is not making full
use of available credit facilities and repaying creditors too soon or company
making payments early to avail early payment discounts
o A high number of days of payables means that the company is having trouble
in making payments on time, or alternatively, exploitation of lenient supplier
terms
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peer companies
2. Activity ratios
Days of inventory on hand
Inventory turnover and days of inventory on hand (DOH)

COGS
Inventories turnover =
Average inventories
365
DOH = Inventories turnover
• Usage: Indicate inventory management effectiveness. A higher inventory

turnover ratio implies a shorter period that inventory is held, and thus a lower
DOH.
• Interpretation:
o A high inventory turnover ratio relative to industry norms might indicate
highly effective management or the company does not hold adequate
inventory levels, which can hurt sales in case shortages arise and vice versa
o A high DOH means that company uses inventory inefficiently and is struggling
to clear its stock.
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peer companies
2. Activity ratios
Days of inventory on hand
Cash conversion cycle

Cash conversion cycle = DOH + DSO – Number of days of payables
• Usage: Indicates the amount of time that elapses from the point when a
company invests in working capital until the point at which the company collects
cash
• Interpretation: A short cycle is desirable, as it indicates greater liquidity
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[LOS 29.d] Evaluate choices of short-term funding
1. Objectives of a short-term borrowing strategy
• Ensuring that sufficient capacity exists to handle peak cash needs

• Maintaining sufficient sources of credit to be able to fund ongoing
cash needs
• Ensuring that rates obtained are cost-effective and do not
substantially exceed market averages
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[LOS 29.d] Evaluate choices of short-term funding
Factors influence a company’s short-term borrowing

2.
strategy
Size and • A borrower’s size can dictate the options

creditworthiness available.
• The borrower’s creditworthiness will determine
the rate, compensation, or even whether the loan
will be made at all.
Legal and Some countries impose constraints on how much a

regulatory company can borrow and under what terms it can
considerations borrow.
Sufficient access Borrowers should diversify to have adequate

alternatives and not be too reliant on one lender or
form of lending if the amount of their borrowing is
very large.
Flexibility of Flexibility means the ability to manage maturities

borrowing efficiently; that is, there should not be any “big”
options days, when significant amounts of loans mature.
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READING 30: COST OF CAPITAL-FOUNDATIONAL

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Learning outcomes
Weighted average cost of capital
30.a. Calculate and interpret the weighted average cost of capital

(WACC) of a company
30.b. Describe how taxes affect the cost of capital from different capital
sources
30.c. Calculate and interpret the cost of debt capital using the yield-to-
maturity approach and the debt-rating approach
30.d. Calculate and interpret the cost of noncallable, nonconvertible
preferred stock
30.e. Calculate and interpret the cost of equity capital using the capital
asset pricing model approach and the bond yield plus risk premium
approach
Beta estimation and flotation costs
30.f. Explain and demonstrate beta estimation for public companies,

thinly traded public companies, and nonpublic companies
30.g. Explain and demonstrate the correct treatment of flotation costs

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[LOS 30.a] Calculate and interpret the weighted average cost
of capital (WACC) of a company
1. How weighted average cost of capital (WACC) is created
Cost of capital is the rate of return that the suppliers of capital (lenders
and owners) require as compensation for their contribution of capital.
Or other perspectives on Cost of capital:
Cost of capital is the opportunity cost of funds for the suppliers of

capital.
A potential supplier of capital will not voluntarily invest in a company

unless its return meets or exceeds what the supplier could earn
elsewhere in an investment of comparable risk.
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Corporate capital
Hybrid instrument
Equity Debt
(Preferred stock,
(Common stock) (Bond, Loan)
Convertible debt)
Cost of other sources

Cost of equity Cost of debt
of capital
Component costs of capital
The weighted average of the costs of the various components used by

the company to finance its operations is known as the weighted average
cost of capital (WACC).
WACC is the expected rate of return that investors demand for financing
an average-risk investment of the company.
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The cost of capital is used in the evaluation of investment opportunities
We should deal with a marginal cost - what it would cost to raise

additional funds for the potential investment project
The cost of capital that the investment analyst is concerned with is a

marginal cost.
The required return on a security is the issuer’s marginal cost for raising
additional capital of the same type.
The WACC is also referred to as the marginal cost of capital (MCC)

Because it is the cost that a company incurs for additional capital.
Further, this is the current cost: what it would cost the company today.
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2. Calculate the weighted average cost of capital (WACC)
The weights are the proportions of the various sources of capital that the
company uses to support its investment program.
Represent the company’s target capital structure, not the current capital
structure
Current capital structure Target capital structure

A company’s chosen (or
A company’s actual weighting
targeted) proportions of debt
of debt and equity.
and equity.
For example: For example:
Source of capital Proportions Source of capital Proportions
Common stock 1/3 Common stock 1/4
Debt 1/3 Debt 1/2
Preferred stock 1/3 Preferred stock 1/4
The firm issues more debt to

finance the new investment Be used to calculate the WACC
→ capital structure changes
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A company’s WACC is calculated using the following formula:
WACC = wd × rd × 1−t (∗) + wp × rp + we × re
Where:
• wd = the target proportion of debt in the capital structure when the
company raises new funds
• rd = the before-tax marginal cost of debt
• t = the company’s marginal tax rate
• wp = the target proportion of preferred stock in the capital structure
when the company raises new funds
• rp = the marginal cost of preferred stock
• we = the target proportion of common stock in the capital structure
when the company raises new funds
• re = the marginal cost of common stock
(*) In some jurisdictions, interest expense may be tax deductible → the

net cost of debt is the amount of interest the company is paying minus
the amount it has saved in taxes. (Refer to LOS 30.b)
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Example 1: WACC calculation

Assume that ABC Corporation has the following capital structure: 30%
debt, 10% preferred stock, and 60% common stock, or equity. Also
assume that interest expense is tax deductible. ABC Corporation wishes
to maintain these proportions as it raises new funds.
• Its before-tax cost of debt is 8%,
• its cost of preferred stock is 10%, and
• its cost of equity is 15%.
If the company’s marginal tax rate is 40%, what is ABC’s weighted
average cost of capital?
Answer:
WACC = wd × rd × 1−t + wp × rp + we × re
= (0.3)(0.08)(1 – 0.40) + (0.1)(0.1) + (0.6)(0.15) = 11.44%.
The cost for ABC Corporation to raise new funds while keeping its
current capital structure is 11.44%.
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[LOS 30.b] Describe how taxes affect the cost of capital from
different capital sources
WACC = wd × rd × 1−t + wp × rp + we × re
The dividend on preferred and

The interest on debt is tax
common stocks are not tax-
deductible by the company based
deductible by the company
on the country’s tax law
→ there is no effect of taxes on
→ there is tax deductibility of debt
these costs.
The company ‘s interest on debt is

rd → the before-tax cost of debt is rd The effective marginal
cost of debt (after-tax
This interest expense reduces taxable
cost of debt) is rd × (1 − t)
income by rd → reduce the tax bill by
rd × t
The tax deductibility of debt reduces the effective marginal cost of debt
to reflect the income shielded from taxation (tax shield)
There may be reasons why additional interest expense is not tax deductible
(e.g., not having sufficient income to offset with interest expense)
→ the effective cost of debt is rd without any adjustment for a tax shield.
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[LOS 30.b] Describe how taxes affect the cost of capital from
different capital sources
Example 2: Effect of taxes on the costs of capital
Jorge Ricard, a financial analyst, is estimating the costs of capital for the
Zeale Corporation. In the process of this estimation, Ricard has
estimated the before-tax costs of capital for Zeale’s debt and equity as
4% and 6%, respectively.
What are the after-tax costs of debt and equity if there is no limit to the
tax deductibility of interest and Zeale’s marginal tax rate is:
1. 30%? and 2. 48%?
Answer:
Marginal tax After-tax Cost of After-tax Cost of
rate debt equity
Solution to 1 30% 0.04(1-0.3) = 2.8% 6%
Solution to 2 48% 0.04(1-0.48) = 2.08% 6%
Discussion: The tax deductibility reduces the effective cost of debt

(from 4% to 2.8% and 2.08%) and do not affect the cost of equity. The
higher tax rate, the lower the effective cost of debt.
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Overview of LOS 30c, d, e
Each source of capital has a different cost because of the differences

among the sources, such as risk, seniority, contractual commitments,
and potential value as a tax shield. We focus on 03 primary sources:
Corporate capital
Equity Debt Preferred stock
Cost of equity Cost of debt Cost of Preferred

(LOS 30e) (LOS 30c) stock (LOS 30d)
Weighted average cost of capital (WACC)

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[LOS 30.c] Calculate and interpret the cost of debt capital
using the yield-to-maturity and the debt-rating approach
The cost of debt is the cost of debt financing to a company when it

issues a bond or takes out a bank loan.
Risk-free Risk premium

rate of return
Cost of debt
(theoretical rate of business financial
return with zero risk) risks risk
affect affect
stability of the higher

profits use of debt
HOW to estimate?
1. Yield-to-maturity approach 2. Debt-rating approach

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1. Yield-to-maturity (YTM) approach
YTM is the annual return that an investor earns on a bond if the investor
purchases the bond today and holds it until maturity.
In other words, it is the yield, rd , that equates the present value of the
bond’s promised payments to its market price:
PMT1 PMTn FV n PMTt FV
P0 = rd + … + r n+ r n = σt=1 r t + r n
1+ 1+ d 1+ d 1+ d 1+ d
2 2 2 2 2
where: Po = the current market price of the bond
PMTt = the interest payment in the period t
rd = the yield to maturity
n = the number of periods remaining to maturity
FV = the maturity value of the bond
Assumptions:
• Bond interest is paid semi-annually (not the case in all countries);
• Any intermidiate (i.e. payments prior to maturity) are reinvested at
r
the rate of d semi-annually.
2
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Example 3: Calculate after-tax cost of debt using YTM approach

Valence Industries issues a bond to finance a new project. It offers a 10-year,
$1,000 face value, 5% semi-annual coupon bond. Upon issue, the bond sells
at $1,025. What is Valence’s before-tax cost of debt? If Valence’s marginal
tax rate is 35%, what is Valence’s after-tax cost of debt?
Answer:
Po = $1,025
PMT = (1,000 x 5%)/2 = $25
n = 10 x 2 = 20
FV = $1,000
$25 $1,000
$1,025 = σ20
t=1 (1+i)t + (1+i)20
We can use a financial calculator to solve for i - the six-month yield (see
next slide) → i = 2.342%
→ the before-tax cost of debt is: rd = 2.342% × 2 = 4.684%.
→ after-tax cost of debt is: rd (1 - t) = 0.04684(1 - 0.35)= 0.03045, or 3.045%
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Calculate i (=𝒓𝒅/2) using financial calculator
Step 1: Enterting the given info

Input Keystro Display
value kes
20 N = 20
-1,025 PV = -1,025
25 PMT = 25
1,000 FV = 1,000
Step 2: Calculate I/Y
Press and then .
rd
→ i = = 2,342 (%)
2
→ rd = 4,684 (%) 196
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2. Debt-rating approach
When a reliable current market price for a company’s debt is not available
Debt-rating approach
Use the yield on comparably

rated bonds for maturities that Estimate the company’s
closely match that of the before-tax cost of debt
company’s existing debt
Example 4: Calculating the After-tax cost of debt

Elttaz Company’s capital structure includes debt with an average maturity of
15 years. The company’s rating is A1, and it has a marginal tax rate of 18%.
The yield on comparably rated A1 bonds with similar maturity is 6.1%. What
is Elttaz’s after-tax cost of debt?
Answer:
Based on debt-rating approach, we estimate the before-tax cost of debt by
using the yield on comparably rate bonds = 6.1%.
→ Elttaz's after-tax cost of debt is: rd 1−t = 0.061 1−0.18 = 5%
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2. Debt-rating approach
Considerations
• Debt ratings are ratings of the debt issue itself, with the issuer being
only one of the considerations.
• Debt seniority and security (*), also affect ratings and yields
→ Care must be taken to consider the likely type of debt to be issued by

the company in determining the comparable debt rating and yield.
(*)
• Debt security means that a debt (i.e. bond) is secured by a form of
collateral.
• Seniority ranking is the systematic way in which lenders are repaid in
case of bankruptcy or liquidation.
Reference: Please refer to Reading 39: Fixed-income Securities: Defining
elements
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3. Issues in estimating cost of debts
Floating-rate Debt
Estimating the cost of a floating-rate security, in which the interest rate

adjusts periodically, is difficult because over the long term, it depends not
only on the current yields but also on the future yields.
Implication: The analyst may use the current term structure of interest rates
and term structure theory to assign an average cost to such instruments.
(Refer to Reading 39 Fixed-Income Securities: Defining Elements).
Nonrated Debt
Debt-rating approach (in case the yields on the company’s debts are not
available) can not be used to estimate the cost of nonrated debts
Impliation: Estimate a company’s “synthetic” debt rating based on financial
ratios to estimate cost of debt using debt-rating approach, however, this
may be imprecise.
Ratings: The grade assigned to a corporation or its debt instrument
showing rating agency's predictions of how well a firm can make as
promised to pay periodic interest and repay the principal.
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Debt with Optionlike features
Bond issuer a. CALL OPTION Bondholder

(Borrower) (Lender)
issues bonds with a call option (callable bonds)
call option: issuer has right to redeem/ buy back

bonds before maturity date at a fixed
predertermined price
When the issuer expects the interest rates will decrease in the
future → bond price will increase
Issuer buy back bonds at lower price and take advantage of this
situation by issuing new bonds at higher new price and lower
interest rates payable to bondholder
Bondholders want to be compensated for the call risk associated

with the bond
Yieldcallable bond > Yieldnon−callable bond
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Bond issuer b. PUT OPTION Bondholder

(Borrower) (Lender)
issues bonds with a put option
put option: bondholder has right to sell bonds

before maturity date at a fixed predertermined
price
When the investor expects the interest rates will increase in the
future → bond price will decrease
Bondholder sells bonds at higher predetermined price and take

advantage of this situation by buying new bonds at lower price
(lend less money) and (receive) higher interest rates.
Bondholder requires lower return if they have put option

Yieldbond with put option < Yieldbond without put option
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Bond issuer c. CONVERTIBLE BOND Bondholder

(Borrower) (Lender)
issues convertible bonds
option of converting the bonds into common stock
The conversion option gives bondholders more flexibility, hence

they require lower rate of return.
Yieldconvertible bond < Yieldnon−convertible
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Implication
If the company already has debt
outstanding with optionlike If the company is believed to add
features that are believed are or remove option features in
representative of the future debt future debt issuance
issuance
make market value adjustments

use the YTM on such debt in
to the current YTM to reflect the
estimating the cost of debt.
value of such additions/ deletions
Note: These optionlike features will be discussed later in Fixed Income.

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Lease
A lease is a contractual obligation that can substitute for other forms

of borrowing, whether it is an operating lease or a finance lease (also
called a capital lease).
Implication: If the company uses leasing as a source of capital, the cost

of these leases should be included in the cost of capital. The cost of
this form of borrowing is similar to that of the company’s other long-
term borrowing.
Note: Please refer to FRA Reading 24 for your revision of Leases .

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[LOS 30.d] Calculate and interpret the cost of noncallable,
nonconvertible preferred stock
The cost of preferred stock is the cost that a company has committed to
pay preferred stockholders as a preferred dividend when it issues
preferred stock.
Cost of preferred stock will be:

Dp
rp =
Pp
where: Pp : the current preferred stock price per share
Dp : the preferred stock dividend per share
rp : the cost of preferred stock
Example 5: Calculating the cost of preferred stock

Consider a company that has one issue of preferred stock outstanding
with a $3.75 cumulative dividend. If the price of this stock is $80. What is
the estimate of its cost of preferred stock?
Answer:
Dp $3.75
Cost of preferred stock = = = 4.6875%
Pp $80
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Issues in estimating cost of preferred stock
When estimating the yield of preferred stocks, the following features

must be considered:
• call option
• convertibility
• cumulative dividends
• participating dividends
• adjustable-rate dividends
Implication:
When estimating a yield based on current yields of the company’s
preferred stock, we must make appropriate adjustments for the effects
of these features on the yield of an issue.
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Example 6: Choosing the best estimate of the cost of preferred stock
Wim Vanistendael is finance director of De Gouden Tulip N.V., a leading
Dutch flower producer and distributor. He has been asked by the CEO to
calculate the cost of preferred stock and has recently obtained the
following information:
• The issue price of preferred stock was €3.5 million, and the preferred
dividend is 5%.
• If the company issued new preferred stock today, the preferred
dividend yield would be 6.5%.
• The company’s marginal tax rate is 30.5%.
What is the cost of preferred stock for De Gouden Tulip N.V.?
Answer:
The current terms indicate the most current actual cost of the preferred
stock.
→ the cost of preferred stock for De Gouden Tulip is 6.5%. Because
preferred dividends offer no tax shield, there is no adjustment made on
the basis of the marginal tax rate.
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[LOS 30.e] Calculate and interpret the cost of equity capital
using the capital asset pricing model approach and the bond
yield plus risk premium approach
The cost of common equity, re , usually referred as cost of equity, is the

rate of return required by a company's common stockholders.
HOW to estimate?
1. Capital asset pricing 2. Bond yield plus risk

model (CAPM) premium (BYPRP)
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1. Capital asset pricing model (CAPM)
Estimate the cost of equity based on the capital asset pricing model
theory:
The expected return on a stock, E(Ri ), is the sum of the risk-free rate of
interest, RF , and a premium for bearing the stock’s market risk,
βi E RM −RF , which is called “Equity risk premium”.
Equity risk premium incorporates the stock’s return sensitivity to changes in

the market return, or market-related risk, known as βi , or beta (LOS 30.f).
E Ri = RF + βi E RM − RF
where: βi = the return sensitivity of stock i to changes in the market return
RF = the risk-free rate of interest
E(RM ) = the expected return on the market
E(RM ) - RF = the expected market risk premium
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1. Capital asset pricing model (CAPM)
Estimation of cost of equity - Step by Step
Step 1: Estimate the risk-free rate, RF .

Yields on default risk-free debt such as U.S. Treasury notes are
usually used. The most appropriate maturity to choose is one that is
close to the useful life of the project.
Step 2: Estimate the stock’s beta, β. This is the stock’s risk measure.
Step 3: Estimate the expected rate of return on the market, E(RM ).
Example 7: Using CAPM to estimate the cost of equity

Valence Industries wants to know its cost of equity. Its chief financial
officer (CFO) believes the risk-free rate is 5%, the market risk premium is
7%, and Valence’s equity beta is 1.5. What is Valence’s cost of equity
using the CAPM approach? What is Valence’s cost of equity using the
CAPM approach?
Answer:
Cost of equity = RF + βi E RM −RF = 5% + 1.5(7%) = 15.5%
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2. Bond yield plus risk premium approach (BYPRPA)
Estimate cost of equity based on the fundamental tenet in financial

theory:
The cost of capital of riskier cash flows is higher than that of less
riskier cash flows.
We sum the before-tax cost of debt, rd , and a risk premium that

captures the additional yield on a company's stock relative to its bonds.
re = rd + Risk premium
Note: Risk premium Equity risk premium

≠
(re − rd ) (re − RF = β(E(RM) - RF ))
Example 8: Using BYPRPA to estimate the cost of equity

Dexter's interest rate on long-term debt is 7.5%. Suppose the risk
premium is estimated to be 4%.
Estimate Dexter's cost of equity.
Answer: Dexter's estimated cost of equity = 7.5% + 4% = 11.5%
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[LOS 30.f] Explain and demonstrate beta estimation for public
companies, thinly traded public companies, and
nonpublic company
1. Overview on Beta
Beta is an estimate of the company’s systematic or market-related risk.
Beta estimation
For thinly traded and nonpublic

For public companies
companies
Slope of ordinary least square
Based on the betas of
regression line of a stock’s
peer/comparable companies
returns on the returns of the
that are publicly traded
market
Used as
A critical component of CAPM
A component of calculation of WACC
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[LOS 30.f] explain and demonstrate beta estimation for public
nonpublic company
2. Beta estimation for public companies
a. Raw/ Unadjusted beta
Raw/ Returns on the stock (dependent variable)

unadjusted
linear relationship
beta
estimation Returns on the market (independent variable)
Points of data The slope of

Return on the this line is
(x1;y1)… stock (y) used as an
Line representing estimate of
linear relationship beta
between returns
on the stock and
Return on the
returns on the
market (x)
market resulted
from ordinary least
square regression
method
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nonpublic company
a. Raw/ Unadjusted beta
The actual values of raw/unadjusted beta estimated are influenced by

several choices:
The length of the data period

The choice of the index used to
and the frequency of
represent the market portfolio
observations
• In US: S&P 500 Index and The most common choice is five
NYSE Composite years of monthly data, yielding
• In Japan: Nikkei 225 Index 60 observations.
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nonpublic company
b. Adjusted beta
Current beta Future beta
Raw/ Move toward

unadjusted 1.0 (*)
beta
Need adjustment to estimate

acccuarately a future beta
Adjusted “Raw”
2/3 1/3 1.0
beta beta
(*) Beta measures a security’s systematic risk relative to the movements in the
overall market → in the long term, the beta values fluctuate less due to more
diversification and growing in size → beta mean reversion
→ future beta move toward the mean value of 1.
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nonpublic company
Example 9: Adjustment of estimated beta

Betty Lau is an analyst trying to estimate the cost of equity for Singapore
Telecommunications Limited. She begins by running an ordinary least
squares regression to estimate the beta. Her estimated value is 0.4,
which she believes needs adjustment. What is the adjusted beta value
she should use in her analysis?
Answer:
Adjusted beta = (2/3) (0.4) + (1/3) (1.0) = 0.6
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nonpublic company
3. Beta estimation for thinly traded and nonpublic companies
We can estimate its beta based on the betas of

Beta
peers/comparable companies that are actively
estimation
traded.
It is NOT possible to run ordinary least squares regression

to estimate beta of thinly traded/nonpublic company
Because with thinly traded and nonpublic company:
Most recent
Share issue trades
transaction price
infrequently
may be stale
Not reflect
Beta is
underlying changes
understated
in value
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nonpublic company
Step 1:
Choose Peer/Comparable company
peer
company Publicly traded Similar business risk
This beta can be considered as:

Step 2: βEquity (peer company)
Estimate peer
company’s This beta can be estimated by using beta estimation
beta for public company in the previous section.
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nonpublic company
• 2 companies in the same industry will have the

same beta of asset – reflecting only systematic
Step 3: risk arising from fundamentals of industry.
Unlevered → Adjust peer company’s beta for its leverage and
peer tax rate to estimate the beta of assets
company’s • Beta of assets can be estimated as following:
beta to estimate 1
βAsset = βEquity (peer company) x
beta of asset 1+ 1−t D
E
In which:
D/E is peer company’s debt-to-equity ratio
t is peer company’s marginal tax rate
Why do we 2 companies in the same industry

must unlevered still have different beta due to
peer company’s different capital structure and
beta? level of financial leverage.
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nonpublic company
• Adjust beta of asset based on the financial

leverage and the marginal tax rate of target
company to reflect the capital structure of the
target companies.
Step 4:
• Beta of target company can be estimated as
Re-levered
following:
beta of D
asset to βEquity (target company) = βAsset x 1 + (1 – t)
E
estimate target
company’s beta In which:
D/E is target company’s debt-to-equity ratio
t is target company’s marginal tax rate
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nonpublic company
Example 10: Estimating the Adjusted Beta for a Nonpublic Company

Raffi Azadian wants to determine the cost of equity for Elucida
Oncology, a privately held company. Raffi realizes that he needs to
estimate Elucida’s beta before he can proceed. He determines that
Merck & Co. is an appropriate publicly traded peer company. Merck has
a beta of 0.7, it is 40% funded by debt and its marginal tax rate is 21%. If
Elucida is only 10% funded by debt and its marginal tax rate is also 21%,
what is Elucida’s beta?
Answer:
Step 1: Choose peer company
Peer company is Merck & Co per question.
Step 2: Estimate peer company’s beta

Merck has a beta of 0.7.
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nonpublic company
Answer: (continued)
Step 3: Unlevered peer company’s beta to estimate beta of asset
Since Merck is 40% funded by debt, it is 60% funded by equity
→ Merck’s D/E = 4/6
1 1
βAsset = βEquity (Merck Co.) x = 0.7 x 4 = 0.46
1+ 1−t D
E 1+ 1−0.21
6
Step 4: Re-levered beta of asset to estimate target company’s beta

Re-lever the asset beta using Elucida’s tax rate and capital structure.
Since Elucida is only 10% funded by debt → It is funded 90% by equity
→ Elucida’s D/E = 1/9
D 1
βEquity (Elucida) = βAsset x 1 + (1 – t) = 0.46 x 1 + (1 – 0.21) = 0.50
E 9
223

TOPICS
[LOS 30.g] Explain and demonstrate the correct treatment of
flotation cost
1. Overview on flotation cost
Flotation costs are the fees charged by investment bankers when a

company raises external equity capital.
Flotation costs can be substantial and often amount to between 2% and

7% of the total amount of equity capital raised, depending on the type
of offering.
2% - 7%
Equity capital raises
Flotation cost
224

TOPICS
flotation cost
2. Treatment of flotation cost
There are 2 views on treatment of flotation cost
a. Treatment 1 b. Treatment 2
Incorporate flotation costs Incorporate into the valuation

directly into the cost of capital analysis as an additional cost
Increase the cost of external

Increase initial project cost
equity
Not preferred to use Preferred to use

225

TOPICS
flotation cost
a. Treatment 1
We incorporate flotation costs directly

into the cost of capital → increasing the cost of external equity
Flotation cost specified in Flotation cost specified in
monetary terms as an monetary terms as a
amount per share percentage of the share price
Cost of equity with treatment of Cost of equity with treatment of

flotation cost flotation cost
D1 D1
re = +g re = +g
P0−F P0 x (1 − f)
re is cost of equity F is monetary per share flotation

D1 is dividend expected at the cost
end of Period 1 f is flotation cost as % of issue share
P0 is current stock price g is the growth rate
226

TOPICS
flotation cost
b. Treatment 2
Flotation costs are a cash outflow that occurs at the initiation of a

project and affect the project NPV by increasing the initial cash outflow
Example 11: Treatment for flotation cost

Omni Corporation is considering a project that requires a $400,000 cash
outlay and is expected to produce cash lows of $150,000 per year for the
next four years. Omni’s tax rate is 35%, and the before-tax cost of debt is
6.5%. The current share price for Omni’s stock is $36 per share, and the
expected dividend next year is $2 per share. Omni’s expected growth
rate is 5%. Assume that Omni finances the project with 50% debt and
50% equity capital and that flotation costs for equity are 4.5%. The
appropriate discount rate for the project is the WACC.
Calculate the NPV of the project using the 2 treatments of flotation costs
and discuss how the result of this method differs from the result
obtained from these treatments of flotation costs.
227

TOPICS
flotation cost
Answer:
Flotation cost = $200,000 × 0.045 = $9,000
Treatment 1 Treatment 2
(1) After-tax cost of debt (1) After-tax cost of debt

= before-tax cost of debt (1 – t) = before-tax cost of debt (1 – t)
= 6.5% (1 – 0.35) = 4.23% = 6.5% (1 – 0.35) = 4.23%
Flotation costs are 4.5% and Flotation costs are 4.5%
incorporated diirectly into cost of and not incorporated into cost of
capital, therefore: capital, therefore:
(2) Cost of equity (2) Cost of equity
D1 D
= re = +g = re = 1 + g
P0 x (1 − f) P0
$2 $2
= + 0.05 = + 0.05
$36 (1 − 0.045) $36
= 10.82% = 10.55%
228

TOPICS
flotation cost
Answer: (continued)
Treatment 1 Treatment 2
(3) WACC (k) = Wd rd + We re (3) WACC (k) = Wd rd + We re

= 0.50 (0.0423) + 0.05 (0.1082) = 0.50 (0.0423) + 0.05 (0.1055)
= 7.39%
= 7.53%
(4) NPV = (4) NPV = CF0 − Flotation costs
CF1 CF2 CF3 CF4 CF1 CF2 CF3 CF4
CF0+ + + + + + + +
(1+k)1 (1+k)2 (1+k)3 (1+k)4 (1+k)1 (1+k)2 (1+k)3 (1+k)4
$150,000 $150,000 $150,000
= −$400,000 + + = −$400,000 − $9,000 +
1.0753 1.0753 2 1.0739
$150,000 $150,000 $150,000
$150,000 $150,000 + + +
+ + 1.0739 2 1.0739 3 1.0739 4
1.0753 3 1.0753 4
= $94,640
= $102,061
229

TOPICS
flotation cost
Answer: (continued)
Discussion:
1. Using these 2 treatments results in different assessments of value:
Compare with treatment 2:
• The cost of equity in treatment 1 would have increased from 10.55%
(treatment 2) to 10.82% (treatment 1) → increase the WACC from
7.39% (treatment 2) to 7.53% (treatment 1)
• NPV of treatment 1 is higher than NPV in treatment 2
2. Adjusting the flotation cost from the initial cash outflow (treatment 2)
is the correct approach because it provides the most accurate
assessment of the project’s value once all cash costs, and their timing,
are considered.
230
READING 31: CAPITAL STRUCTURE

231
Learning outcomes
31.a. Describe how a company’s capital structure may change over its
life cycle
31.b. Explain the Modigliani–Miller propositions regarding capital

structure.
31.c. Describe the use of target capital structure in estimating WACC,

and calculate and interpret target capital structure weights
31.d. Explain factors affecting capital structure decisions
31.e. Describe competing stakeholder interests in capital structure

decisions.
232
Introduction
Capital structure: A company’s capital structure refers to how it has

financed its assets and operations.
This reading reviews some of the key factors affecting capital structure,
including the following:
Company life Companies typically evolve over time from cash consumers to
cycle cash generators, with decreasing business risk and increasing
debt capacity. (Refer to los 31.a)
Cost of capital Company management determines an optimal capital structure

to minimize the company’s weighted average cost of capital
(WACC). (Refer to los 31.b, c)
Financing Company management may consider several factors in capital

considerations structure decisions and the use of leverage. (Refer to los 31.d)
Competing In seeking to maximize shareholder value, company

stakeholder management may make capital structure decisions that are not
interests in the interests of other stakeholders, such as debtholders,
suppliers, customers, or employees. (Refer to los 31.e)
233

[LOS 31.a] Describe how a company’s capital structure may
change over its life cycle
1. Overview of Capital structure and company life cycle
+ Revenue
Cashflow
0
Time
-
Stage in life cycle Start-up (a) Growth (b) Mature (c)
Financial management
Revenue growth Beginning Rising Slowing
Cash flow Negative Improving Positive/Predictable
Business risk High Medium Low
Debt capital/leverage
Availability Very limited Limited/improving High
Cost High Medium Low
Typical cases N/A Secured Unsecured
Typical % of capital Close to 0% 0%–20% 20% +
structure
234

2. Capital structure during company life cycle
a. Start-up stage
Business characteristics:
• Sales are just beginning and operating earnings and cash flows tend to be
low or negative.
• Business risk is relatively high.
• Assets, both accounts receivable and fixed assets, typically are low and
therefore not available as collateral for debt.
• Company debt is quite risky and require high interest rates.
Capital structure characteristics:

Start-up companies are financed almost exclusively with equity.
235

b. Growth stage
• Revenue and cash flow are rising and business risk is reduced.
• Debt financing cost is reduced and investors may be willing to lend to the
company, often with the loans secured by fixed assets or accounts
receivable.
• There may be assets that can be used to secure debt, such as receivables,
inventory, or fixed assets.

Depending on the company, debt issuance may be as much as 20% of the
firm’s capital structure (and secured debts are the typical cases).
236

c. Mature stage
• Revenue growth is slowing.
• Cash flow is significant and relatively stable, business risk is much lower.
• Debt financing is widely available at relatively low cost.

• Firms issue debt, both secured and unsecured, in amounts in excess of
20% of a firm’s capital structure and sometimes significantly more than
that.
• Over time, as the equity value of a mature company grows, the debt
proportion will fall.
• Some companies may repurchase their debt, reducing its proportion in
the capital structure (deleveraging) in addition to paying significant cash
dividends.
237

d. Unique situations (exceptions)
Capital Intensive Businesses with Marketable Assets
Example: real estate, utilities, shipping, airlines,…

The underlying assets can be bought and sold fairly easily, tend to retain
their value
→ These assets can secure for substantial debt
→ Can use high level of debt.
Capital structure characteristics: These businesses use high levels of

leverage regardless of their development stage.
238

d. Unique situations (exception)
Cyclical Industries
Example: mining, materials,…

Revenues and cash flows vary widely through the economic cycle.
→ Debt capacity is limited
→ Use low level of debt.
Capital structure characteristics: Theses business use less leverage.
“Capital-Light” Businesses
Example: software-based technology businesses

Business characteristics: These companies have minimal fixed investments or
working capital needs → Have little debt in their capital structures
• Capital structure characteristics: They tend to have little debt in their capital
structures and in many cases have substantial net cash
239

[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
1. Modigliani–Miller assumptions
In 1958, Nobel laureates Franco Modigliani and Merton Miller (we will refer
to them as MM) published their seminal work on capital structure theory.
Modigliani and Miller (MM) used simplifying assumptions to show the
irrelevance of capital structure to firm value.
With no tax, Modigliani–Miller assumptions are:
1. Perfect capital markets: No transaction costs, no taxes, no bankruptcy

costs. Everyone has the same information.
2. Investors have homogeneous expectations: Investors agree on a given

investment’s expected cash flows
3. Risk-free rate: Investors can borrow and lend at the risk-free rate.
4. No agency costs: Managers always act to maximize shareholder wealth.
5. Independent decisions: Operating income is independent of how the firm

is financed
240

2. MM Proposition I (No Taxes): Capital Structure Irrelevance
MM Proposition I without taxes: The market value of a company is not

affected by the capital structure of the company.
Illustrative example for MM position I

Let’s begin by imagining a company’s capital structure as a pie, with each
slice of the pie representing a specific type of capital (e.g., common equity or
debt) and the size of the pie representing the company’s total value. We can
slice the pie in any number of ways, yet the total size remains the same
40% 40%
60% 60%
Common equity
Debt
241


Explanation: Arbitrage appoach
Assume that Unlevered company’s value is higher than levered company’s
value.
Unlevered company Levered company
100% equity > 70% equity, 30% debt
Sell overvalued Buy undervalued

Proceeds
Investor
share share
Arbitrage profit
 Unlevered company’s value and  levered company’s value
Unlevered company = Levered company

Forcing values to become equal
242


Explanation: The market value of a company appoach
Conclusion, the value of the levered company (VL) is equal to the value of
the unlevered company (Vu ),
Vu = VL
The value of the company

Operating earnings are not effected
= PV of operating earnings
by financing decisions
with a discount rate that depends on
(Assumption 5)
the weighted average cost of capital
Weighted average cost of capital (WACC) is unaffected by capital structure
Note: This proposition holds only under the restrictive assumptions of

Modigliani and Miller.
243


Results of MM Proposition I :
• Managers cannot create firm value simply by changing the company’s
capital structure
• The value of a company is determined solely by its cash flows, not by its
relative reliance on debt and equity capital.
Under this formula: The value of the company = PV of operating earnings

Where oprerating earnings are separated into the cash flows to debtholders
and equityholders. So we have an extended formula:
Suppose that:
• D is the PV of cash flows to debtholders,
• E is the PV of cash flows to equityholders
PV of operating earnings = PV of CF to debtholders + PV of CF to
equityholders = D + E
(note: D discounted by cost of debt, E discounted by cost of equity)
244

3. MM Proposition II (No Taxes): Cost of Equity and Leverage
MM Proposition II without taxes: The cost of equity is a linear function

(Y = a + bX) of the company’s debt-to-equity ratio.
Cost of equity linear function:

D
re = r0 + (r0 − rd )
E
Where:
• re (Y) is the cost of equity
• r0 (a) is the cost of capital for a company financed only with equity
• rd is the cost of debt ((r0 − rd ) represents for b)
D
• (X) is D/E ratio, that reflects the proportion of debt and equity in
E
capital structure.
re
D
re = r0 + (r0 − rd )
E
r0
D/E
245

MM Proposition II without taxes: The cost of equity is a linear function of

the company’s debt-to-equity ratio.
Demonstration:
(1) According to MM Proposition I, Weighted average cost of capital (WACC)
is unaffected by capital structure.
WACC = constant = r0
(2) M&M also give theory on the assumption that:
• There is no financial distress and agency costs
• Ability to borrow and lend at the risk-free rate
 rd = constant
(3) To understand the M&M view, we go back with WACC formula:
E.re + D.rd (1 − t)
WACC =
E+D
In M&M view without tax, we ignore the impact of tax, so t = 0
246


Demonstration:
• Buiding cost of equity linear function:
From (3), we have:
E.re + D.rd
WACC = = r0 [from (1)]
E+D
D D
⇒ r0 = ( )r +( )r
E+D d E+D e
r (E + D) − D.rd
⇒ re = 0
E
D
 Linear function: re = r0 + (r0 − rd )
E
What is the trend of re when company use more leverage?

247


What is the trend of re when company use more leverage?

D E
From (3): WACC = ( )r + ( )r
D+E d E+D e
E E
⇒ WACC = (1 − )r + ( )r
E+D d E+D e
E
⇒ WACC= rd + r − rd
E+D e
E
⇒ WACC − rd = r −r
E+D e d
As in case of liquidation, the shareholders of the company would face higher
risk of not recovering their investment, re > rd .
 WACC − rd > 0
 WACC > rd
From (1) with WACC = r0  r0 > rd
Conclusion: re will increase as D/E increase (higher gearing)
248

4. Conclusion for MM Proposition without taxes
MM Proposition without taxes:

I. The market value of a company is not affected by the capital structure of
the company.
II. The cost of equity is a linear function of the company’s debt-to-equity
ratio.
The proportions of debt versus equity in the firm’s capital structure do not
affect the firm’s overall cost of capital or the value of the firm
Cost of D
re = r0 + (r0 − rd )
capital E
E.re + D.rd (1 − t)
r0 WACC =
E+D
rd rd =constant
Gearing D/E
249

Example:
Unlevered capital structure
Leverkin Company, which currently has an all-equity capital structure.
Leverkin has expected annual cash flows to equityholders (which we denote
as “CFe”) of $5,000 and a cost of equity, which is also its WACC, of 10%.
For simplicity, we assume that all cash flows are perpetual. Therefore,
Leverkin’s value is equal to
CFe $5,000
V= = = $50,000
WACC 10%
Levered capital structure
Now suppose that Leverkin plans to issue $15,000 in debt at a cost of 5%
and use the proceeds to buy back $15,000 worth of its equity.
Under MM Proposition I, VL = VU, so the value of Leverkin must remain the
same at $50,000. Under MM Proposition II, the cost of Leverkin’s equity
when it has $15,000 debt and $35,000 equity is
$15,000
re = 10% + 10% − 5% ≈ 12.143%
$35,000
250

Example:
Levered capital structure (cont.)
Furthermore, the value of Leverkin must equal the sum of the present value
of cash flows to debtholders and equityholders. With $15,000 debt at a cost
of 5%, Leverkin makes annual interest payments of $750 to debtholders,
leaving $5,000 − $750 = $4,250 for equityholders. Therefore, the total value
of the company is:
$750 $4,250
V=D+E= + = $15,000 + $34,999.59 ≈ $50,000
5% 12.143%
The more debt the company uses, the greater the cost of equity, but the
total value of the company does not change and neither does the weighted
average cost of capital.
With its new capital structure, the company’s WACC remains at 10%:
$15,000 $35,000
WACC = 5%+ 12.143%=10%
$50,000 $50,000
251

Example:
We can summarize the impact of change in capital structure as the
following graph:
Cost of capital D
re = 10% + 5%
E
12.143%
10% WACC
rd = 5%
0 $15,000 Gearing D/E

$35,000
252

5. MM Propositions with Taxes
Now let’s explore what happens when we take a more realistic assumption,
that of corporate taxes.
Under the tax code of most countries:

• Interest payments → tax deductible
• Dividends paid to equity holders → not tax deductible
Debt provides a tax shield that adds value to the company

After-tax cost of debt = Before-tax cost of debt × (1 − Marginal tax rate).
253

MM Proposition I with corporate taxes: The market value of a levered company

is equal to the value of an unlevered company plus the value of the debt tax
shield.
Illustration for MM Propositions with Taxes

To continue our analogy of a pie, with the introduction of taxes, the government
gets a slice of the pie. When debt financing is used, the government’s slice of the
pie is smaller, so that the amount of pie available to debt and equity holders is
greater.
No leverage With leverage

Value available to
shareholders and
debtholders
Value owned by
government
Debt tax shield
The slide taken by the government ↓

→ the amount of pie available to debt and equity holders ↑
254

MM Proposition I with corporate taxes:

The market value of a levered company is equal to the value of an
unlevered company plus the value of the debt tax shield.
Company’s value equation:

VL = VU + tD
Where:
• VL is the value of the levered company
• VU is the value of the unlevered company
• t is the marginal tax rate
• tD is the debt tax shield
Demonstration for this proposition is presented in [Additional reading]

Demonstration for MM Proposition with tax, session 1
255

MM Proposition II with corporate taxes: The cost of equity is a linear

function (Y = a + bX) of the company’s debt-to-equity ratio with an
adjustment for the tax rate.
Cost of equity linear function:

D
re = r0 + (r0 − rd )(1 − t)
E
Where:
• re (Y) is the cost of equity,
• r0 (a) is the cost of capital for a company financed only with equity
• rd is the cost of debt
• t is the marginal tax ((r0 − rd )(1 − t) represents for b)
D
• (X) is D/E ratio, that reflects the proportion of debt and equity in
E
capital structure.

Demonstration for MM Proposition with tax, session a
256

MM Proposition with corporate taxes:

I. The market value of a levered company is equal to the value of an
unlevered company plus the value of the debt tax shield.
II. The cost of equity is a linear function (Y = a + bX) of the company’s debt-
to-equity ratio with an adjustment for the tax rate.
D
re = r0 + 0 (r0 − rd )(1 − t)
E0
When t is not zero, the term (1 − t) is less than 1 and serves to reduce the
cost of levered equity (re )
The cost of equity rises as the company increases the amount of debt in its
capital structure, but it rises at a slower rate than in the no-tax case
The increase in re does not offset the benefit of the cheaper debt finance
and therefore the WACC falls.
257

Continued from the previous slide.

The WACC decreases when the company raise the debt proportion in capital
structure, and moves toward rd (1-t)
D
Cost of re = r0 + (r0 − rd )(1 − t)
E
capital
r0 E.re + D.rd (1 − t)
WACC =
E+D
rd (1−t)
rd (1−t) = constant
Gearing D/E

Demonstration for MM Proposition with tax, session b
258

Additional reading:
a. Demonstration for MM I with taxes
Debtholders receive: rd .D
Shareholders in a levered firm receive: (EBIT − rd D)(1-t)
 The total cash flow to allstakeholders is: (EBIT − rd D)(1-t) + rd .D
The present value of this stream of cash flows is VL
VL = PV of ((EBIT − rd D)(1-t) + rd D) = PV of (EBIT 1 −t +rd .D.t)
Note that, PV of EBIT(1-t) is VU , PV of rd .D.t is tD  VL = VU + tD
259

Additional reading:
b. Demonstration for MM II with taxes
Similar to MM Proposition II without taxes, but t is not zero, the term (1 − t)

is less than 1 and serves to reduce the cost of levered equity.
Let start with this scenario for a firm with both debt and equity and a life of
1 year:
• Value of the firm today: V0 = E0 + D0
• Value of the firm after 1 year: V1 = E1 + D1
• Value of a similar unlevered firm today: V0U
• Value of a similar unlevered firm today: V1U
• Proportion of equity in the capital structure: E
• Proportion of debt in the capital structure: D
• Cash flow distributed to both debt and equity holders in period 1: X1
When there are no intermediate payments:
E1 = E0 (1 + re )
D1 = D0 (1 + rd )
260

Additional reading:
b. Demonstration for MM II with taxes (cont)
From MM position I with corporate taxes, we have

V1 = V1U + tD1
Furthermore:
• V1 = E1 + D1 = E0 (1 + re ) + D0 (1 + rd );
• V1U = (1 + r0 )V0U; (with r0 is cost of capital for a unlevered company),
• D1 = D0 (1 + rd )
Thus, (1 + r0 )V0U + D0 (1 + rd )t = E0 (1 + re ) + D0 (1 + rd )
⇒ E0(1 + re ) = (1 + r0)V0U - D0 (1 + rd )(1 – t)
V D
⇒ (1 + re ) = (1 + r0 ) 0U − (1 + rd )(1 – t) 0
E0 E0
With V0 = V0U + tD0
V − tD0 D
⇒ (1 + re ) = (1 + r0 ) 0 − (1 + rd )(1 – t) 0
E0 E0
E0 + D0 − tD0 D
Since V0 = E0 + D0 ⇒ (1 + re ) = (1 + r0 ) − (1 + rd )(1 – t) 0
E0 E0
261

Additional reading:
b. Demonstration for MM II with taxes (cont)
Demonstration:
E + (1 − t)D0 D
⇒ (1 + re ) = (1 + r0 ) 0 − (1 + rd )(1 – t) 0
E0 E0
D0 D
⇒ (1 + re ) = (1 + r0 )+(1 + r0 )(1 − t) − (1 + rd )(1 – t) 0
E0 E0
D0
⇒ (1 + re ) = (1 + r0 )+(1 + r0 − 1 − rd )(1 − t)
E0
D0
⇒ re = r0 + (r0 − rd )(1 − t)
E0
262

Example:
Let us return to the example of the Leverkin Company. Recall that annual
cash flows to equityholders are $5,000 and the WACC is 10%. As before,
Leverkin is planning to issue $15,000 of 5% debt in order to buy back an
equivalent amount of equity. Now, however, assume that Leverkin pays
corporate taxes at a rate of 25%.
Since the company does not currently have debt, the after-tax cash flows
are $5,000(1 – 0.25) or $3,750.
Because the cash flows are assumed to be perpetual, the value of the
company at 10% is $37,500, considerably less than it was when there were
no taxes. Now suppose Leverkin issues $15,000 of debt and uses the
proceeds to repurchase common stock.
According to MM Proposition I with corporate taxes, the value of the
company is:
VL = VU + tD = $37,500 + 0.25($15,000) = $41,250
263

Example:
Since the value of the debt is $15,000, the value of the equity (after the
buyback) must be ($41,250 − $15,000) = $26,250. According to MM
Proposition II with corporate taxes, the cost of the levered equity is:
D $15,000
re = r0 + (r0 − rd )(1 − t) = 10% + (10% −5%)(1 − 25%) = 12.143%
E $26,250
Note that the value of the company must also equal the present value of
cash flows to debt and to equity:
re D (CFe − rd D)(1 − t) $750 ($5,000 − $750)(1 − 25%)
VL = D + E = + = +
rd re 0.05 12.143%
≈ $41,250
which is the same result that we got from MM Proposition I with corporate
taxes. As a further check, using Equation 5, the WACC for the levered
Leverkin is:
$15,000 $35,000
WACC = 5%(1 − 25%) + 12.143%
41,250 $41,250
= 9.091% < 10% (unlevered WACC )
The result confirms that the WACC would fall as we use leverage in our
capital structure.
264

6. Costs of Financial Distress
One type of cost that can be expected to increase at higher levels of debt
financing is costs of financial distress.
Operating and financial leverage Put companies into financial

may magnify losses distress
Financial distress refers to the heightened uncertainty regarding a

company’s ability to meet its various obligations because of diminished
earnings power or actual current losses
Costs of financial distress are the increased costs a company faces when
earnings decline to the point where the firm has trouble paying its fixed
financing costs (interest on debt).
265

The expected costs of financial distress have two components:
Expected cost = Cost of financial distress (a) x probability of financial distress (b)
a. Costs of financial distress and bankruptcy
Direct costs Indirect costs
Include costs arising during periods in

which the company is near or in
bankruptcy:
• forgone investment
Include actual cash expenses
opportunities
associated with the bankruptcy
• reputational risk
process:
• impaired ability to conduct
• legal fees
business
• administrative fees
• costs arising from conflicts of
interest between managers and
debtholders (agency costs of
debt)
266

b. Probability of financial distress
Probability of financial distress is related to the firm’s use of operating and

financial leverage.
The probability of financial distress and bankruptcy increases when:

• There is a greater amount of debt in the capital structure
• There is a greater amount of business risk
• Fewer reserves available to delay bankruptcy
Other factors:
• The company’s corporate governance structure
• The quality of the management team.
Conclusion: Higher expected costs of financial distress tend to discourage

companies from using large proportions of debt in their capital structures
267

[LOS 31.c] describe the use of target capital structure in
estimating WACC, and calculate and interpret target capital
structure weights
1. Static Trade-Off Theory
We consider only the tax shield provided by debt and the costs of financial
distress. As a result, we can write the value of a leveraged company as
VL = VU + tD − PV of costs of financial distress
The static trade-off theory seeks to balance the costs of financial distress
with the tax shield benefits from using debt
Value of the tax shield from

additional borrowing > The value reduction of higher
expected costs of financial distress
This point represents the optimal capital structure for a firm, where the WACC
is minimized and the value of the firm is maximized.
Note: each firm’s optimal capital structure depends on its business risk
(operating risk and sales risk), tax rate, corporate governance, industry
influences, and other factors.
268

structure weights
Static Trade-Off Theory: Cost of Capital vs. Capital Structure
Value of
levered firm
Firm value Cost of financial
Maximum firm distress
value Value of Levered Firm
PV of tax shield with Financial Distress
Value of
Unlevered Firm
Optimal capital Gearing D/E

stucture
Balancing the expected costs from financial distress

against the tax benefts of debt service payments
269

structure weights
Static Trade-Off Theory: Firm Value vs. Capital Structure
The proportion of debt in a

business rises
Cost of re
capital
The costs of both debt - rd
and equity - re
WACC are likely to rise
rd (1−t) The cost increases brought

about by leverage reduce or
even negate the cost savings
Optimal capital Gearing D/E caused by tax shield
stucture
The result is a U-shaped

weighted average cost of capital
curve
270

structure weights
2. Application of Static trade-off theory in capital management
Company may adopt its optimal capital structure as Target capital structure
A company’s capital structure at any point in time may differ from the target
due to:
• Management may exploit short-term opportunities in one or another
financing source
• Market-value fluctuations continuously affect the company’s capital
structure
Note: Target capital structure may be impractical (due to market conditions

making it inadvisable to raise capital) and expensive (because of flotation
costs) for a company to continuously maintain its target structure.
271

structure weights
2. Determine what WACC weights to use
Ideally, we want to use the proportion of each source of capital that the
company would use in the project or company
Know the company’s target Use target capital structure for

capital structure analysis
Do not know the target capital Must estimate target capital

structure structure
1. Assume the company’s current capital structure, at market value weights

for the components, represents the company’s target capital structure.
2. Examine trends in the company’s capital structure or statements by
management regarding capital structure policy to infer the target capital
structure.
3. Use averages of comparable companies’ capital structures as the target
capital structure.
272

structure weights
2. Determine what WACC weights to use
Calculating proportions of each sources in capital structure
Example: suppose a company has the following market values for its capital:
Bonds outstanding $5 million

Preferred stock $1 million
Common stock $14 million
Total capital $20 million
The weights that we apply would be as follows:
Weights
Bonds outstanding $5 million 25%
Preferred stock $1 million 5%
Common stock $20 million 70%
273
[LOS 31.d] Explain factors affecting capital structure decisions
In this LOS, we will look at 04 practical considerations that affect capital

structure and the use of leverage by management.
Capital structure
policies and
targets (1)
Market Capital
conditions (3) Capital structure investment
financing (2)
Asymmetric
information (4)
274
1. Capital Structure Policies and Target Capital Structures
Company
Establish capital structure policy
Use rating agency thresholds as “margin of safety,” to ensure

that the debt limits are not breached (mentioned in session a)
Define reasonable limits for borrowing
Determine target capital structure

(mentioned in session b)
275
a. Debt Ratings
Definition: Debt ratings are independent, third-party measures of the

quality and safety of a company’s debt based upon an analysis of the
company’s ability to pay the promised cash flows.
Implication:
Debt ratings reflects a company’s level of leverage as well as financial risks
→ Debt ratings are an important consideration in the practical management
of leverage, and maintaining the company’s rating at a certain level may
also be an explicit policy target for management.
For example: A company might target an S&P debt rating of A or higher.
When debt rating drops When debt rating rises
Significantly higher borrowing Lower borrowing costs, greater

costs borrowing flexibility and better
terms
276

b. Market value vs book value in targeting capital structure
While optimal capital structure is calculated using the market value of equity
and debt, company capital structure targets often use book value instead for the
following reasons:
1. Market values can fluctuate substantially and seldom impact the appropriate
level of borrowing.
2. For management, the primary concern is the amount and types of capital
invested by the company.
Book value reflects the amount of Market value only reflects the price
capital that is actually used by the that shares of capital are traded on
≠
company to finance for its the market, thus are affected by
investments. invester’s expectation of return.
3. Capital structure policy ensures management’s ability to borrow easily

and at low cost. (Because lenders, debt investors, and rating agencies
generally focus on the book value of debt and equity for their calculation
measures.)
277

2. Financing Capital Investments
Firms often match their debt issuance to their capital investments.
1. Observe the nature of the investment
If the nature of the investment is suited to leverage

The assets acquired will generate significant cash flow that can be
used to reduce the debt over time.
Use leverage (issue debt) to finance the investment.
2. Match the cash flows and maturity structure of the assets and debt.
Asset liability misalignment increases the risk of default and cost
of capital for companies:
• A company financing long-term assets with short-term obligations faces
rollover risk, which may threaten profitability if short-term financing
costs go up over the financing period.
• A company financing short-term assets with long-term financing beyond
the term needed faces the risk that the company overpays in financing
cost.
278

3. Market conditions
Market conditions:
• Macro-economics
• Country’s specific factors
• Credit market conditions
Cost of debt
Company’s capital structure
Market conditions Borrowing Borrowing

becomes less becomes more
costly if costly if
Interest rates and Inflation rates Low High
Business & credit cycle Expansionary stage Contractionary
stage
Banking systems and capital markets Developed Underdeveloped
Currencies Strong Weak
Legal system Lender-friendly Not lender-friendly
Market development Developed Emerging
279
4. Information Asymmetries and Signaling
Asymmetric information
Asymmetric information (an unequal distribution of information) arises

from the fact that managers have more information about a company’s
performance and prospects (including future investment opportunities)
than do outsiders, such as owners and creditors.
Information that managers

own
Information that stakeholders
own
Firms with complex products or little transparency in financial statements

tend to have higher costs of asymmetric information.
280

Asymmetric information
Shareholders and Investors often closely watch manager

creditors are aware that behavior for insight into insider opinions
asymmetric information on the company’s prospects, for
problems exists. example:
• Issuing equity is typically viewed as a
negative signal that managers believe
Managers consider how a firm’s stock is overvalued
their actions might be • Taking on the commitment to make
interpreted by outsiders. fixed payments sends a signal that
management is confident in the firms’
prospects
A hierarchy to managers’
selection of methods for
financing – pecking order
theory (next slide)
281

Pecking order theory
The theory suggests that managers choose methods of financing according

to a hierarchy that gives first preference to methods with the least
potential information content * (internally generated funds) and lowest
preference to the form with the greatest potential information content
(public equity offerings).
Level of potential
information content * Information content: It is the
amount of information conveyed
Internal financing through an action taken by the
managers.
Debt For example, financing by internal
funds hardly gives out any signal to
Equity the market, so the information
content of this action is low.
Prefencces of
managers
282

Pecking order theory
Example: The choice of financing

Level of potential
information
content
Internal financing comes directly from the company and
Internal
minimizes the amount of information that the stakeholders are
financing
exposed to.
Stakeholders, especially debtholders would the debt issue as a

“signal” about the performance of the company and a lot of
Debt
question would be raised about the potentiality, solvency,
uncertainty related to the company
With common shares, the uncertainty that the investors face

becomes larger, so shareholders and also the public is
Equity concerned over the (pessimistic) future of the company,
whether the company is struggling with financing by cheaper
sources, or whether the shares are now over valued.
Prefencces of managers
283

Definition of agency costs of equity

• Agency costs are the incremental costs arising from conflicts of interest
when an agent makes decisions for a principal.
• In the context of a corporation, agency costs arise from conflicts of
interest between managers, shareholders, and bondholders.
Analysing the origin of agency costs
The stake managers have ↓
Their share in bearing the cost of excessive perquisite consumption ↓
Their desire to give their best efforts in running the company ↓
Agency cost ↑
“Perquisite consumption” refers to items that executives may legally authorize for
themselves that have a cost to shareholders, such as subsidized dining, a corporate jet
fleet, and chauffeured limousines.
284

Components of agency costs of equity

Managers Stakeholders
The agency costs of equity
Monitoring costs Bonding costs Residual losses
• supervising management • assuring shareholders • incur when bonding

reporting to shareholders that the managers are provisions do not provide
• paying the board of working in the a perfect guarantee
directors. shareholders’ best
interest
Effect of leverage on agency costs
Financial leverage of a company ↑
Freedom for managers to either take on more debt or unwisely spend cash ↓
Agency cost ↓
285

[LOS 31.e] Describe competing stakeholder interests in capital
structure decisions
1. Impacts of capital structures on stakeholders
Impact of leverage on stakeholders
Higher financial leverage Benefits of increased leverage accrue

increases risk for all stakeholders. almost entirely to shareholders
All stakeholders Shareholders Other stakeholders
• Managers and shareholders might prefer decisions that increase the

company’s financial leverage, while debtholders and other stakeholders
in the company generally will not.
In the next slides, we will look at how company’s capital structure decisions
affect different groups of stakeholders.
286

structure decisions
We will look at how company’s capital structure decisions affect different

groups of stakeholders
Debt vs equity
Customers [6]
holders [2]
Common vs Suppliers [6]

preferred stock
holders [3] Capital
structure Employees [7]
Controlling vs decision
minority
shareholders [4] Managers and
directors [8]
Bank/ private
lenders vs public Regulators and
lenders [5] governments [9]
287

structure decisions
2. Debt vs. equity conflicts
Risk-return profile of equityholders and debtholders
Downside risk Mean Upside return

Equityholders
Debtholders
Both equityholders and Equity holders can make a profit equal

debtholders can lose 100% of their to multiple times of the investment,
investment, in case of default. unlimited as the share price increases
The profit of debtholders is limited to
a specified level, equal to the interest
or dividend paid
• Debtholders will almost always favor decisions that reduce a company’s

leverage and financial risk
• Common shareholders often prefer higher leverage levels that offer
them greater return potential.
• This conflict is greater for owners of long-term debt compared to short-
term debt, and greater for debts with lower seniority.
288

structure decisions
3. Preferred Stockholders
Risk-return profile of preferred stock holders and common stock holders
Downside risk Mean Upside return

Common stock holders
Preferred stock holders
Common stock holders can make a
Both type of equityholders can lose
profit (capital gain) equal to multiple
100% of their investment, in case
times of the investment, unlimited as
of default.
the share price increases
Holder of preferred stock are
entitled to receive a fixed amount of
dividends before dividends are paid
to common stock holder.
The conflict of interest between common stock holders and preferred stock
holders is similar to the conflict of interest between common stock holders
and debt holder.
289

structure decisions
4. Private Equity or Controlling Shareholders
Minority
shareholder
Controlling
shareholder
Graph of control over a public company

Some important specific circumstances in which conflicts of interest
happens:
• A controlling shareholder may pursue personal interests that will not
necessarily increase shareholder value
• A controlling shareholder may have a short-term focus if they intend to
sell their shares
• A controlling shareholder may oppose share issuance that would dilute
their holdings or lead to a loss of control.
290

structure decisions
5. Bank & Private Lenders versus public debt holder
Bank and Private Lenders Public debt holder
Information access Have access to nonpublic Only have access to

information public information
Terms flexibility Can more easily Can not restructure

restructure debt or adjust debts or adjust terms
terms if problems arise
Involved in companies’ Yes No

decision
Investment horizon Often hold to maturity Can usually sell that

debt if they believe the
company’s
The risk varies between Bank/private lenders and Public debt holder
291

structure decisions
6. Customers and Suppliers
Customers
Customers of specialized products have an interest in the financial health
and survival of firms that are their key suppliers, similar to the interest of
debt holder.
Suppliers
• Suppliers typically are short-term creditors of a firm and thus have an
interest in the firm’s continuing ability to meet its obligation.
• Some suppliers have invested time and capital in developing specialized
products for a firm and will lose significant revenue if that firm fails.
Exception: Suppliers for more commodity-like products typically have many

customers and less exposure to the financial problems of a single firm.
292

structure decisions
7. Employees
• Employees sometimes own the company’s common stock in retirement

accounts or employee stock ownership plans. For most employees, the
value of their employment with the company is much larger than their
stock ownership.
• Employees who have specialized skills, such that they would face
difficulties in finding alternative employment, have a stronger
preference for less financial and operational risk, compared with
employees that are more easily transferable.
293

structure decisions
8. Managers and Directors
• In practice, compensation is the principal tool used to create alignment

of interests between management and directors and shareholders.
Equity compensation can be a substantial portion of their total
compensation.
• However, the alignment of interests between managers and
shareholders is never perfect, some examples of misalignment is listed
below.
o The overall level of director or executive compensation can be
excessive → Avoidance of taking risk motivated by the desire to
keep one’s position, also called “entrenchment”.
o Where senior management compensation is high and tied to the
size of the business → Managers are motivated to pursue
acquisitions and expansion that might not increase shareholder
value, also called “growth for growth’s sake” or “empire building”.
o Optionholders participate only in upside share price moves
→ management stock options can motivate risk-taking behavior,
particularly with respect to capital structure decisions.
294

structure decisions
9. Regulators and Government
• Financial institutions must generally maintain certain levels of solvency

or capital adequacy, as defined by regulators.
• Utilities may have pricing determined based on allowable rates of
return, which depend on capital structure.
• Distressed companies may seek government support in order to remain
in business, and those governments, in turn, may require new equity
investments, block dividends, or otherwise constrain the company’s
financing decisions.
295
READING 32: MEASURES OF LEVERAGE

Learning outcomes
32.a. Define and explain leverage, business risk, sales risk, operating risk,
and financial risk and classify a risk
32.b. Calculate and interpret the degree of operating leverage, the

degree of financial leverage, and the degree of total leverage
32.c. Analyze the effect of financial leverage on a company’s net income

and return on equity
32.d. Calculate the breakeven and operating breakeven quantity of sales

and determine the company's net income at various sales levels
296

[LOS 32.a] Define and explain leverage, business risk, sales
risk, operating risk, and financial risk and classify a risk
Leverage refers to a company’s use of fixed costs in conducting business.
Operating leverage Financial leverage
The use of operating cost The use of financial cost

(eg: depreciation or rent) (eg: interest expense)
Magnify the effect of the Magnify the effect of the

changes in sales on operating changes in operating earnings
earnings on net income (or EPS)
Operating risk (2.1) Financial risk (2.2)
• Increase the volatility of a company’s earnings and cash flows

→ increase the risk borne by investors in the company
→ increase the discount rate that must be used to value the company
• A company that is highly leveraged risks significant losses during
economic downturns.
297

1. Effect of using leverage on the value of company
Cost of Affect Level of Affect Volatility of

structure 1 leverage 2 Net income
remain the same irrespective of the level of

Fixed cost
production and sales.
Variable cost vary with the level of production and sales.
Illustrate the effects of leverage on company value.
Company A ($) B ($)
Number of units produced and sold (1) 200,000 200,000
Sales price per unit (2) 20 20
Variable cost per unit (3) 7 14
Fixed operating cost (4) 1,000,000 200,000
Fixed financing expense (5) 800,000 200,000

298


Calculate the Net income of 2 companies
Comapny A ($) B ($)
Revenue = (1) × (2) 4,000,000 4,000,000
Operating costs = (1) × (3) + (4) 2,400,000 3,000,000
Operating income 1,600,000 1,000,000
Financing expense 800,000 200,000
Net income 800,000 800,000
These companies have the same net income, but are they identical in
terms of operating and financial characteristics? Would we appraise these
two companies at the same value?
Continue in the next slide
299


1 Cost structure of 2 companies affects the level of leverage.
Company A ($) B ($)
Variable cost = (1) × (3) 1,400,000 2,800,000
Total fixed cost = (4) + (5) 1,800,000 400,000
% Total fixed cost 56.25% 12.5%
Discussion:
Both companies earned a net income of $800,000 but have different cost
structure:
Company A has a higher proportion of fixed costs (56.25%) in its cost
structure → higher level of leverage.
→ resulting in differing volatility of net income.
300


2 Evaluate the impact of their different level of leverage on the volatility of Net income
If the number of units sold change 25% compared with the initial 200,000 units:
150,000 units sold 200,000 units sold 250,000 units sold
A ($) B ($) A ($) B ($) A ($) B ($)
Revenue 3,000,000 3,000,000 4,000,000 4,000,000 5,000,000 5,000,000
Operating 2,050,000 2,300,000 2,400,000 3,000,000 2,750,000 3,700,000

costs
Operating 950,000 700,000 1,600,000 1,000,000 2,250,000 1,300,000

income
Financing 800,000 200,000 800,000 200,000 800,000 200,000

expense
Net 150,000 500,000 800,000 800,000 1,450,000 1,100,000

income
% change −81% −38% 81% 38%

in NI
301

Discussion:
The dominance of fixed costs (both operating and financial) in company
A’s cost structure (higher leverage) results in higher earnings volatility. A
25% fluctuation in sales results in an 81% fluctuation in company A’s net
income, but only a 38% fluctuation in company B’s net income.
The higher level of leverage, the higher volatility in earnings of a

company → leverage has its rewards in terms of potentially greater
profit, but it can also increase loss → more risks arising (2).
302

2. Risk arises from using leverage
2.1. Business risk
Business risk refers to the risk associated with a company’s operating

earnings.
Business risk
(uncertainty in operating earnings)
Uncertainty in total revenue (*) Operating cost structure (**)
Sales risk Operating risk
(*) Revenue (prices and quantity of (**) The greater the fixed operating
sales) is affected by economic costs relative to variable operating
conditions, industry dynamics, costs → difficult to adjust its
government regulation, and operating costs to changes in sales
demographics. → the greater the operating risk.
Measured by degree of operating leverage (DOL) (LOS 32.b – 1)

303

2. Risk arises from using leverage
2.2. Financial risk
Financial risk
(uncertainty in net income)
Financial cost structure
The greater the proportion of debt in a firm’s capital structure → the

higher proportion of fixed financing cost → the greater the firm’s
financial risks.
Measured by degree of financial leverage (DFL) (LOS 32.b – 2)

304

[LOS 32.b] Calculate and interpret the degree of operating
leverage, the degree of financial leverage, and the degree of
total leverage
1. Degree of operating leverage
a. DOL formula
Degree of operating leverage (DOL) is a quantitative measure of the

sensitivity of changes in a company’s operating income (EBIT) to
changes in demand (refer to as the unit sales).
Percentage change in operating income (EBIT)

DOL =
Percentage change in units sold
Example 1: Degree of operating leverage (DOL)

100,000 units sold 110,000 units sold % change
Revenue $1,000,000 $1,100,000 +10%
Variable costs 200,000 220,000
Fixed costs 500,000 500,000
Operating income $300,000 $380,000 +26.67%
→ DOL = 26.67%/10% = 2.67

305

total leverage
a. DOL formula
Degree of operating leverage (DOL) can be expressed in terms of the

basic elements: the price per unit (P), variable cost per unit (AVC),
number of units sold (Q), and fixed operating costs (F)
Illustrate the degree of operating leverage (DOL) in term of P, Q, AVC, F

Operating income (EBIT) = Total revenue – Total operating cost
= P × Q – AVC × Q – F
Contribution margin
= Q × (P – AVC) – F
Per unit contribution margin - the amount that
each unit sold contributes to covering fixed costs
(Continue in the next slide)

306

total leverage
a. DOL formula
Illustrate the degree of operating leverage (DOL) in term of P, Q, AVC, F
Percentage change in operting income (EBIT) %∆EBIT

DOL = =
Percentage change in units sold %∆Q
∆EBIT × Q {[(∆Q + Q) × (P − AVC) − F] − Q × P − AVC − F } × Q

= =
EBIT× ∆Q Q × P − AVC − F × ∆Q
∆Q × (P −AVC) × Q
=
Q × P −AVC − F × ∆Q
Q × (P −AVC)
=
Q × P −AVC − F
Q × (P −AVC)
DOL =
Q × P −AVC − F
307

total leverage
a. DOL formula
Example 2: Degree of operating leverage (DOL) in term of P, Q, AVC, F
At 100,000 units sold
Number of units sold (Q) 100,000
Sales price per unit (P) 10
Variable cost per unit (AVC) 2
Fixed operating cost (F) 500,000
Answer
DOL = Q × (P – AVC) / [(Q × (P – AVC) –F]

= 100,000 × (10 – 2) / [100,000 × (10 – 2) – 500,000]
= 2.67
When the number of units sold increase by 1% → the operating income
will increase by 2.67%.
308

total leverage
b. DOL at different level of sales
Example 3: Degree of operating leverage (DOL) at different level of sales

The information about company’s operation as in Example 2, but the sale
level is 200,000 units sold instead of 100,000 units sold. Calculate the DOL at
200,000 units sold?
Answer:
At 200,000 units sold:

DOL = Q × (P – AVC) / [(Q × (P – AVC) – F]
= 200,000 × (10 – 2) / [200,000 × (10 – 2) – 500,000]
= 1.45
Compare with DOL at 100,000 units sold (2.67), DOL at 200,000 units sold is
lower (1.45)
• DOL is different at different levels of sales.

• The sensitivity of operating income to changes in units sold (DOL)
decreases at higher sales volumes (in units).
309

total leverage
c. DOL at different cost structure
Example 4: Degree of operating leverage (DOL) at different cost structure
A ($) B ($)
Number of units sold 100,000 100,000
Sales price per unit 10 10
Variable cost per unit 2 2
Fixed operating cost 500,000 100,000
DOL 2.67 1.14
Discussion: Company A has a higher proportion of fixed operating costs than

company B, so that company A has a higher DOL.
The higher the proportion of fixed operating costs in a company’s cost structure,
the more sensitive its operating income is (the higher DOL) to changes in units sold
→ the higher the company’s operating risk.
310

total leverage
2. Degree of financial leverage
a. DFL formula
Degree of financial leverage (DFL) is a quantitative measure of the

sensitivity of changes in a company’s net income (or EPS) to changes in
operating income.
Percentage change in net inome (EPS)

DFL =
Percentage change in operating income (EBIT)
Example 5: Degree of financial leverage (DFL)
% change
Operating income 1,600,000 1,920,000 +20%
Interest expense 800,000 800,000
Net income 800,000 1,120,000 +40%
→ DFL = 40%/20% = 2
311

total leverage
a. DFL formula
Degree of financial leverage (DFL) can be expressed in terms of the basic

elements: the price per unit (P), variable cost per unit (AVC), number of
units sold (Q), fixed operating costs (F) and fixed financial cost (C)
Illustrate the degree of financial leverage (DFL) in term of P, Q, AVC, F, C
• Operating income (EBIT) = Q × (P – AVC) – F (as explained in slide 11)

• Net income (EPS) = (EBIT – C) × (1 – t) (t is the tax rate)

DFL =
Percentage change in operting inome (EBIT)
%∆EPS
=
%∆EBIT
(Continue in the next slide)

312

total leverage
a. DFL formula
Illustrate the degree of operating leverage (DFL) in term of P, Q, AVC, F, C

Percentage change in net inome (EPS) %∆EPS
DFL = =
Percentage change in operting inome (EBIT) %∆EBIT
∆EPS EBIT
= ×
EPS ∆EBIT
(∆EBIT + EBIT − C) × (1 − t) − (EBIT − C) × (1 − t) EBIT

= ×
(EBIT – C) × (1 – t) ∆EBIT
∆EBIT × (1 − t) EBIT EBIT Q × (P −AVC) − F

= × = =
(EBIT – C) × (1 – t) ∆EBIT (EBIT – C) Q × P −AVC − F − C
→ the DFL is not affected by the tax rate
Q × (P −AVC) − F
DFL =
Q × P −AVC − F − C
313

total leverage
a. DFL formula
Example 6: Degree of financial leverage (DFL) in term of P, Q, AVC, F, C
Fixed operating cost (F) 1,000,000
Fixed financing expense (C) 800,000
Answer
DFL = [Q × (P – AVC) – F]/ [(Q × (P – AVC) – F – C]

= [200,000 × (20 – 7) – 1,000,000]/[200,000 × (20 – 7) – 1,000,000 –
800,000]
=2
314

total leverage
b. DFL at different level of fixed financial cost
Example 7: Degree of financial leverage (DFL) at different level of fixed financial

cost
A ($) B($)
Number of units sold (Q) 200,000 200,000
Sales price per unit (P) 20 20
Variable cost per unit (AVC) 7 7
Fixed operating cost (F) 1,000,000 1,000,000
Fixed financing expense (C) 800,000 1,200,000
DFL 2 4
Discussion: Company B has a higher proportion of fixed financial costs than
company A, so that company B has a higher DFL.
The higher the use of fixed financing sources by a company, the greater the
sensitivity of net income to changes in operating income (higher DFL)
→ the higher the financial risk of the company.
315

total leverage
3. Degree of total leverage
Degree of total leverage (DTL) is a quantitative measure of the

sensitivity of changes in a company’s net income (or EPS) to changes in
sales (units sold).

DTL =
Percentage change in number of units sold
Q × (P −AVC) [Q × (P −AVC) − F]
= DOL × DFL = ×
Q × P −AVC − F [Q × P −AVC − F − C]
Q × (P −AVC)
=
[Q × P −AVC − F − C]
Degree of total leverage (DTL) measure the combined effects of the

operating leverage (DOL) and the financial leverage (DFL) on the volatility
of net income.
316

total leverage

Example 8: Degree of total leverage (DTL)
Fixed operating cost (F) 1,000,000
Fixed financing expense (C) 800,000
DOL = Q × (P – AVC) / [Q × (P – AVC) – F]

= 200,000 × (20 – 7)/[200,000 × (20 – 7) – 1,000,000]
= 1.625
DFL = [Q × (P – AVC) – F]/ [Q × (P – AVC) – F – C]
= [200,000 × (20 – 7) – 1,000,000]/[200,000 × (20 – 7) – 1,000,000 – 800,000]
=2
→ DTL = DOL × DFL = 3.25
or DTL = Q × (P − AVC)/[Q × (P – AVC) – F – C]
= 200,000 × (20 – 7)/[200,000 × (20 – 7) – 1000,000 – 800,000]
= 3.25
317

total leverage
Conclusion:
Operating leverage Financial leverage
The greater the proportion of The greater the proportion of

the fixed operating costs the fixed financing costs
The more sensitive net income

The more sensitive operating
is to changes in operating
income is to changes in sales.
income.
Combining the effects of both types of leverage, we see that fixed

operating and financial costs together increase the sensitivity of earnings
to owners (net income).
318

[LOS 32.c] Analyze the effect of financial leverage on a
company’s net income and return on equity
Consider the example below:
Example 9: Effect of financial leverage on Net income and ROE

Assume that the Beta Company has $500,000 in assets. Fixed costs are
$120,000. Beta is expected to sell 100,000 units, resulting in operating
income (EBIT) of 100,000 × ($4 - $2) - $120,000 = $80,000.
Beta’s tax rate = 40%.
Case 1: Beta’s assets are financed with 100% equity
Case 2: Beta’s assets are financed with 50% equity and 50% debt and the
interest rate on the debt is 6%.
Calculate Beta’s Net income and ROE if its EBIT changes by 10% in 2
cases?
319

Case 1: equity = $500,000, debt = 0 EBIT − 10% EBIT EBIT + 10%
EBIT (1) 72,000 80,000 88,000
Interest expense (2) 0 0 0
EBT (3) = (1) – (2) 72,000 80,000 88,000
Taxes at 40% (4) = (3) × 40% 28,800 32,000 35,200
Net income (5) = (3) – (4) 43,200 48,000 52,800
ROE = (5)/500,000 8.64% 9.6% 10.56%
Case 2: equity = debt = $250,000 EBIT − 10% EBIT EBIT + 10%
EBIT (1) 72,000 80,000 88,000
Interest expense (2) = 250,000 × 6% 15,000 15,000 (1) 15,000
EBT (3) = (1) – (2) 57,000 (2) 65,000 73,000
Taxes at 40% (4) = (3) × 40% 22,800 26,000 29,200
Net income (5) = (3) – (4) 34,200 39,000 43,800
ROE = (5)/250,000 13,68% 15,6% 17,52%

320

Example 9: Effect of financial leverage on Net income and ROE

Discussion:
(1) Compare with Case 1:
Case 2 considers using debt in capital financing
→ lower net income due to interest expense and smaller equity base
in the firm’s capital, however, the decrease in net income is much less
than the decrease in equity base
→ higher NI/Equity
→ magnify the ROE
→ ROE is higher using financial leverage than it is without financial
leverage.
(2) The volatility of ROE is higher than it is without financial leverage (as
illustrated in the table above)
Using financial leverage reduce net income due to increasing fixed costs,
but increase ROE as well as the variability of ROE compared to without
financial leverage.
321

[LOS 32.d] Calculate the breakeven and operating breakeven
quantity of sales and determine the company's net income at
various sales levels
1. Breakeven quantity of sales
A company’s breakeven point occurs at the number of units produced

and sold at which a company’s revenues equal its total costs
→ its net income equals zero.
Revenue/Expense
Revenue
Net income
Net loss Total cost
Breakeven point
Units sold
QBE
Net income/loss = revenue – total cost = P × Q – (AVC × Q + F + C)
P = price per unit F = the fixed operating costs

Q = the number of units sold C = the fixed financial cost
AVC = the variable cost per unit
322

1. Breakeven quantity of sales
Calculate the breakeven quantity of sales
Breakeven quantity of sales (QBE ) is the quantity at which net income = 0
Revenue Total cost
P × QBE AVC × QBE + F + C
F+C
QBE =
P − AVC
323

2. Operating breakeven quantity of sales
• A company’s operating breakeven point occurs at the number of units

produced and sold at which a company’s revenues equal its
operating costs → its operating income equals zero.
• In this case, we consider only fixed operating costs and ignore fixed
financial costs
Operating breakeven quantity of sales (QOBE ) is the quantity at which

operating income = 0
Revenue Operating cost
P × QOBE AVC × QOBE + F
F
QOBE =
P − AVC
324

Effect of leverage on operating breakeven and
3.
breakeven point
Example 10: Operating breakeven and breakeven point

Consider the prices and costs for Atom Company and Beta Company
shown in the following table.
1. Compute and illustrate the breakeven point?
2. Compute the operating breakeven point?
Atom Beta
Price 4 4
Average variable costs 3 2
Fixed operating costs 10,000 80,000
Fixed financing costs 30,000 40,000

325

3.
breakeven point

Answer:
F+C
1. QBE (Atom) = = (10,000 + 30,000)/(4 – 3) = 40,000 units
P − AVC
F+C
QBE (Beta) = = (80,000 + 40,000)/(4 – 2) = 60,000 units
P − AVC
Revenue/ Revenue/
Revenue
Expense Expense
Net income
Revenue Total
Net income cost
Net loss
Total
Net loss cost Fixed costs
Fixed costs = 120,000
= 40,000
40,000 Units sold 60,000 Units sold
Atom Beta
326

3.
breakeven point
Answer:
1. Discussion:
• Beta company which has a higher level of leverage has a greater
breakeven quantity of sales → Beta must produce and sell more units
compared with Atom to get profit.
• In addition, Beta’s net income/loss volatility is greater than Atom’s
due to its high leverage → the profit/loss that Beta generates/incurs
beyond/below its breakeven point is greater than that of Atom
→ leverage has its rewards in terms of potentially greater profit, but it
also increases risk.
F
2. QOBE (Atom) = = 10,000/(4 – 3) = 10,000 units
P − AVC
F
QOBE (Beta) = = 80,000/(4 – 2) = 40,000 units
P − AVC
Discussion: Similar to the breakeven point, Beta company has greater

operating breakeven point due to its higher operating leverage.
327

3.
breakeven point
Conclusion
• A firm that choose operating and financial structure that result in
greater total fixed cost (level of leverage) will have a higher
breakeven point.
• Leverage can magnify the effects of changes in sales on net income
(illustrated by charts in Example 10)
• The further the units of sold are from the breakeven point, the greater
the net income → the greater the magnifying effects of leverage on
net income.

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1

READING 27: INTRODUCTION TO CORPORATE

27.a. Describe corporate governance

27.b. Describe a company’s stakeholder groups, and compare interests

27.c. Describe principal–agent and other relationships in corporate

27.d. Describe stakeholder management

27.e. Describe mechanisms to manage stakeholder relationships and

27.f. Describe functions and responsibilities of a company’s board of

READING 27: INTRODUCTION TO CORPORATE

27.g. Describe market and non-market factors that can affect

27.h. Identify potential risks of poor corporate governance and

27.i. Describe factors relevant to the analysis of corporate governance

27.j. Describe environmental and social considerations in investment

27.k. Describe how environmental, social, and governance factors may

READING 27: INTRODUCTION TO CORPORATE

Definition: Corporate governance is a system of internal controls,

Missions: Provides a framework that defines the right, roles and

Goals: Minimize and manage the conflicting interests between insiders

Under shareholder theory Under stakeholder theory

• The primary focus is the interests • The focus of corporate

READING 27: INTRODUCTION TO CORPORATE

1. Primary stakeholders of a corporation

Internal Connected External

• Board of derectors • Shareholder • Regulators

READING 27: INTRODUCTION TO CORPORATE

1. Primary stakeholders of a corporation

Board of director Senior managers

READING 27: INTRODUCTION TO CORPORATE

2. Interests and influence of stakeholder groups

• Have interest in compensation, bonuses

Have interests in continuing employment

READING 27: INTRODUCTION TO CORPORATE

2. Interests and influence of stakeholder groups

Have an interest in rate of pay,

• Have a residual interest in the net

READING 27: INTRODUCTION TO CORPORATE

2. Interests and influence of stakeholder groups

• Receive interest and principal payments,

• Receive payments for their services and

READING 27: INTRODUCTION TO CORPORATE

2. Interests and influence of stakeholder groups

Goods and Have an interest in a good value for the

Taxes earnd Have an interest in having corporations act

READING 27: INTRODUCTION TO CORPORATE

When a principal hires an agent to act on its behalf, a principal-agent

Principal Conflict of interest Agent

Act and make decisions

The principal-agent conflict arises because an agent is hired to act in the

READING 27: INTRODUCTION TO CORPORATE

Principal-agent conflict Nonprincipal-agent conflict

READING 27: INTRODUCTION TO CORPORATE

Business risks Management Information asymmetry

READING 27: INTRODUCTION TO CORPORATE

• Conflicts between the board of directors and management can arise

READING 27: INTRODUCTION TO CORPORATE

Controlling shareholders under different voting structure

Straight voting structure

Multiple – class structure

READING 27: INTRODUCTION TO CORPORATE

The controlling shareholders act against the interests of the minority

Takeover transactions Related – party transactions

READING 27: INTRODUCTION TO CORPORATE

Shareholders Conflict of interest Creditors