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Corporate Finance
Third Edition FlexText
TM
David J. Moore, Ph.D.
http://www.ecientminds.com
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Copyright (c) 2010, 2011, 2012, 2013, 2014 By David J. Moore, Ph.D.
All rights reserved.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any
form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the
prior consent of the author. For more information contact the author via
http://www.ecientminds.com.
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What is FlexText
TM
?
I have taught corporate nance at the introductory undergraduate, intermediate undergraduate, and
introductory MBA levels. While teaching those courses I noticed signicant overlap in the material
covered. For instance, net present value is covered at all levels. To promote eciency I have combined
my lecture notes from all three levels into this single text.
This book oers a new approach for multilevel instruction. With this Corporate Finance book
professors can choose their own subset of chapters tailored to the level of instruction. In so doing
professors and students have a consistent text for a sequence of corporate nance courses.
About this book
It is my wish that these notes equip the reader in at least three ways. First, I would like the reader to
understand ways to improve operating, investing, and nancing activities. Second, I would like the
reader to learn the tools for project selection, project risk assessment, and project risk management.
Third, I would like the reader to become familiar with the implications of debt vs. equity nancing.
Throughout the notes you will nd questions to check your understanding of the material. These
questions foster classroom interaction. Answers are available at the end of the book. Also, I in-
tentionally omitted numerical example details to encourage note taking during class. Numerical
examples will be worked in class so you can ll in the blanks. So, watch for the symbol that
indicates a numerical example is near.
These lecture notes are organized into three parts. Part I covers the fundamental concepts of
nancial management including the nancial managers role, corporate governance, the time value
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of money, bond valuation, stock valuation, and risk and return. Part II utilizes the concepts of Part
I to analyze and forecast forecast nancial statements, compute the cost of capital, and to increase
awareness of the debt vs. equity choice.
While Part II is focused on broader issues in corporate value, Part III is focused on project
selection concepts. Part III includes detailed discussions on project selection criteria, project risk
assessment, and managing project risk using decision trees and real options.
Thank you for purchasing this text. Lets learn how to make our corporations more valuable...
-David J. Moore, Ph.D.
Whats new in the Third Edition?
1. Added answers to embedded questions at the end of the book.
2. Added several appendices to Chapter 4: (1) using the nancial calculator, (2) formulas for n,
and (3) approximation of i.
3. Updated Discounted Free Cash Flow valuation discussion (Section 5.7).
4. Updated Market Multiple valuation discussion (Section 5.8).
5. Updated CAPM and SML estimation (Section 7.4.3) with reference to CAPM inputs and
equation for direct computation of .
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6. Added 3 inches of space to the bottom of each page so students may take notes.
7. Corrected equation numbering.
8. Standardized variable notation to capital letter with lowercase subscripts.
9. Miscellaneous typographical error corrections.
Contents
I Fundamental concepts 19
1 Corporate nance introduction 21
1.1 Financial managers role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.2 Cash ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1.3 Three fundamental decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1.4 Legal business forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.5 Typical corporation organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2 Corporate governance 31
2.1 Stockholder-manager agency conict . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
2.2 Stockholder-creditor conict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3 Financial reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.4 Are ethics important to business? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.5 Preventing managerial entrenchment . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2.6 The compensation carrot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
7
8 CONTENTS
2.7 Optimal corporate governance structure . . . . . . . . . . . . . . . . . . . . . . . . . 43
3 Time value of money 45
3.1 Why is there a time value of money? . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3.2 Future value, simple interest, and compound interest . . . . . . . . . . . . . . . . . . 47
3.3 Present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3.4 Additional information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
3.5 Multiple cash ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
3.6 Annuities and perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3.7 Growing annuities and perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.8 Five ways to describe interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3.9 Three bonus examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
4 Bond valuation 65
4.1 Bond prices and yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
4.2 Sinking fund provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
4.3 Interest and reinvestment rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
4.4 The Malkiel theorems of bond price changes . . . . . . . . . . . . . . . . . . . . . . . 72
4.5 Default risk and bond contract provisions . . . . . . . . . . . . . . . . . . . . . . . . 78
4.6 Bond ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
4.7 Bond markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
4.8 Term structure of interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
4.9 Real vs. nominal rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
4.10 Market interest rate components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
CONTENTS 9
4.11 Bond price and duration example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
4.A Financial calculators: behind the scenes . . . . . . . . . . . . . . . . . . . . . . . . . 92
4.B The elusive n . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.C The more elusive i . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
5 Stock valuation 105
5.1 Legal issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
5.2 Common stock markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
5.3 The dividend discount model (DDM) . . . . . . . . . . . . . . . . . . . . . . . . . . 108
5.4 The constant growth DDM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
5.5 From DDM to expected return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
5.6 Multiple growth rate DDM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.7 Discounted FCF approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.8 Valuation by market multiple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
5.9 Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
5.A Preemptive right workaround . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
5.B Multi-growth rate DDM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
6 Financial options 125
6.1 Financial options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
6.2 Binomial option pricing model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
6.3 The Black-Scholes option pricing model . . . . . . . . . . . . . . . . . . . . . . . . . 137
6.4 Put options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
6.5 Corporate nance applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
10 CONTENTS
7 Risk and return 145
7.1 Stand alone return and risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
7.2 Portfolio return and risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
7.3 Ecient portfolios and portfolio selection . . . . . . . . . . . . . . . . . . . . . . . . 157
7.4 Asset pricing models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
7.5 Tests of the CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
7.6 Stock market equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
II Corporate valuation 169
8 Managerial accounting 171
8.1 Financial reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
8.2 Balance sheet (BS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
8.3 Income statement (IS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
8.4 Statement of cash ows (SoCF) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
8.5 Modifying accounting data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
8.6 Free cash ow (FCF) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
8.7 MVA and EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
8.8 Federal tax considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
9 Financial statement analysis 203
9.1 Why ratio analysis? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
9.2 Liquidity ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
CONTENTS 11
9.3 Asset management ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
9.4 Debt management ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
9.5 Protability ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
9.6 Market value ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
9.7 Trend, common size, and percent change analysis . . . . . . . . . . . . . . . . . . . . 214
9.8 The DuPont equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
9.9 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
9.10 Closing comments on ratio analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
9.11 Qualitative analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
10 Financial statement forecasting 223
10.1 Financial planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
10.2 Sales forecast . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
10.3 Percent of sales forecasting method . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
10.4 The AFN formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
10.5 Forecasting with variable balance sheet ratios . . . . . . . . . . . . . . . . . . . . . . 241
11 Cost of capital 245
11.1 The weighted average cost of capital (WACC) . . . . . . . . . . . . . . . . . . . . . . 246
11.2 Cost of debt R
d
(1 ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
11.3 Cost of preferred stock R
ps
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
11.4 Cost of common equity R
s
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
11.5 WACC factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
11.6 Divisional and project risk adjustments . . . . . . . . . . . . . . . . . . . . . . . . . 256
12 CONTENTS
11.7 Flotation cost adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
11.8 Cost of capital estimation problems . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
11.9 Common WACC estimation mistakes . . . . . . . . . . . . . . . . . . . . . . . . . . 260
11.A Example R
s
estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
12 Value based management 263
12.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
12.2 Corporate valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
12.3 The corporate valuation model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
12.4 Value-based Management (VBM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
13 Capital structure 277
13.1 Tax free world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
13.2 A world with taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
13.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
III Project selection 283
14 Project selection criteria 285
14.1 Project classications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
14.2 Decision rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
14.3 Implementation of capital budgeting methods . . . . . . . . . . . . . . . . . . . . . . 295
14.4 Special applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.5 The optimal project mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
CONTENTS 13
14.A Another look at IRR vs. MIRR plus incremental IRR . . . . . . . . . . . . . . . . . 302
15 Estimating project cash ows 307
15.1 Who estimates cash ows? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
15.2 Relevant cash ows: incremental free cash ow . . . . . . . . . . . . . . . . . . . . . 308
15.3 Tax eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
15.4 Capital budgeting project example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
15.5 Ination adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
16 Equivalent annual cost 323
16.1 The AEC procedure and interpretations . . . . . . . . . . . . . . . . . . . . . . . . . 324
16.2 Acme Inc. example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
16.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
17 Project risk analysis 331
17.1 Project (stand-alone) risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
17.2 Incorporating project risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
17.3 Phased decisions and risk management . . . . . . . . . . . . . . . . . . . . . . . . . . 336
17.4 Real options introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
18 Real options 341
18.1 Real option valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
18.2 Investment timing option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
18.3 Growth option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
18.4 Use of real options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
14 CONTENTS
19 Change Log 349
20 Answers to embedded questions 353
List of Tables
4.1 Discount rate interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
4.2 Reinvestment rate risk illustration . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4.3 Bond price sensitivity to market yields and maturity . . . . . . . . . . . . . . . . . . 73
4.4 Maturity-interest rate change sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . 75
4.5 Coupon - interest rate sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.6 Malkiel Theorem Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.7 Perspectives and signs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
5.1 DDM denitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
5.2 Value vs. years of dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
6.1 The long and short of call and put . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
8.1 Balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
8.2 Income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
8.3 Statement of cash ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
15
16 LIST OF TABLES
9.1 ROE interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
10.1 Forecasted income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.2 Forecasted balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
10.3 AFN formula inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
14.1 Project classications, analysis, and rewards . . . . . . . . . . . . . . . . . . . . . . . 286
14.2 Capital budgeting method matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
14.3 Capital budgeting methods used in industry . . . . . . . . . . . . . . . . . . . . . . . 298
List of Figures
1.1 U.S. Business Forms in 2008. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.1 Interest and principal over time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
3.2 Sample QIR and APR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
6.1 Stock price tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
6.2 Call option value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
6.3 Option replicating portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
7.1 Portfolio risk vs. number of securities . . . . . . . . . . . . . . . . . . . . . . . . . . 153
17
18 LIST OF FIGURES
Part I
Fundamental concepts
19
Chapter 1
Corporate nance introduction
Overview
What is a corporation supposed to do?
Why would KKR/TPG borrow money and pay a 20% to 27.5% premium for TXU (February
2007)? Because they expect to make money!
How do they expect to make money on the deal?
1. Taking over management and selecting the right projects.
2. Choosing the lowest cost (most ecient) means of funding those projects.
3. Improving day-to-day operational eciency
21
22 CHAPTER 1. CORPORATE FINANCE INTRODUCTION
1.1 Financial managers role
The basic goal of a nancial manager or managers of a rm in general is to maximize share-
holder value subject to government-imposed constraints.
QUESTION: What are some of those constraints? What are some laudable
self-imposed constraints?
1.1
Inadequate oversight leaves poor management in place erosion of shareholder value.
Examples: Enron, Worldcom, Satyam (India), current nancial crisis, etc.
Recent gains in oversight: concentrated ownership by institutional investors and regulatory
changes/enforcement.
1.1.1 Societal considerations
How maximizing shareholder value (subject to government-imposed constraints) with a long term
focus can simultaneously maximize social well being:
Benet to consumers Maximizing prot implies reducing production costs and developing prod-
ucts that add value to consumers. Prices charged to consumers are impacted by competition.
QUESTION: How else does competition benet consumers?
1.2
Benet to employees Shareholder value maximization is a result of a companys ability to attract,
develop, and retain quality employees.
1.1. FINANCIAL MANAGERS ROLE 23
Other benets High stock prices lead to (1) wealthier people (and increased spending) and (2)
greater corporate investment via enhanced ability to raise capital.
1.1.2 Managerial actions to maximize shareholder wealth
Firm value is a function of current and future free cash ows (FCFs).
FCFs are a function of revenues, costs, required new investments.
The current value of future FCFs related to size, timing, and risk (discount rate) of those FCFs.
QUESTION: Is it clear what managerial actions should accomplish?
1.3
Regarding FCFs, managers can act to
1. Increase sales: develop products people want (an ongoing endeavor).
2. Reduce production costs: be mindful that cheap labor and materials may produce poor
quality products or products that consumers do not want.
3. Minimize reinvestment costs: reduce capital requirements (e.g., use just-in-time inventory
management).
An overview of all the considerations of a nancial manager):
1. Financing decisions: debt vs. equity, what kind of debt and equity, which project?
2. Reinvestment decision: reinvest earnings, pay dividends, or repurchase stock?
24 CHAPTER 1. CORPORATE FINANCE INTRODUCTION
1.1.3 Market vs. intrinsic value
The intrinsic or fundamental value is based on investors estimate of cash ows.
The market value is the aggregation of cash ow estimates from all investors.
QUESTION: Should nancial managers maximize market or intrinsic value?
1.4
Equilibrium is attained when market value equals true fundamental value.
QUESTION: Who knows the true fundamental value?
1.5
1.1.4 Short-term vs. long-term price
The current stock price reects all [publicly and some privately] available information (short-
term price).
QUESTION: Should nancial managers maximize short term or long term stock
price?
1.6
Some private information at time t does not become publicly available until time t +n (long-
term price).
QUESTION: What types of information take time before public revelation?
1.7
1.2. CASH FLOWS 25
1.2 Cash ows
Financial manager should make decisions to maximize cash ows to shareholders. These
decisions should balancing dividend payments, stock repurchases, and reinvestment in the
rm.
Three board decision categories
1. Capital budgeting
2. Financing
3. Working capital management
These are the same decisions and analysis KKR and TPG should have done as part of the
TXU leveraged buyout.
Bankruptcy occurs if expenses persistently exceed income.
1.3 Three fundamental decisions
26 CHAPTER 1. CORPORATE FINANCE INTRODUCTION
Captial Budgeting Decisions Project selection {includes estimates of future cash ows}, patents
to purchase, machines to purchase, anything that will generate, or contribute in the generation
of, cash ows.
Financing Decisions How do you pay for the assets you decided to buy?
Debt Obtain loans or issue bonds
Equity Issue stock or use cash
Capital Structure The mix of debt and equity at a point in time.
Working Capital Decisions The management of working capital including the collection of sales
revenues, repayment of debt, inventory management, etc.
QUESTION: What is the denition of working capital?
1.8
1.4 Legal business forms
1.4.1 Sole proprietorship
Owned by one person (hence use of the word sole)
Easy to start
Unlimited liability exposure
1.4. LEGAL BUSINESS FORMS 27
Income taxed at normal income tax rate
Dicult to sell the business since there are no shares of stock must sell o assets
1.4.2 Partnership
Like a proprietorship but with two or more owners joined together legally
Legal agreement includes initial investments, management roles and decisions, prot distribu-
tion, sale of business, actions after death of partner, etc.
General Partnership: Everyone has unlimited liability
Limited Partnership: General partners have unlimited liability.
QUESTION: What kind of liability do limited partners have?
1.9
1.4.3 Corporations
Entity distinct from its owners (stockholders)
Limited liability for owners: If you were a stockholder of Exxon during the Valdez accident,
you could not be sued but could your investment if Exxon were sued and lost and went
bankrupt
28 CHAPTER 1. CORPORATE FINANCE INTRODUCTION
Can be publicly held (shares traded on public markets such as NYSE and NASDAQ) or
closely held (smaller number of investors and not publicly traded).
QUESTION: What are some advantages and disadvantages of having a business
in the form of a corporation as opposed to a sole proprietorship?
1.10
1.4.4 Hybrid forms
We are not talking about fuel ecient cars
LLPs/LLCs have two advantages
Limited Liability for Partners: If one partner commits malpractice the whole rm is not
taken down.
Single-taxation.
QUESTION: Can anyone distinguish between single taxation for partnerships and
double taxation for corporations?
1.11
Figure 1.1 illustrates that the majority of businesses in the United States are sole proprietorships
while most of the income is attributed to corporations.
1.4. LEGAL BUSINESS FORMS 29
!"#$ &'"(')$*"'+,)(
-./
&0'*1$'+,)(
23/
4"'("'05"1
26/
!"#$%& () *"+,-%++%+
!"#$ &'"(')$*"'+,)(
-./
&0'*1$'+,)(
23/
4"'("'05"1
.6/
!"# %&'()"
Figure 1.1: U.S. Business Forms in 2008.
Source: Table 744, U.S. Census Bureau, Statistical Abstract of the United States: 2012
30 CHAPTER 1. CORPORATE FINANCE INTRODUCTION
1.5 Typical corporation organization
Lets take a look at a typical org chart...
External Auditor Are the nancial statements a fair representation of the rms nancial position?
QUESTION: Did Arthur Andersen do a good job of this when they were external
auditor for Enron back in the day?
1.12
Audit committee A group of board members who oversee the accounting of a rm
Compliance and Ethics Director
Reports to the boards audit committee to ensure independence.
QUESTION: Why might one be skeptical of true independence?
1.13
This position is distinct from the Internal Auditor.
QUESTION: How so?
1.14
Chapter 2
Corporate governance
Overview
In this chapter we look at some of the issues surrounding corporate governance including
agency conicts,
ethics,
managerial entrenchment, and
compensation.
31
32 CHAPTER 2. CORPORATE GOVERNANCE
2.1 Stockholder-manager agency conict
The principal (owner, stockholder) hires the agent (management) to manage (control) rm
such that principals interests are taken care of, that is, stock price maximization.
Agency conict sources:
1. Since agent (manager) does not own 100% of the rm, manager will receive less than
100% of the prots might put in less than 100% eort
2. Agent will bear less than 100% of expenses also agent can use 100% of the private jet
but using the principals money to buy the jet!
3. Ownership is disperse (many shareholders) so it is dicult to get together and discipline
or remove poor management
Studies suggest that in practice managers are concerned with rm size maximization (Wild-
smith, 1974) more job security (harder to takeover), more compensation, more ego
Stockholders incur agency costs in order to reduce the agency conict.
Two extremes for dealing with agency conict:
1. Compensate solely on long-run stock performance near-zero agency costs
Good: could minimize falsied accounting statements.
QUESTION: How so?
2.1
2.1. STOCKHOLDER-MANAGER AGENCY CONFLICT 33
Bad: (1) economic events beyond managers control could impact stock price; (2)
managers need income during the time it takes from good decision to market price
increase
2. Monitory every managerial action (high agency costs)
Costly (time, money, and inecient)
If shareholders have that kind of time they should manage the rm themselves.
Optimum solution is somewhere between the extremes however...
Tools to align principal (stockholder) and agent (management) interests:
1. Compensation tied to rm performance.
QUESTION: What are some problems with this?
2.2
2. Managerial labor market.
Theory: If you do well, other rms will want to pay you big bucks. If you do poorly, no
one will want to hire you.
Practice: Poor performance does not appear to stop those who have connections and
the compensation of poor performers comes at the expense of others.
3. Board of directors.
Theory: Hire the best managers, monitor, set compensation fairly, etc. so that share-
holder value is maximized.
34 CHAPTER 2. CORPORATE GOVERNANCE
Practice: Hire buddy and pay him as much as possible.
4. Other managers.
Theory: Competition within rm for CEO position will keep everyone on their toes.
Practice: Cut-throat and clique-ish environment where everyone is pursuing self-interest
which, at times, is at the expense of the rm (and rms owners).
5. Large stockholders.
Theory: Have enough skin in the game to take the time and attend board meetings and
pushing through meaningful management changes to maximize shareholder wealth.
Practice: (1) Maybe large stockholder wants another company they own to acquire the
target on the cheap. (2) Maybe large stockholder knows nothing about the particular
business and will mess it up.
6. The takeover market.
Theory: Management makes bad decisions stock price drops rm is taken over
management is red. Knowing this progression, management gets their act together
to maximize stock price and save their jobs.
Practice: (1) Sometimes management blocks shareholder wealth-enhancing acquisitions
to hold on to their jobs such as the Microsoft attempted takeover of Yahoo (2)
Sometimes management allows acquisitions that reduce shareholder value
7. Legal environment. Can we really legalize Morality?
2.2. STOCKHOLDER-CREDITOR CONFLICT 35
2.2 Stockholder-creditor conict
Creditors lend at a rate based on perceived risk at the time of the loan.
Stockholders want rms to take risky projects since they will benet if the projects succeed.
Thus, rms could take money from creditors (banks) and invest in risky projects or repurchases
stock (which increases leverage and bankruptcy risk but can enhance gains).
If creditors sense rms will do a bait and switch with borrowed money, they (creditors) will
charger higher rates or impose constraints on how the debt is used.
QUESTION: How well has our government done this with bailout funds?
2.3
2.3 Financial reporting
Market transparency: reliable and accurate information available to all.
Securities Act of 1933 - Requires companies to register with the SEC
Securities Exchange Act of 1934 - extends disclosure requirements
1933 and 1934 Acts include safeguards to ensure transparency (and consequently, eciency) :
1. Publicly-owned rms (POFs) are supposed to follow GAAP.
2. POFs must have nancial statements examined by independent auditors.
36 CHAPTER 2. CORPORATE GOVERNANCE
3. Accounting industrys Public Oversight Board is supposed to set policy and discipline
those who do not follow it.
4. POFs must submit nancial statements to SEC then SEC makes statements freely avail-
able.
5. POFs must release information to all investors simultaneously.
6. Analysts are supposed to form objective opinions based on available information and make
honest recommendations.
7. Violators are supposed to be prosecuted expeditiously with sucient penalties.
Late 1990s, early 2000s these safeguards were not in place and/or insucient (Enron)
Sarbanes-Oxley Act of 2002 (SOX)
Auditors were complicit because they were not independent.
QUESTION: Why not?
2.4
Analyst recommendations were at times dishonest and not necessarily independent.
QUESTION: Why not?
2.5
Penalties for these violations were too weak to prevent their recurrence.
2.4. ARE ETHICS IMPORTANT TO BUSINESS? 37
SOX regulation designed to reduce/eliminate these violations by ensuring that
1. auditors are suciently independent,
2. key executive (e.g., CEO) personally certies completeness and accuracy of nancial
statements,
3. audit committee is relatively independent of management,
4. analysts are relatively independent of POFs they analyze, and
5. Companies release all important information publicly and promptly.
2.4 Are ethics important to business?
Ethics: what is right and what is wrong (set of moral principals)
Some corporate nance textbooks reference the Golden Rule in the Bible: do unto others as
you wish others to do unto you.
The capitalist mantra pursue self-interest appears to be at odds with considering the impact
of your actions on others.
Read about the triple bottom line on Wikipedia (people, planet, prot)
For historical context, read Religion, Discipline, and the Economy in Calvins Geneva.
38 CHAPTER 2. CORPORATE GOVERNANCE
Is business like poker where you deceive to make a prot? As a result of the accounting scandals
previously mentioned, $2.3T in stockholder value was lost.
It is dicult to attract capital in the presence of corruption and investment is needed for
economic growth.
Agency costs and conicts of interest are two types of ethical issues in business (see earlier
examples).
Another is information asymmetry: do you tell someone interested in your used car the
full story?
Since the legal systems and market forces have proven insucient mechanisms to ensure ethical
business, the book suggests establishing an ethical business culture.
This culture is set at the top of the organization. Contrast Enrons management with Googles.
QUESTION: Upon graduation would you choose a $50,000 salary at a company
with some obvious ethical problems or $45,000 at a company with solid ethics?
2.6
Ethical failings have serious consequences: in the past you would get a slap on the wrist now
you will go to jail for decades.
2.5 Preventing managerial entrenchment
A manager is entrenched when conditions exist that impede the ability to remove that manager.
2.5. PREVENTING MANAGERIAL ENTRENCHMENT 39
Consequences include excess non-pecuniary benets, empire-building, and reluctance to cancel
underperforming divisions or projects.
2.5.1 Barriers to hostile takeovers
Microsoft attempted to takeover in Q1 2008 Yahoo management rejected MSFTs $33/share
oer Yahoo management entrenched and concerned about their egos stock closed at 12.50
on 2008.11.07 after MSFT rejected the begging of Yahoos CEO for MSFT to make another
oer.
QUESTION: So what is the barrier here?
2.7
Target share repurchases (greenmail): Allows poorly performing rm to repurchase stock from
raider at an elevated price in exchange for agreement to cease takeover attempts for a specied
number of years.
Poison pill (shareholder rights provision): Enables existing shareholders to purchase additional
shares at a bargain price if an acquisition attempt is detected (e.g., once a raider acquires 20%
of the rm)
Restricted voting rights: if you own more than X% of the stock, your voting rights are restricted
to Y % where Y < X. For example, you could own 50% of the rm but only have voting rights
as if you owned 25%.
40 CHAPTER 2. CORPORATE GOVERNANCE
2.5.2 Monitoring by board members
Insider: board member who also holds management position within the rm
Outsider: does not have a management position within the rm
Problems (the good ol boy network)
1. If the CEO is also chairman of the board disagreement will get you kicked o the board
and/or red.
2. Outsider is not necessarily independent.
QUESTION: Why not?
2.8
3. Combined eect: entrenched CEO
The [alleged] improvements in board structure
Stock and options instead of cash compensation for board members
More independent outsiders
Additional entrenchment mechanisms
Non-cumulative voting plus 51% ownership: you own the board.
QUESTION: What is the dierence between cumulative and non-cumulative
voting?
2.9
2.6. THE COMPENSATION CARROT 41
staggered terms: fewer board seats up for election each year
QUESTION: What has caused boards to be more eective in recent times?
2.10
2.6 The compensation carrot
Average package breakdown: 21% salary, 79% performance-based bonuses.
QUESTION: Why do I question performance-based?
2.11
Bonus breakdown: 34% short term goals (e.g., current year EPS growth), 20% long term goals,
46% stock price
Can be cash, stock, options, non-pecuniary. May not vest immediately
QUESTION: What does vesting mean?
2.12
2.6.1 Stock options
Theory: if executives own options, their interests are in alignment with shareholder interests
Reality: not so. An important example...
Additional problems
42 CHAPTER 2. CORPORATE GOVERNANCE
Falsied nancial statements
Options are not worth the Black-Scholes value to the recipients even though the company
expenses them using that value.
QUESTION: Why?
2.13
2.6.2 Employee stock ownership plans
ESOP formation process
1. Issue 500,000 shares @ $100 per share (50M).
2. Form legal entity (ESOP) to purchase newly issued shares with a loan guaranteed (and
paid indirectly) by the parent company (thus, an o-balance sheet liability since debt
appears on the books of the ESOP not the parent company).
3. Parent company makes payments to the ESOP sucient to cover loan payments.
4. Equity builds as the loan is paid o, and this equity is associated with the ESOP partic-
ipants (employees).
5. Employees receive pro rata amount of parent company stock at retirement.
Reasons for ESOPs
1. Motivate employees to be more productive thereby improving shareholder value.
2. More money at retirement.
2.7. OPTIMAL CORPORATE GOVERNANCE STRUCTURE 43
3. Employee retention.
4. Tax benet for borrower (ultimately the parent company) and lender if ESOP owns 50%
of parent company stock. Dividend payments to ESOP for distribution to participants
or loan repayment are tax deductible by the parent company.
5. Makes labor cutbacks as a result of acquisition more dicult (benets employees, not
shareholders).
QUESTION: What does this sound like?
2.14
In sum, ESOPs can be used to boost employee motivation, retention, and retirement income
but can also be used to entrench management (i.e., make takeover less attractive)
QUESTION: Are ESOPs more prevalent with privately held companies? Why or
why not?
2.15
2.7 Optimal corporate governance structure
Okay, so we have seen dierent types of sticks, carrots, monitoring, and take-over prevention mech-
anisms.
QUESTION: What is the optimum mix?
2.16
44 CHAPTER 2. CORPORATE GOVERNANCE
Chapter 3
Time value of money
Overview
Assume you have plenty of money and are considering the purchase of a new $36,000 car. You
go to the dealer and are given 2 options:
Option 1: Pay cash and receive a $3,321 discount sale price = $32,679
Option 2: Finance the car for 3 years @ 0% but pay full price = $36,000
QUESTION: Which option do you choose? What if CD rates were 3%? 7%?
3.1
Understanding this chapter is critical for your understanding of corporate nance (Parrino
and Kidwell, 2010). I would argue this applies to personal nance also.
45
46 CHAPTER 3. TIME VALUE OF MONEY
Value Creation: From a corporations perspective, buying productive assets today at cost $X
with hopes (belief) future cash ows will be $X.
3.1 Why is there a time value of money?
Simple example (that is similar to our car example): winning the lottery:
Option 1: Receive $60 million today.
Option 2: Receive $100 million spread out evenly over 26 years ($3,846,154 per year)
Thus we say the time value of money, or the market price of 26 annual payments of $3,846,154
is $60,000,000
QUESTION: Why is the lump-sum payment so much less than $100,000,000?
3.2
Since humans are impatient (and risk averse) they must be compensated for deferring con-
sumption (and taking risk).
Problem Solving tool : Time lines...
Future vs. Present Value:
Future Value is found by compounding cash ows.
Present Value is found by discounting cash ows.
3.2. FUTURE VALUE, SIMPLE INTEREST, AND COMPOUND INTEREST 47
Use of Financial Calculator: You will need to use a nancial calculator to solve problems in the
remainder of this course (and when you are sitting at the car dealer or the real estate brokers
desk).
3.2 Future value, simple interest, and compound interest
One, two, and n-period calculation
FV
1
= P
0
+ (P
0
i) = P
0
(1 + i) = PV (1 + i) (3.1)
FV
2
= FV
1
(1 + i) = (P
0
(1 + i)) (1 + i) = PV (1 + i)
2
(3.2)
FV
n
= P
0
(1 + i)
n
= PV (1 + i)
n
(3.3)
Simple vs. Compound Interest
Simple: interest gained on principal investment
Compound: interest gained on prior earned interest
Compound interest in a powerful phenomenon from both a good and bad perspective. From
a good perspective, you will gain interest on top of interest (i.e., on money in excess of what
you invested).
QUESTION: How can compound interest be a bad thing?
3.3
Another example of the power of compound interest: The Rule of 72...
48 CHAPTER 3. TIME VALUE OF MONEY
Lets work through a few FV, simple interest, and compound interest calculations...
QUESTION: How long will it take for a $100 investment to double @8%?
3.4
Thus far we have discussed annual compounding. What if compounding is quarterly, monthly,
daily, or continuous? A simple modication to the FV formula:
FV
n
= PV
_
1 +
i
m
_
mn
(3.4)
Where n is number of years and m is the number of times per year that interest is compounded.
QUESTION: What is m for semi-annual, quarterly, monthly, and daily
compounding? What about continuous compounding?
3.5
Lets take a look at compounding bank deposit rates and compounding frequency...
More frequent compounding more compound interest
3.3 Present value
Present value = todays value of a future cash ow.
Future values are discounted to account for (1) delayed consumption and (2) risk.
3.3. PRESENT VALUE 49
The discount rate is the rate used to arrive at the present value of future cash ows.
n-period calculation:
PV =
FV
n
(1 + i)
n
(3.5)
QUESTION: Look familiar?
3.6
Lets look at how time n, interest rates i, and future value FV impact the present value PV ...
Important note when doing PV/FV calculations on your nancial calculator: PV is a negative
number and FV is a positive number.
QUESTION: Why?
3.7
One more discounting example: Lottery payo options. You have access to a 10% CD if you
have the minimum $1M investment. Fortunately, you won the lottery and have been presented
the following choices:
Take money today PV=$1,000,000
2 years from now receive FV
2
= $1, 200, 000
5 years from now receive FV
5
= $1, 500, 000
8 years from now receive FV
8
= $2, 000, 000
QUESTION: Which option do you choose and why?
3.8
50 CHAPTER 3. TIME VALUE OF MONEY
3.4 Additional information
Finding the interest rate. As I write these notes I cannot help but think most students would
take the $1,000,000 today without doing a simple calculation. However, there must be some
amount you would be willing to wait for.
QUESTION: What is that amount and what interest rate is associated with that
amount?
3.9
Another example: You want to purchase a $50,000 car, do not have the money now, and are
expecting a bonus in a couple years (or expecting to somehow save with the same mindset used
to buy a car you do not have cash for). You violate a second rule and ask a family member
to loan the down payment of $20,000 and have agreed to pay that family member $28,800 in
two years to settle the debt.
QUESTION: Is that a good deal for the borrower? the lender?
3.10
Money is not the only thing subject to compounding. In the book Richest Man in Babylon
(I think), the author refers to money as your children and how your children have children and
so on.
Thus, population is something else that compounds.
Simply use population for PV/FV and call the compound growth rate g
FV
n
= PV (1 + g)
n
(3.6)
3.5. MULTIPLE CASH FLOWS 51
Other examples include sales, GDP, commodities prices, etc.
An example: U.S. Population in 1970 was 203,211,926. Somehow Wikipedia has 2010 census
data and puts the number at 309,162,581.
QUESTION: What was the U.S. population growth rate CAGR from 1970 to 2010?
3.11
The computation of sales CAGR is a preliminary step in forecasting nancial statements.
QUESTION: Why would you want to forecast nancial statements?
3.12
Lets compute Apples sales CAGR...
3.5 Multiple cash ows
Example 3.1. Future Value. Simple example: put $1,000 in savings account today, then another
$1,000 in your account next year. What is the value (total) of the account in two years if the interest
rate is 3%?
QUESTION: What is the rst step to solving this problem?
3.13
Example 3.2. Future Value. You deposit $3,000 today, $4,000 next year, and $5,000 two years
from now. What is the value in year 3 if the interest rate = 8%?
Present Value. You have a friend that wants to borrow $3,000 from you today and pay you
back $1,000 per year for 3 years.
52 CHAPTER 3. TIME VALUE OF MONEY
QUESTION: What are two reasons to reject the loan?
3.14
Example 3.3. Lets say your friend does go to a bank and rates for 3 year loans are 7%. We can
examine this problem from two angles: (1) if your friend does not need $3,000, how much will bank
lend today such that repayment is $1,000 per year for 3 years such that the bank earns 7%? (2)
Your friend needs $3,000 today so how much must he/she repay each year for the next 3 years to
ensure the bank earns 7%? Lets take a look...
Cash ows in the previous example were the same in each year, so you could use the N, I,
PMT, FV, PV buttons to arrive at the answers.
You cannot do so when the cash ows are uneven. Rather, you can use the CF
0
, CF
i
, I, NPV
buttons. I will redo Ex. 2 using these buttons...
Example 3.4. You go to a car dealer to purchase a car. You can nance $35,000 for 5 years @ 9%
or 4 years @ 7%.
QUESTION: Which do you choose and why?
3.15
3.6 Annuities and perpetuities
Both annuities and perpetuities have level cash ows
Annuities have a nite number of previous while perpetuities are innite
3.6. ANNUITIES AND PERPETUITIES 53
The present value of an annuity (PVA) (or perpetuity) is the present value (PV) of all future
cash ows.
PV A
n
=
CF
1
1 + i
+
CF
2
(1 + i)
2
+ +
CF
n
(1 + i)
n
=
n

t=1
CF
t
(1 + i)
t
(3.7)
Moreover, we know
CF
1
= CF
2
= = CF
n
CF
therefore
PV A
n
= CF
_
1
1 + i
+
1
(1 + i)
2
+ +
1
(1 + i)
n
_
. (3.8)
This equation simplies to
PV A
n
=
CF
i

_
1
1
(1 + i)
n
_
(3.9)
where CF is the cash ow received at the end of the rst period.
Example 3.5. How much should you pay (i.e., the maximum you would pay) for an 8% annuity
with 3,500 annual payments for 4 years?
QUESTION: How would you begin this problem?
3.16
54 CHAPTER 3. TIME VALUE OF MONEY
You can also nd the interest rate of an annuity given (1) the length of the annuity, (2) the
size of the cash ow, and (3) the price of the annuity.
QUESTION: What is the interest rate of 3-year 2,000 per year annuity selling for
5,154.19?
3.17
Perpetuities pay periodic cash ows forever. Recall equation 3.9:
PV A
n
=
CF
i

_
1
1
(1 + i)
n
_
(3.10)
To determine the value of a perpetuity, take the limit as n approaches
PV A

= lim
n
CF
i

_
1
1
(1 + i)
n
_
=
CF
i
(1 0) =
CF
i
(3.11)
Thus far we have covered ordinary annuities, annuities with cash payments that occur at the
end of each period. With an annuity due cash payments occur at the beginning of each period.
The simplest way to compute the value of an annuity due is (1) ignore the fact that payments
are at the beginning and calculate the ordinary annuity value; (2) multiply the ordinary annuity
value by (1+i):
Annuity due value = Ordinary annuity value (1 + i) (3.12)
Example 3.6. Redo the previous example for an annuity due.
3.6. ANNUITIES AND PERPETUITIES 55
Monthly Payments. When purchasing a car or home you are typically presented with an
annual rate and monthly payments. To ensure you are not being cheated, use this information
to calculate the monthly payments yourself.
Example 3.7. You are about to purchase a new car for $30,000 and have obtained 1.9% annual
nancing for 5 years. What will your monthly payment be?
QUESTION: To begin, what values do you put into N and I?
3.18
The dealer oers to lower your repayment to 400 by increasing the length of the loan from 60
to 111 months.
QUESTION: Do you take the deal?
3.19
Amortization Schedule. By the way, you want an amortizing loan, that is, a loan in which
the principal balance is reduced with each payment. Please be sure you see amortized before
you sign. With amortized loans, you pay more principle and less interest with each successive
payment:
56 CHAPTER 3. TIME VALUE OF MONEY
Figure 3.1: Interest and principal over time
Lets create an amortization schedule for a $50,000 30 year mortgage nanced @ 5.25%. in
particular, we want to compare the interest and principal payments at the end of years 1, 12,
and 29...
QUESTION: By the way, what is the monthly payment for this mortgage?
3.20
Okay, now on to the amortization schedule
3.6. ANNUITIES AND PERPETUITIES 57
Future Value of an Annuity. Perhaps you have a monthly savings plan, or retirement plan
that has xed payments (contributions to the plan) and you receive a lump sum at the end.
(Also has xed interest rate). This is nothing more than an annuity and you can calculate the
future value dierent ways.
1. Compute FV of each cash ow then add
2. Compute PV A
n
then multiply by (1 + i)
n
QUESTION: Which do you think is easier?
3.21
Now for the formula:
FV A
n
= PV A
n
(1 + i)
n
=
CF
i
_
1
1
(1 + i)
n
_
(1 + i)
n
=
CF
i
((1 + i)
n
1) (3.13)
Note: This is similar to what we did with Ex 2.
QUESTION: What is the FVA for a perpetuity?
3.22
Example 3.8. Suppose you are saving for a retirement and purchase an annuity (which I cannot
recommend). You are going to retire in 15 years, will save $1,000 per month, and see that the going
rate for 15 year annuities is 4%. How much will you have in 15 years?
58 CHAPTER 3. TIME VALUE OF MONEY
Rewind: Viewing/Valuing preferred stock as a perpetuity. On September 24, 2008 Warren
Buets company purchased $5B of perpetual preferred shares of Goldman Sachs that pay a
10% dividend.
QUESTION: What is the annual cash ow? Was this a good idea?
3.23
3.7 Growing annuities and perpetuities
Think back to the XYZ example at the beginning of the chapter
Company X=Starbucks, Company Y=Low Point Coee, Z=how much should Starbucks pay
for Low Point Coee
Example 3.9. Suppose Low Points after-tax cash ows are 100,000 per year, there is a 50-year
lease already in place so we assume the coee shop will be in business for 50 years, and cash ows
will grow each year at the estimated ination rate of 3%.
QUESTION: How much should Starbucks pay for Low Point when using a discount
rate of 15%?
3.24
We begin by modifying the PVA formula to include growing payments:
PV A
n
=
CF
1
i g

_
1
_
1 + g
1 + i
_
n
_
(3.14)
where CF is the cash ow at the end of the rst period. By the way, i must be larger than g (i > g).
3.7. GROWING ANNUITIES AND PERPETUITIES 59
QUESTION: Why?
3.25
Now, on to the estimated coee shop value...
Several notes:
1. The discount rate, in this case 15%, is reective of the riskiness associated with future
cash ows.
2. The growth rate, in this case 3%, is constant.
3. Unfortunately, there is not a button to enter the growth rate on the HP12C. However,
you can search for HP 12C growing annuity on the Internet and nd steps to do so.
The last example (Ex 9) was a growing annuity, now we look at growing perpetuities:
PV A

=
CF
1
i g
(3.15)
where CF is the cash ow at the end of the rst period.
Example 3.10. Suppose the Low Point Coee Shop to be acquired by Starbucks is anticipated
to be in business forever (you can obtain an indenite lease just like the United States did with
Guantanamo Bay).
QUESTION: Now what should Starbucks pay for an innitely-lived Low Point Coee
Shop?
3.26
60 CHAPTER 3. TIME VALUE OF MONEY
3.8 Five ways to describe interest rates
1. Quoted Interest Rate (QIR): The simple annual interest rate obtained by multiplying the
number of compounding periods by the per-period rate. E.g., 1% per month represents a QIR
of 12%. This rate does not include fees such as closing costs nor does it include compounding
eects.
2. Annual Percentage Rate (APR): In Parrino and Kidwell (2010) this is the same as QIR. In
the real world this will include fees. APR is typically associated with loans.
3. Nominal APR: Not mentioned in Parrino and Kidwell (2010) but is the same as QIR.
4. Eective Annual Interest Rate or Eective APR (EAR): In Parrino and Kidwell (2010) this
is the annualized rate that includes compounding eects but not fees:
EAR =
_
1 +
QIR
m
_
m
1 (3.16)
In the real world, EAR includes fees and compounding eects.
5. Annual Percentage Yield (APY ): Not mentioned in Parrino and Kidwell (2010). The annual-
ized interest rate that does take into account the eects of compounding.
APY =
_
1 +
i
m
_
m
1 (3.17)
where i = QIR or nominal APR. APY is typically associated with deposit instruments (CDs,
deposit accounts, etc.).
3.9. THREE BONUS EXAMPLES 61
Two paths to the same summit
Path 1: Compute EAR, then use annual FV formula (3.3)
Path 2: Forget about EAR and use modied FV formula (3.4)
3.9 Three bonus examples
Bonus 1: Your business is in need of $100,000 loan to expand operations and have received quotes
from three dierent lenders as follows:
Lender Interest rate (QIR) Compounding
A 10.40% monthly
B 10.90% annually
C 10.50% quarterly
QUESTION: Which lender do you choose and why?
3.27
Bonus 2: Compute the future value of a $100 investment in a ve year savings bond that pays 10%
interest compounded monthly using two approaches. First, compute EAR then use the simple
FV formula. Then try using the modied FV formula.
Bonus 3: You are purchasing a $100,000 home and have the 20% down payment. You are going
to nance the remaining $80,000 with a 30 year xed rate home loan. You take a look at
Bankrate.com and see quotes from several lenders:
62 CHAPTER 3. TIME VALUE OF MONEY
9/18/10 8:51 AM Mortgage Rates in Memphis, Tennessee by Bankrate
Page 1 of 3 http://www.bankrate.com/funnel/mortgages/mortgage-results.aspx?loan=80000&prods=1&market=82&perc=20&points=Zero
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Sort by:
APR
APR: 5.052% Point: 0 Est. payments: $423
Adv: Get your 3-Bureau Credit Score
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National Average
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30 yr fixed mtg, 0 Points 4.44% APR - 5.05% APR 4.54% RATE 4.52% RATE
Add other products
30 yr fixed mtg, 0 Points - Sorted by APR
Lender APR Rate Costs and fees Comments
4.438%
Fri Sep 17
4.375%
at 0.000 pts
30 day rate
lock
Fees in APR:
$595
Est payment:
$399
TENNESSEE IS
OUR HOME
STATE
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4.444%
Fri Sep 17
4.375%
at 0.000 pts
30 day rate
lock
Fees in APR:
$647
Est payment:
$399
Getting you the
home loan that's
right for you is our
business.
Contact Us
4.464%
Fri Sep 17
4.250%
at 0.000 pts
30 day rate
lock
Fees in APR:
$1,995
Est payment:
$394
Apply & Lock Rate
24/7! View Online
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4.564%
Fri Sep 17
4.500%
at 0.000 pts
30 day rate
lock
Fees in APR:
$597
Est payment:
$405
102 Year Old
Family-Owned
National Bank.
Calls Answered
24/7/365!
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4.618%
Fri Sep 17
4.500%
at 0.000 pts
30 day rate
lock
Fees in APR:
$1,095
Est payment:
$405
A+ Rating Close in
10 days Visit our
web site
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5.052%
Fri Sep 17
4.875%
at 0.000 pts
45 day rate
lock
Fees in APR:
$1,600
Est payment:
$423
A+ Rating with the
Better Business
Bureau!
Contact Us
BancorpSouth Bank
4.668%
Thu Sep
16
4.625%
at 0.000 pts
30 day rate
lock
Fees in APR:
$399
Est payment:
$411
Regions Bank
4.592%
Wed Sep
15
4.500%
at 0.000 pts
30 day rate
lock
Fees in APR:
$855
Est payment:
$405
The rates on this table are valid for credit scores of 700 and above. For scores from 680 to 699,
borrowers would typically see increased fees up to 1% of the loan value, or an adjustment in the
rate. If you believe that you have received an inaccurate quote or are otherwise not satisfied with the
services provided to you by the lender you choose, please click here.
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Figure 3.2: Sample QIR and APR
QUESTION: Calculate the fees associated with each option. Which lender do you
choose and why?
3.28
To get you started, I will calculate the fees associated with EverBank.
1. Compute the monthly payment of a $80,000 loan using the APR. This payment is the amount
3.9. THREE BONUS EXAMPLES 63
of the check you will send to the lender.
PV = 80, 000
N = 30 12
I = 4.444/12
FV = 0
PMT 402.69
2. Given that monthly payment and QIR compute the present value of the loan.
N = 30 12
I = 4.375/12
FV = 0
PMT = 402.69
PV 80, 653.43
Therefore you are being charged $653.43 in fees with this loan (close to the $647 estimate quoted
on Bankrate.com). Thus, an $80,000 loan at the APR of 4.444% is the same as an $80,653.43 loan
at the quoted interest rate of 4.375%. After you sign the closing papers you will have an $80,653.43
loan if you do not pay the $653.43 fees at closing. Now your turn to repeat the calculations for the
other lenders.
In Step #1 the fees are included (embedded) in the APR. In Step #2 the fees are explicitly
included in the loan amount. In both cases fees are accounted for just once. It would be incorrect
to use the higher APR and the higher loan amount simultaneously.
64 CHAPTER 3. TIME VALUE OF MONEY
Chapter 4
Bond valuation
Overview
Review bond price and yield calculations (including callable and non-callable bonds)
Interest rate and reinvestment risk
Changes in bond prices
Default risk and bond contract provisions
Bond ratings (including a brief discussion of junk bonds and bankruptcy)
Bond markets
65
66 CHAPTER 4. BOND VALUATION
Before I begin,
QUESTION: Who issues bonds and why?
4.1
4.1 Bond prices and yields
4.1.1 Non-callable bonds
Value of any nancial asset = present value of all future cash ows discounted at rate appro-
priate for asset
P =
n

t=1
PMT
(1 + R
d
)
t
+
FV
(1 + R
d
)
n
(4.1)
where R
d
is the market yield (a.k.a., discount rate, yield to maturity or YTM) and PMT is
the coupon payment.
The summation can be replaced with the formula for the present value of an annuity:
P =
PMT
R
d
_
1
1
(1 + R
d
)
n
_
+
FV
(1 + R
d
)
n
(4.2)
Coupon rate-discount rate relationship:
4.1. BOND PRICES AND YIELDS 67
Table 4.1: Discount rate interpretations
Rate Meaning
R
d
< R
coupon
bond will sell at a premium
R
d
= R
coupon
bond will sell at par value
R
d
> R
coupon
bond will sell at a discount
If payments are semi-annual, substitute 2n for n, PMT/2 for PMT, and R
d
/2 for R
d
.
Example 4.1. Consider a bond with the following characteristics:
AAA rated corporate bond
10% annual coupon rate
3 years until maturity
semi-annual coupon payments
face value of $1,000
current price of $1,052.42
QUESTION: Why is the current price greater than $1,000?
4.2
QUESTION: What is the yield to maturity?
4.3
68 CHAPTER 4. BOND VALUATION
QUESTION: What would the bonds price be if the yield to maturity were
12%?
4.4
Current yield
The ratio of a bonds annual coupon divided by current market price:
CY =
annual coupon
current market price
=
10%$1, 000
$1, 052.42
= 9.5% (4.3)
Better than quoting just the coupon rate because you will have to incur a cost to receive
the coupon.
Does not include PV of future redemption at par value.
4.1.2 Callable bonds
Corporate bonds may be callable, typically after some deferred call period
QUESTION: Why might a corporation call in a bond?
4.5
QUESTION: What does this tell you about the yield on callable bond vs. an
otherwise identical non-callable bond?
4.6
4.2. SINKING FUND PROVISIONS 69
The yield to call measure can be extracted from:
P =
fc

t=1
PMT
(1 + Y TC)
t
+
CP
(1 + Y TC)
fc
(4.4)
where
P = current price of bond
fc = number of periods until rst call date
Y TC = yield to call
PMT = coupon payment
CP = call price to be paid by issuer
4.2 Sinking fund provisions
A sinking fund is money set aside to ensure repayment of face value at maturity.
The sinking fund can also be used to repurchase a portion of the existing bonds periodically
at a specied price. The repurchase price is typically lower than that of a callable bond.
In contrast to callable bonds where the entire issue can be repurchased, there is a limit to the
amount that can be repurchased under sinking fund provisions.
Required funds level can be obtained a few ways
70 CHAPTER 4. BOND VALUATION
1. Cash
2. Call in a small percentage of bonds (specic bonds chosen randomly) at a specic price
3. Purchase bonds on the open market
When bonds with sinking fund provisions are called in, the amount of required funds will drop
proportionally.
QUESTION: Why?
4.7
In short, a sinking fund provision is both good and bad for the investor.
Good: The presence of a sinking fund lowers default risk.
Bad: The realized yield will decline as repurchases are made.
4.3 Interest and reinvestment rate risk
Interest rate risk
Denition: Risk of bond price decrease due to an interest rate increase.
A bond price increase due to an interest rate decrease is not considered risk. This subtle
point has signicance later in our discussion.
Reinvestment risk
4.3. INTEREST AND REINVESTMENT RATE RISK 71
Denition: The risk that future reinvestment rates will be less than the YTM at the time
bond was purchased.
YTM calculations assume coupon payments (interest payments) are reinvested at the
YTM rate and gain interest again. Since interest rates are not constant one can not
reasonably expect all future reinvestment of coupon payments to be at the YTM.
Table 4.2 emphasizes the impact of the assumed reinvestment rate risk:
Table 4.2: Reinvestment rate risk illustration
Income for a 10% annual coupon 20 year bond purchased at face value and held until maturity.
Coupon income Reinvestment rate Reinvestment income Total income
2000 8% 2576.20 5576.20
2000 10% 3727.50 6727.50
2000 12% 5205 8205
Note the large percentage of total dollar return attributable to reinvestment.
QUESTION: Anyone familiar with duration matching?
4.8
A couple yield measures that incorporate time-varying market rates:
Realized compound yield One of the assumptions in the YTM calculation was reinvest-
ment of coupon payments at the YTM rate. An after-the-fact measure, called realized com-
72 CHAPTER 4. BOND VALUATION
pound yield can be calculated to assess the actual yield realized:
RCY =
_
total ending wealth
purchase price of bond
_
1/n
1.0 (4.5)
Horizon (or total) return An ex-ante estimate of total return based on explicit reinvest-
ment rate assumptions.
4.4 The Malkiel theorems of bond price changes
Ultimately, bonds will be worth their face value as the maturity date approaches
Before the maturity date however, interest rates and bond prices do change.
Burton Malkiel (1962) derived ve bond price and yield theorems.
Here I present three. Table 4.3 shall be used to illustrate the following theorems and corollaries.
4.4.1 Theorem 1: Bond price - interest rate relationship
Theorem Bond prices move inversely to interest rates. This is evident by equation (4.1). In
equation form:
P
r
< 0 (4.6)
4.4. THE MALKIEL THEOREMS OF BOND PRICE CHANGES 73
Table 4.3: Bond price sensitivity to market yields and maturity
Bond prices for a $1,000 face value 10% coupon bond.
Market yield
TTM 8% 10% 12%
5 years 1,081 1,000 926
15 years 1,173 1,000 862
30 years 1,226 1,000 838
where r is the market yield (or Y TM).
Proof Simply take the partial derivative with respect to r of (4.1):
P
r
=
n

t=1
c
t
t(1 + r)
t1
((1 + r)
t
)
2
+
FV n(1 + r)
n1
((1 + r)
n
)
2
=
_
n

t=1
c
t
t(1 + r)
t1
+ FV n(1 + r)
n1
_
< 0 (4.7)
4.4.2 Percentage change - interest rate relationship
A corollary
1
to the previous theorem.
1
a proposition that follows from one already proven
74 CHAPTER 4. BOND VALUATION
Corollary A decrease in rates will raise bond prices more on a percentage basis than a correspond-
ing increase in rates will lower prices.
Proof Simplify the bond price equation to be P = 1/X where X embodies the interest rate. The
percent change in bond price for an increase in interest rates is:
P
1
P
0
=
1
X+z
1
X
=
X
X + z
(4.8)
Similarly the percent change in bond price for a corresponding decrease in rate is:
P
1
P
0
=
1
Xz
1
X
=
X
X z
(4.9)
Clearly the percent change for a decrease is larger than the percent change for an increase:
X
X z
>
X
X + z
(4.10)
4.4.3 Theorem 2: Bond price - maturity relationship
Theorem As interest rates change, the prices of longer term bonds will change more than the
prices of shorter term bonds, ceteris paribus. Let P
n
and P
m
represent the the change in prices
for bonds with maturities n and m, respectively. Let n > m. In equation form:
P
n
r
>
P
m
r
(4.11)
4.4. THE MALKIEL THEOREMS OF BOND PRICE CHANGES 75
Proof Clearly the longer the maturity, the more terms that are added in (4.1).
Example 4.2. Consider two bonds:
Table 4.4: Maturity-interest rate change sensitivity
Bond M Bond N
Coupon 10% 10%
Maturity 15 yr 30 yr
Price @ Y TM = 12% 862 838
Price @ Y TM = 10% 1000 1000
Price @ Y TM = 8% 1173 1226
As shown, in either case (increase from 10 to 12 or decrease from 10 to 8), the change in bond
price is larger for the longer maturity bond M. Also see the graph on page 140 of Brigham and Daves
(2010).
4.4.4 Percentage change - maturity relationship
A corollary to the previous theorem.
76 CHAPTER 4. BOND VALUATION
Corollary As TTM increases, the percentage price change that occurs increases at a diminishing
rate. Let %P represent the percentage price change that occurs from a change in interest rate.
Restating Theorem 2 in equation form:
(%P)
TTM
> 0 (4.12)
This Corollary states:

2
(%P)
TTM
2
< 0 (4.13)
Proof Maybe another time...
4.4.5 Theorem 3: Bond - coupon price relationship
Theorem Bond price volatility, measured in terms of percentage-price uctuations, is inversely
related to coupon rate (not the Y TM). Let %P represent the bond price percentage change as a
result of a change in interest rates. In equation form:

2
(%P)
cr
< 0 (4.14)
In other words, the change in price due to a change in interest rates of larger coupon bonds is less
than that of smaller coupon bonds.
4.4. THE MALKIEL THEOREMS OF BOND PRICE CHANGES 77
Proof by example Given two bonds, X and Y , identical in all aspects except the coupon rate.
The prices of each bonds at dierent Y TMs are shown below:
Table 4.5: Coupon - interest rate sensitivity
Bond X Bond Y
Coupon 10% (100) 15% (150)
Maturity 15 yr 15 yr
Price @ Y TM = 10% 1000 1384
Price @ Y TM = 15% 705 1000
%P 29.5% 27.7%
As shown, the percentage change in bond price decreases as the coupon rate increases, the inverse
relationship we were looking for.
4.4.6 Malkiel theorem implications
1. If interest rates are anticipated to decline investors should purchase low-coupon, long-maturity
bonds.
2. If interest rates are anticipated to rise investors should purchase short-maturity, high-coupon
bonds.
78 CHAPTER 4. BOND VALUATION
Table 4.6: Malkiel Theorem Implications
r increase r decrease
P
r
< 0 (The 1) bond price decreases bond price increases
(%P)
TTM
> 0 (The 2) want short maturity to minimize
exposure to price decrease
want long maturity to maximize
exposure to price increase
(%P)
c
< 0 (The 3) want high coupons to minimize
exposure to bond price decrease
want low coupons to maximize
exposure to price increase
4.5 Default risk and bond contract provisions
Bond indentures Legal document describing bondholders protection
Administered by trustee
Approved by SEC
Recall default-risk: risk that a company will default and be unable to repay its obligations.
QUESTION: How can indentures reduce default risk?
4.9
Mortgage bonds Bond secured by pledged assets.
QUESTION: How does this impact the ordinary unwinding of assets in a
bankruptcy?
4.10
4.6. BOND RATINGS 79
Debentures Unsecured bond; claims secured by un-pledged property
Subordinated debentures Claims subordinate to all other debt
Development bonds A means to subsidize private industry by issuing tax-exempt bonds on their
behalf in the name of development.
QUESTION: Why is it a subsidy?
4.11
Municipal bond insurance Insurance against municipal default.
QUESTION: What impacts the default risk reduction associated with municipal
bond insurance?
4.12
4.6 Bond ratings
Ratings are supposed to reect default-risk.
High-rated (AAA, AA) bonds are called investment grade.
Low rated (BB and lower) bonds are called junk or high yield bonds.
80 CHAPTER 4. BOND VALUATION
4.6.1 Rating criteria
Criteria include nancial ratios, legal standing, time to maturity, and many other items. See
page 135, 136 of Brigham and Daves (2007) or page 136 of Brigham and Daves (2010).
Ratings have some amount of subjectivity. There is no precise formula with the 15 criteria as
input and bond rating as an output).
QUESTION: Could this lack of a precise formula have anything to do with the 2008
nancial crisis?
4.13
4.6.2 Bond rating importance
Many institutions are restricted to investment grade securities.
Rating impacts required yield which in turn impacts cost of capital.
Covenants may impose rating-sensitive interest rates.
4.6.3 High-yield (junk) bonds
Denition: high-yield, high-risk bond
Michael Milken (ab)used historical studies suggesting benets (high yield) outweighed the costs
(high risk of default).
4.6. BOND RATINGS 81
A brief history:
1970s: The beginning: junk bonds were used to nance Public Service of New Hampshire
(Seabrook nuclear plant), CNN, and Turner Broadcasting.
1980s: Phenomenal growth of junk bonds (CBS, Union Carbide, USX) observed.
1989: Milken sentenced to prison.
Now:
QUESTION: Do MBSs look like junk bonds?
4.14
4.6.4 Bankruptcy and reorganization
Firms go bankrupt when they become insolvent. That is, when they can not meet interest and
principle payments.
Or... they get bailed out by the U.S. government!
Chapter 7 bankruptcy is a forced liquidation.
Chapter 11 bankruptcy is a reorganization.
Federal bankruptcy judge chooses Chapter 11 if V
after re-org
> V
liquidate
.
In reorganization
82 CHAPTER 4. BOND VALUATION
Debt is restructured via lower interest rates, maturity lengthening, etc.
Debt may be converted to equity.
Dilution of common stockholder position occurs.
There is an order of claims on liquidated rms assets.
QUESTION: Guess who comes rst?
4.15
4.7 Bond markets
Most bond trading occurs over-the-counter between nancial institutions, not in organized exchanges
due to the large size of the bonds.
4.8 Term structure of interest rates
Factors that impact interest rates include, but are not limited to, the following:
1. Marketability risk: The ability to sell with low transaction costs. We call the impact on
interest rates the marketability risk premium:
MRP = i
low mkt
i
high mkt
> 0 (4.15)
4.8. TERM STRUCTURE OF INTEREST RATES 83
QUESTION: Which is more marketable, U.S. Treasury Bonds or bonds of
little-known corporations? How does this impact their respective interest
rates?
4.16
2. Call risk: Callable bonds impose risk on the purchaser.
QUESTION: What risk?
4.17
Therefore there is a call interest premium (CIP):
CIP = i
callable
i
not callable
> 0 (4.16)
3. Default risk: In a default the issuer of the bond is unable to meet their interest (coupon)
obligations and possibly repayment of principal. The default risk premium is the dier-
ence in interest rate of an otherwise identical risk-free bond (e.g., time to maturity and
marketability):
DRP = i
risky
i
risk free
> 0 (4.17)
With regard to default risk, bonds are rated [albeit imperfectly] by ratings agencies Moodys
and Standard & Poors. The default risk premium increases with riskiness.
Ratings: http://www.bondsonline.com/asp/research/bondratings.asp
Rates: http://nance.yahoo.com/bonds/composite_bond_rates
Term structure of interest rates: the relationship between time to maturity and yield to ma-
turity, ceteris paribus.
84 CHAPTER 4. BOND VALUATION
Relationship depicted in the yield curve (see Yahoo nance link above for an example).
Three factors aect the shape of the curve:
1. The real rate of interest.
QUESTION: What is the real rate of interest?
4.18
2. Ination expectations impact the yield curve slope positively if ination is expected
to increase or negatively if ination is expected to decrease.
3. Interest rate risk increases with maturity thus longer term bondholders must be
compensated for bearing that risk. This puts an upward sloping bias on the yield
curve.
So, in general, the yield curve is upward sloping.
Downward sloping yield curves tend to precede recessions.
QUESTION: Any idea why?
4.19
4.9 Real vs. nominal rates
Real rate of interest: The [typically unobservable] rate of interest that does not include
ination
Nominal rate of interest: The observable rate of interest that does include ination. Some-
times this is referred to as the quoted interest rate.
Two factors that determine real interest rates: supply and demand!
4.9. REAL VS. NOMINAL RATES 85
1. The demand for money. When rates are high, businesses less likely to borrow money and invest
in projects. Also, consumers less likely to borrow money and consume.
QUESTION: Why? Also, why would a business be more inclined to borrow when
rates are low?
4.20
2. The supply of money. When rates are low, might as well consume. When rates are high, buy
CDs.
Equilibrium: When supply equals demand.
Fluctuations in equilibrium real rate occur when economic conditions change.
A technology shock could shift demand curve to the right.
QUESTION: Why?
4.21
A reduction in the corporate tax rate will cause the demand curve to shift.
QUESTION: Which way?
4.22
An increase in the personal tax rate will shift the supply curve to the left.
Read the text for more examples.
Impact of ination
86 CHAPTER 4. BOND VALUATION
You want to buy a surfboard next year (time t = 1) that costs $1,040 today (time t = 0)
Today (time t = 0) you lend $1,000 to me @ 4% interest for one year so that you will
have $1,040 at time t = 1.
Unfortunately, at time t = 1 the price of the surfboard went up 10% and is now $1,144.
This increase in price from $1,040 to $1,144 is what we call ination and thus a loss in
purchasing power.
So what rate should you have charged me? It is hard to say. At time t = 0 you did not know
what ination was going to be. However, you would have an expectation of what ination
would be.
Let P
e
represent the annualized expected ination rate (in our case, P
e
= 10%).
To incorporate expected ination into the nominal (quoted) interest rate, use the Fisher
Equation:
1 + i = (1 + r) (1 + P
e
) (4.18)
Intuitively, the real rate (1 + r) is grossed up by expected ination (1 + P
e
)
Back to the surfboard example (get your pens out)...

If r or P
e
are small, the Fisher Equation (4.18) can be approximated as:
i r + P
e
(4.19)
4.10. MARKET INTEREST RATE COMPONENTS 87
An example of a change in expected ination (get your pens out)...
Cyclical [random] nature of interest rates.
Recession: declining real output and increasing unemployment.
[Nominal] interest rates and ination move together.
QUESTION: Is this a surprise given the Fisher Equation?
4.23
Rates rise in expansionary periods and fall in contractionary periods.
Impact on nancial managers decisions: know what stage in the cycle you are in to assess
whether or not capital is expensive or inexpensive.
QUESTION: Is now a good time to get a xed rate loan or should a business wait
until next year?
4.24
4.10 Market interest rate components
quoted interest rate = r = r

+ IP + DRP + LP + MRP (4.20)


Nominal rate r: Stated or quoted interest rate
88 CHAPTER 4. BOND VALUATION
Real risk-free rate r

: (on a short term ( 1 year) risk less security (government securities) if


there were no ination
Ination premium IP: average expected ination over the life of the security. Note r
T-bill
=
r
RF
= r

+ IP. The rate on TIPS are pretty good estimates of the real risk-free rate.
QUESTION: Why?
4.25
Default risk premium DRP: premium that increases with the probability of default by issuer.
QUESTION: What is the DRP for a U.S. T-Bond?
4.26
Liquidity premium LP: premium that increases with the diculty in converting the security
to cash. Care must be taken when distinguishing between marketability and liquidity. High
liquidity means can go from sale to cash quickly. High marketability means one can go from
sale to cash with minimal transaction costs. A home has both low liquidity (takes a long time
to go from sale to cash) and low marketability (lots of fees involved in selling a home).
QUESTION: Can anyone think of a high liquidity low marketability asset? How
about a low liquidity high marketability?
4.27
Maturity risk premium MRP: premium that increases with maturity. This is due to (1) higher
sensitivity to interest rate changes of long-term bonds vs. short-term bonds, i.e., interest
rate risk; (2) the fact that the issuer is holding your par or face value longer. In contrast,
short-term bonds are exposed to reinvestment rate risk.
4.11. BOND PRICE AND DURATION EXAMPLE 89
QUESTION: What is reinvestment rate risk and how are short-term bonds
exposed to it?
4.28
4.11 Bond price and duration example
The problem Consider a bond with a 7% annual coupon rate, current market yield of 10%
annually, $1,000 par value, three years until maturity, and makes semi-annual payments.
1. What is the bond price?
2. What is the duration?
The formulas
P =
n

t=1
c
t
(1 + r)
t
+
FV
(1 + r)
n
(4.21)
where P is bond price today, r is the appropriate semi-annual discount rate or market yield , n is
the number of semi-annual periods, and FV is the bond face (par) value.
D =
n

t=1
_
PV [CF
t
] t
P
_
=
1
P
_
n

t=1
CF
t
t
(1 + r)
t
_
(4.22)
where D is the duration, P is the bond price, and CF
t
is the cash ow at time t.
90 CHAPTER 4. BOND VALUATION
Solution
Price
The number of semi-annual periods is 3 2 = 6.
The semi-annual coupon rate is 7.0%/2 = 3.5%.
The semi-annual market yield is 10.0%/2 = 5.0%.
Therefore
P =
6

t=1
35
(1 + 0.05)
t
+
1000
(1 + 0.05)
6
Expanding this equation gives you:
P =
_
35
1.05
1
+
35
1.05
2
+
35
1.05
3
+
35
1.05
4
+
35
1.05
5
+
35
1.05
6
_
+
1000
1.05
6
After several button presses on your calculator (or just a few if you program (4.21) into your calcu-
lator) you arrive at:
P 923.86
4.11. BOND PRICE AND DURATION EXAMPLE 91
Duration According to (4.22), you will need to have computed P correctly above. Plugging
values into (4.22):
D =
1
923.86
_
6

t=1
CF
t
t
1.05
t
_
You must be careful when considering the cash ows, CF
t
. The cash ows are the semi-annual
coupon payments (periods 1 up to and including 6). In semi-annual period 6, you also receive the
face (par) value. Therefore, expanding the summation:
D =
1
923.86
_
35 1
1.05
1
+
35 2
1.05
2
+
35 3
1.05
3
+
35 4
1.05
4
+
35 5
1.05
5
+
(35 + 1000) 6
1.05
6
_
After several button presses on your calculator you arrive at:
D 5.5 semi-annual periods or 2.75 years
92 CHAPTER 4. BOND VALUATION
4.A Financial calculators: behind the scenes
In this section I will show what formulas are behind your nancial calculators nance-specic but-
tons. This section also relates perspectives (e.g., bondholder vs. bond issuer) and appropriate signs
(positive or negative) of inputs into the nancial calculator.
The mother of nance equation
Let me begin with the "Mother of Finance" (MF) equation that illustrates the present value V
0
of
any nancial asset is the discounted (by the discount rate i) future cash ows CF
t
:
V
0
=
CF
1
(1 + i)
1
+
CF
2
(1 + i)
2
+ +
CF
n
(1 + i)
n
Now move V
0
to the right hand side:
0 = V
0
+
CF
1
(1 + i)
1
+
CF
2
(1 + i)
2
+ +
CF
n
(1 + i)
n
(4.23)
Let CF
0
= V
0
and we have the net present value (NPV) equation:
NPV 0 = CF
0
+
CF
1
(1 + i)
1
+
CF
2
(1 + i)
2
+ +
CF
n
(1 + i)
n
(4.24)
where i is also referred to as the internal rate of return IRR. Eq. (4.24) is the formula behind your
nancial calculators cash ow CF
i
, NPV, and IRR buttons.
4.A. FINANCIAL CALCULATORS: BEHIND THE SCENES 93
The Fab ve buttons
We can apply Eq. (4.24) to an example with constant periodic cash ows PMT and a cash ow
of FV in the nal period, i.e., a bond. Lets rework Eq. (4.24) to represent a bond by letting
CF
0
= PV , CF
1
= CF
2
= CF
n1
= PMT, and CF
n
= PMT + FV :
0 = PV +
PMT
i
_
1
1
(1 + i)
n
_
+
FV
(1 + i)
n
(4.25)
Eq. (4.25) reveals why PV is treated as a negative cash ow by your nancial calculator: PV is the
same as V
0
in Eq. (4.23)! Eq. (4.25) is indeed the equation behind your nancial calculators Fab
ve buttons: n, i, PMT, PV, and FV.
A matter of perspective
Users of nancial calculators must be mindful of the sign of numbers entered in the PMT, PV, and
FV buttons. The correct sign is a matter of perspective. Table 4.7 summaries the perspective in
signs. In general, the sign is positive if it is a cash inow and negative if it is a cash outow.
94 CHAPTER 4. BOND VALUATION
Table 4.7: Perspectives and signs
Type Perspective PV PMT FV
Bond Purchaser (holder) () (+) (+)
Bond Seller (issuer) (+) () ()
Periodic savings Individual (saver) 0 () (+)
Periodic savings Bank 0 (+) ()
Simple interest loan Individual (+) () 0
Simple interest loan Bank () (+) 0
4.B The elusive n
Fortunately nancial calculators, when given correct inputs with the correct signs (see Table 4.7),
can easily solve for the number of periods n. However, there is some debate on the correct n to
report. Should n be rounded up? Rounded down? Allowed to be expressed as a decimal?
I dont take a position on that debate. Here I provide derivations of algebraic solutions to Eq.
(4.25) so you may compute a precise n. At that point you may decide on your own to round up,
down, or leave as a decimal. The formulas are:
4.B. THE ELUSIVE N 95
n =
ln
_
1 +
iPV
PMT

ln[1 + i]
Simple interest loan, FV = 0 (4.26)
n =
ln
_
1
iFV
PMT

ln[1 + i]
Saving for the future, PV = 0 (4.27)
n = ln
_
1
iFV
PMT
1 +
iPV
PMT
_
ln[1 + i] Bonds (4.28)
Note: you must enter PV , PMT, and FV with the signs appropriate for the perspective you are
taking (see Table 4.7).
Simple interest loan
In a simple interest loan FV = 0. As such we can rewrite Eq. (4.25):
0 = PV +
PMT
i
_
1
1
(1 + i)
n
_
+ 0
Applying a little algebra we can arrive at n:
96 CHAPTER 4. BOND VALUATION
0 =
iPV
PMT
+
_
1
1
(1 + i)
n
_
1
(1 + i)
n
= 1 +
iPV
PMT
(1 + i)
n
= 1 +
iPV
PMT
ln
_
(1 + i)
n

= ln
_
1 +
iPV
PMT
_
nln[1 + i] = ln
_
1 +
iPV
PMT
_
Finally we arrive at:
n =
ln
_
1 +
iPV
PMT

ln[1 + i]
(4.29)
Note: it is imperative to follow the sign conventions of Table 4.7 when computing n.
Example 4.3. How many years will it take to pay o a 10% $8,700 loan with $1,000 annual pay-
4.B. THE ELUSIVE N 97
ments? Taking the perspective of the lender, PV = 8, 700 and PMT = 1, 000.
n =
ln
_
1 +
iPV
PMT

ln[1 + i]
=
ln
_
1 +
0.108700
1000

ln[1 + 0.1]
=
ln[0.13]
ln[1.1]
= 21.4061
Note: the HP12C reports n = 22 when using the Fab ve.
Saving for the future
Making periodic deposits of PMT at interest rate i will lead to some future balance FV after n
periods. In this case we begin with PV = 0 and rewrite Eq. (4.25):
0 = 0 +
PMT
i
_
1
1
(1 + i)
n
_
+
FV
(1 + i)
n
Applying a little algebra we can arrive at n:
98 CHAPTER 4. BOND VALUATION
0 = 1
1
(1 + i)
n
+
iFV
PMT
1
(1 + i)
n
0 = (1 + i)
n
1 +
iFV
PMT
(1 + i)
n
= 1
iFV
PMT
ln [(1 + i)
n
] = ln
_
1
iFV
PMT
_
nln[1 + i] = ln
_
1
iFV
PMT
_
Finally we arrive at:
n =
ln
_
1
iFV
PMT

ln[1 + i]
(4.30)
Example 4.4. How many years will it take to save $30,000 by saving $1,000 per year and earning
10% annual? Taking the perspective of the saver, PMT = 1, 000, FV = 30, 000, i = 0.10, and
PV = 0.
4.B. THE ELUSIVE N 99
n =
ln
_
1
iFV
PMT

ln[1 + i]
=
ln
_
1
0.1030,000
1,000
_
ln[1 + 0.1]
=
ln[4]
ln[1.1]
= 14.5451
Note: the HP12C reports n = 15 when using the Fab ve.
Bonds
In the case of bonds we have both a PV and an FV so the derivation is a bit more complicated.
Beginning with Eq. (4.25):
0 = PV +
PMT
i
_
1
1
(1 + i)
n
_
+
FV
(1 + i)
n
0 =
iPV
PMT
+ 1
1
(1 + i)
n
+
iFV
PMT
1
(1 + i)
n
0 = (1 + i)
n
_
1 +
iPV
PMT
_
1 +
iFV
PMT
100 CHAPTER 4. BOND VALUATION
Moving things around a bit more:
(1 + i)
n
_
1 +
iPV
PMT
_
= 1
iFV
PMT
(1 + i)
n
=
1
iFV
PMT
1 +
iPV
PMT
nln[1 + i] = ln
_
1
iFV
PMT
1 +
iPV
PMT
_
And nally we arrive at:
n = ln
_
1
iFV
PMT
1 +
iPV
PMT
_
ln[1 + i] (4.31)
Example 4.5. Consider a $1,000 par value bond that sells for $847.88. The annual coupon is $80
and the yield to maturity is 10%. How many more coupon payments will you receive? Taking the
perspective of the bondholder, FV = 1, 000, PV = 847.88, PMT = 80, and i = 0.10.
4.C. THE MORE ELUSIVE I 101
n = ln
_
1
iFV
PMT
1 +
iPV
PMT
_
ln[1 + i]
= ln
_
1
0.101,000
80
1 +
0.1(847.88)
80
_
ln[1 + 0.1]
= ln[4.1771] ln[1.1]
= 14.9997
Note: the HP12C reports n = 15 when using the Fab ve.
4.C The more elusive i
Unfortunately solving for the interest i is more complicated. Technically speaking, there are no
closed form (exact) solutions for i. I have found a couple approximations.
102 CHAPTER 4. BOND VALUATION
i
_
_
1
PMT
PV
_
1/q
1
_
q
1 where q =
ln [1 + 1/n]
ln[2]
Simple interest loan, FV = 0
(4.32)
i
PMT + FV/n
FV/2
Saving for the future (4.33)
i
PMT +
FV +PV
n
FV PV
2
Bonds (4.34)
Note: you must enter PV , PMT, and FV with the signs appropriate for the perspective you are
taking (see Table 4.7).
Simple interest loan
The approximation was obtained from David Cantrells Finding interest rate without approxima-
tion or root nding. The without approximation referred to here is without numerical iterative
approximation.
Example 4.6. Consider an $8,700 loan with 5 annual payments of $2,295.04. What is the interest
rate? Taking the perspective of the borrower, PV = 8, 700, FV = 0, n = 5, and PMT =
4.C. THE MORE ELUSIVE I 103
2, 295.04.
q =
ln [1 + 1/5]
ln[2]
= 0.2630
i
_
_
1
2, 295.04
8, 700
_
1/0.2630
1
_
0.2630
1
i 0.0998 or 9.98%
Note: the HP12C reports i = 10 when using the Fab ve.
Saving for the future
Note: citation needed. I cant remember where I found the bond interest rate approximation Eq.
(4.34). However, setting PV = 0 allows one to arrive at the saving for the future formula Eq.
(4.33).
Example 4.7. What interest rate do I need to earn to have $610.51 in ve years if I save $100 per
year? Taking the savers perspective, FV = 650.51, PMT = 100, n = 5, and PV = 0.
i
100 +
650.51
5
650.51
2
0.0925 or 9.25%
Note: the HP12C reports i = 10 when using the Fab ve.. Thus, a better approximation would be
nice. Let me know if you nd one!
104 CHAPTER 4. BOND VALUATION
Bonds
Note: citation needed.
Example 4.8. Consider a $1,000 par value bond that sells for $847.88. The annual coupon is $80
and there are 15 years until maturity. What is the yield to maturity of this bond? Taking the
perspective of the bondholder, FV = 1, 000, PV = 847.88, PMT = 80, and n = 15.
i
PMT +
FV +PV
n
FV PV
2

80 +
1,000+(847.88)
15
1,000(847.88)
2
0.0976 or 9.76%
Note: the HP12C reports i = 10.000 when using the Fab ve. This illustrates how Eq. (4.34) is
just an approximation.
Chapter 5
Stock valuation
Overview
Much like the previous chapter this chapter discounts future cash ows to obtain stock values. We
also take a look at stock market equilibrium.
5.1 Legal issues
5.1.1 Control of the rm
Stockholders elect directors and directors elect ocers.
In a small rm the largest shareholder is typically CEO/Board chair.
105
106 CHAPTER 5. STOCK VALUATION
In a large rm ocer/director holdings typically insucient for voting control.
Votes occur in person or by proxy at annual meetings.
QUESTION: What is a proxy vote?
5.1
5.1.2 Preemptive right
Preemptive right is the current common stockholders right to purchase additional shares.
Preemptive rights prevent management from seizing control and transferring wealth from stock-
holders.
An example...
Preemptive right vs. employee stock ownership plans The preemptive right allows existing
shareholders to purchased newly issued shares of stock. With employee stock ownership plans no new
shares are issued. The company itself purchases shares on the open market, sells them to employees
at a discount, and accounts for the loss as some form of business expense. So, the key distinction is
preemptive rights deals with newly issued shares whereas employee stock purchases are with existing
shares.
For an executive pre-emptive right workaround see the Appendix 5.A.
5.2. COMMON STOCK MARKETS 107
5.1.3 Classications
Classications vary in voting and dividend rights.
Dividend payments can be tied to performance including performance of a particular division
(i.e., tracking stock).
QUESTION: Which stock is more valuable, one with voting rights or one without?
5.2
5.2 Common stock markets
Closely-held: owned by a few people (small companies).
Publicly-held: what you and I own.
Institutional investors own more than 60% of publicly held stock and account for 75% of
transactions.
IPO: initial sale of privately owned company to the public.
SEO: seasoned equity oering. Issuance of new shares of already-public rm (primary market).
Outstanding shares - what we can trade on NYSE/Nasdaq (secondary market).
Do not bother with IPOs unless you get in on the ground oor (i.e., able to purchase at the
oering price). If you do not you will underperform the market in the long run.
108 CHAPTER 5. STOCK VALUATION
QUESTION: What do we mean by underperform the market?
5.3
5.3 The dividend discount model (DDM)
Current price is present value of expected future cash ows.
QUESTION: If a stock is a non-dividend paying stock, what is the expected future
cash ow?
5.4
5.3. THE DIVIDEND DISCOUNT MODEL (DDM) 109
110 CHAPTER 5. STOCK VALUATION
5.3.1 Denitions
Table 5.1: DDM denitions
Term Denition
D
t
Expected dividend at time t
P
0
Actual market price today

P
t
Expected value at end of time t

P
0
Intrinsic value. May vary from investor to investor. However,

P
0
= P
0
in
equilibrium.
QUESTION: Why?
5.5
D
1
/P
0
Expected dividend yield (DY)

P
1
P
0
P
0
Expected capital gains yield (CGY)
g Expected dividend growth rate.
QUESTION: If g is constant, what are the earnings and stock price
growth rates?
5.6
R
s
Required rate of return based on the riskiness of the stock and returns available
on other investments (e.g., obtained from CAPM, the fundamental return)

R
s
Expected rate of return. the sum of DY and CGY, or, the arithmetic average,
or, some other estimate. (the market return as determined by the marginal
or average investor)
R
s
Realized or actual return (geometric average)
5.4. THE CONSTANT GROWTH DDM 111
QUESTION: What are the relationships between R
s
,

R
s
, and R
s
?
5.7
5.3.2 Expected dividends and stock values
The dividend discount model is one method to compute the intrinsic or fundamental value of a stock:

P
0
=

t=1
D
t
(1 + R
s
)
t
(5.1)
QUESTION: Why start at t = 1
5.8
QUESTION: Does this change if you plan to sell the stock in a couple years?
5.9
5.4 The constant growth DDM
The constant growth model is also known as the Gordon Growth Model.

P
0
=
D
0
(1 + g)
1
(1 + R
s
)
1
+
D
0
(1 + g)
2
(1 + R
s
)
2
+ +
D
0
(1 + g)

(1 + R
s
)

(5.2)
= D
0

t=1
(1 + g)
t
(1 + R
s
)
t
(5.3)
=
D
0
(1 + g)
R
s
g
=
D
1
R
s
g
R
s
> g (5.4)
QUESTION: What happens if R
s
< g?
5.10
112 CHAPTER 5. STOCK VALUATION
5.4.1 Constant growth stock illustration
Acme corp just paid a $1.15 dividend. It has a required rate of return of 13.4% and dividends are
expected to growth at 8%.
QUESTION: What is the current value of the stock?
5.11
5.4.2 Dividends and earnings growth
Dividends are the portion of earnings that are not retained.
QUESTION: Can a rm increase its value by simply increasing its dividends?
5.12
5.4.3 Do stock prices reect long term or short term events?
Assume D
0
= 1.15, R
s
= 13.4%, and g = 8%. The following table illustrates the percentage of rm
value, as measured by the dividend discount model, by number of annual dividends received.
Observations regarding table 5.2:
You do not need to wait forever to receive all of the dividend payments included in the stocks
current value.
Managers gripe about the markets unmerited attention to quarterly results. Are they justied?
5.4. THE CONSTANT GROWTH DDM 113
Table 5.2: Value vs. years of dividends
Years % of value
5 22%
25 70%
50 90%
100 99.4%
PV of rst 5 dividend payments is $5, or 22% of todays value near term earn-
ings/dividends should not have a huge impact on price since value is obtained from long
term.
But wait! Reduced earnings because of things like R&D increases are generally good
since it may lead to higher g. However reduced earnings due to slow sales is bad due to
lower g.
Also, managers bonuses tend to be tied to quarterly performance, a result of the attention
given to quarterly earnings.
5.4.4 When to use the constant growth model
Mature companies with a history of stable growth, for example, Johnson and Johnson (JNJ).
General expectation for these rms: 5 to 8% growth, about the same rate as nominal GDP.
114 CHAPTER 5. STOCK VALUATION
5.5 From DDM to expected return
r
s
=
D
1
P
0
+ g (5.5)
Example 5.1. Lets look at EQR. P
0
= 58.51, D
0
= 2.27, g = 8.82%. What is the expected return
r
s
?
Example 5.2. For fun, what is the required return based on CAPM? Presume = 1.34, R
f
=
2.00%, and E [R
m
] = 6.24%.
QUESTION: What would be the stock price at the beginning of year 1?
5.13
Note:

P
1
= P
0
(1.08)
The capital gains yield from t = 0 to t = 1:
CGY =
24.84 23
23
= 8% (5.6)
Dividend yield from t = 0 to t = 1:
DY =
D
1

P
0
=
1.24
23
= 5.4% (5.7)
Conditions that must hold for constant growth stocks
5.6. MULTIPLE GROWTH RATE DDM 115
1. Dividends expected to grow at constant g forever
2. Stock price growing at the same rate
3. Expected DY is constant
4. Expected CGY= g and is constant
5. r
s
= DY + CGY
Note expected means statistically expected, i.e., the best prediction (guess) for any future
year is 8%.
5.6 Multiple growth rate DDM
The dot-com boom period could be viewed as supernormal. Afterwards things returned to
normal.
If you anticipate a period of super- or sub-normal growth, use the non-constant growth model.
See an example in Appendix 5.B at the end of this chapter.
5.7 Discounted FCF approach
1. Compute the market value of operating assets:
V
op
=
FCF
0
(1 + g)
WACC g
(5.8)
116 CHAPTER 5. STOCK VALUATION
2. Compute the value of the entire rm:
V
total
= V
op
+ V
non-op
(5.9)
where V
non-op
is the value of non-operating assets such as short- and long-term investments.
3. Subtract the value of debt and preferred stock to obtain the value of common stock.
V
cs
= V
total
V
debt
V
preferred stock
(5.10)
4. Divide by the number of common shares outstanding to obtain the price per share of common
stock P.
P =
V
cs
n
cs
(5.11)
Example 5.3. Lets apply the discounted FCF approach to Johnson and Johnson (JNJ)...
5.8 Valuation by market multiple
Price-to-earnings ratio
Another way to estimate the value of stock.
Less precise than dividend discount method.
To nd the value of a share of common stock:
5.8. VALUATION BY MARKET MULTIPLE 117
1. Compute the average P/E ratio for similar public companies.
PE =
1
n
n

i=1
P
i
E
i
(5.12)
2. Multiply by forecasted EPS

E of the company under consideration to obtain the price
per share of common stock P.
P =

E PE (5.13)
Example 5.4. Lets apply the P/E market multiple approach to Johnson and Johnson (JNJ)...
Entity multiple
Another approach to estimating the rm value estimation is the entity multiple approach.
The entity multiple, V
total
/EBITDA, is analogous to P/E but uses the ratio of whole-rm
value V
total
to EBITDA rather than price-to-earnings.
To nd the value of a share of common stock:
1. Compute the average entity multiple for similar public companies.
V E =
1
n
n

i=1
V
total,i
EBITDA
i
(5.14)
118 CHAPTER 5. STOCK VALUATION
where V
total,i
is obtained for each rm (except the rm under consideration) using the
steps in Section 5.7. Also, V E is analogous to the average price-to-earnings ratio PE.
2. Multiply by EBITDA of the company under consideration.
V
total
= EBITDA V E (5.15)
3. Subtract the value of debt and preferred stock from total value.
V
cs
= V
total
V
debt
V
preferred stock
(5.16)
4. Divide by the number of common shares outstanding to obtain the price per share of
common stock P.
P =
V
cs
n
cs
(5.17)
Example 5.5. Lets apply the V
total
/EBITDA entity multiple approach to Johnson and Johnson
(JNJ)...
5.9 Preferred stock
A hybrid between xed-income and equity securities.
pays xed dividend known in advance
like bonds preferred stock has par value and xed dividends that must be paid before common
stock
5.A. PREEMPTIVE RIGHT WORKAROUND 119
unlike bonds, company is not legally required to pay dividends and will not be in default if it
fails to pay
cumulative dividends if dividends can not be paid, unpaid dividends must be paid in the
future before common stock but after debt obligations
non-cumulative dividends - in the event of omitted dividends, preferred stock holders may
be allowed to vote for board of director members (you didnt pay my dividends, Ill vote you
out of there)
convertible preferred stock provides the preferred stockholder the option to convert preferred
shares into common shares.
QUESTION: Can you think of a couple reasons a preferred stockholder would
convert to common shares?
5.14
preferred stockholders have a claim on liquidation value after debt holders but before stock-
holders (and has an associated par value)
QUESTION: If dividend payments are xed and last forever, what is the value of
preferred stock?
5.15
5.A Preemptive right workaround
Does the issuance of new stock dilute shareholder value? It depends...
120 CHAPTER 5. STOCK VALUATION
Begin with the following:
P
0
= $100
n = 1, 000
MKTCAP = $100 1, 000 = $100, 000
where P
0
is the current market value, n is the number of shares outstanding, and MKTCAP is the
total market capitalization.
Scenario 1 The rm issues 1,000 new shares of stock at a price lower than the current market
price (P

0
= 50):
MKTCAP

= $100, 000 + $50 1, 000 = $150, 000


P

0
= $150, 000 2, 000 = $75
Since the new price per share P

0
= $75 is less than the original price per share P
0
= $100 this
issuance of stock has diluted the value of outstanding shares.
Scenario 2 The rm issues 1,000 new shares of stock at the current market price (P

0
= $100):
MKTCAP

= $100, 000 + $100 1, 000 = $200, 000


P

0
= $2000, 000 2, 000 = $100
Since the new price per share P

0
= $100 is equal to the original price per share P
0
= $100 this
issuance of stock does not dilute the value of outstanding shares.
5.A. PREEMPTIVE RIGHT WORKAROUND 121
We talked about the preemptive right typically held by existing shareholders in Section 5.1.2.
Thus, Scenario 1 is unlikely. However, companies can and do issue warrants to executives. Warrants
are like stock options except a new share is issued by the corporation when exercised. Similar to a
call option a warrant is exercised only if the exercise price is below the current market price. In that
case we are back at Scenario 1 where the value of existing shares is diluted.
So, in general, issuing stock does not dilute shareholder value. This is because new shares are
typically issued at the current market price. However, with warrants executives can issue new shares
to themselves at below market prices. It is in this shady and questionable practice that shareholder
value is transferred from the many existing stockholders to the few executives.
122 CHAPTER 5. STOCK VALUATION
5.B Multi-growth rate DDM
In the Multi-growth rate DDM model dividends grow at a super- (or sub-) normal rate g
s
for n years.
After that dividends grow at a constant rate g
c
forever. Lets begin with the "Mother of Finance"
equation:

P
0
=
D
1
(1 + R
s
)
1
+
D
2
(1 + R
s
)
2
+ +
D
n
(1 + R
s
)
n
+
D
n+1
(1 + R
s
)
n+1
+
D
n+2
(1 + R
s
)
n+2
+ (5.18)
Multiple growth rate formula I use

P
0
to emphasize this is an intrinsic value calculation, not
the actual market value.

P
0
=
D
1
(1 + R
s
)
1
+
D
2
(1 + R
s
)
2
+ +
D
n
(1 + R
s
)
n
+
P
n
(1 + R
s
)
n
(5.19)
=
D
1
(1 + R
s
)
1
+
D
2
(1 + R
s
)
2
+ +
D
n
+ P
n
(1 + R
s
)
n
(5.20)
5.B. MULTI-GROWTH RATE DDM 123
where
g
s
= short term super- or sub-normal dividend growth rate
g
c
= long-term constant dividend growth rate
D
n
= dividend at the end of the abnormal growth period
R
s
= required rate of return
P
n
=
D
n+1
R
s
g
c
= the value of all remaining dividends in year n
D
n+1
= D
n
(1 + g
c
)
Expressed in compact form:

P
0
=
_
n

t=1
D
0
(1 + g
s
)
t
(1 + R
s
)
t
_
+
D
n
(1 + g
c
)
R
s
g
c

1
(1 + R
s
)
n
(5.21)
Example 5.6. D
0
= $1.00, g
s
= 12%, n =5 years, g
c
= 6%, R
s
= 10%
1
. What is P
0
?
1
From the 9th edition of Investments by Charles P. Jones
124 CHAPTER 5. STOCK VALUATION
Plugging into (5.21):

P
0
=
_
5

t=1
1(1 + 0.12)
t
(1 + 0.10)
t
_
+
_
1(1 + 0.12)
5
(1 + 0.06)
0.10 0.06

1
(1 + 0.10)
5
_
=
_
1(1.12)
1
1.10
1
+
1(1.12)
2
1.10
2
+ +
1(1.12)
5
1.10
5
_
+ 28.9983
= 5.2794 + 28.9983
= 34.28
For another example, see Brigham and Daves (2010) page 170.
Chapter 6
Financial options
Overview
Before delving into real options we must rst understand how options are priced. Since the value of
real options are based on nancial option theory we shall start there.
6.1 Financial options
Financial options are options to buy or sell an underlying asset at a pre-specied price on or before
a pre-specied date.
125
126 CHAPTER 6. FINANCIAL OPTIONS
6.1.1 Option types and markets
Call vs. put: buy vs. sell
American vs. European: any time vs. at expiration date only
Conventional vs. LEAPS: 6 months vs. 6 months to 2.5 years
Covered vs. naked: own underlying asset vs. do not
In-the-money vs. out-of-the-money: could exercise at a gain vs. would not exercise
Important features: option price, strike price, expiration date, volatility of underlying asset
Underlying asset can be individual stock, index, futures contract, etc.
No voting rights until after exercise
A couple of examples...
Table 6.1: The long and short of call and put
Call Put
Buyer (long position) option to buy option to sell
Seller (short position) obligation to sell obligation to buy
6.1. FINANCIAL OPTIONS 127
6.1.2 Factors that aect the value of a call option
S K, dierence between stock and exercise price
Expiration date
Volatility
6.1.3 Intrinsic value vs. option price
Intrinsic value for call option = max[P
0
X, 0], aka, exercise value
Market value = intrinsic value + time value
Time value diminishes as you approach expiration date
Options magnify returns and losses (but with a lower limit)
An example...
Note the option payo is asymmetric. The maximum loss for the long position is what you paid
for the option irrespective of how far the stock price drops.
QUESTION: What about the maximum loss for the short position, i.e., writer of a
call?
6.1
Three important factors associated with option values:
128 CHAPTER 6. FINANCIAL OPTIONS
1. Time until expiration: more time to see a large gain. c increases with t
2. Volatility: With greater volatility (risk) comes greater chance of a big gain. Combine this with
the limited downside and you have c increases with .
3. Risk free rate: Exercising requires cash. If interest rates are high, it will require less cash now
to exercise in the future.
QUESTION: How so?
6.2
Lower cost makes the option more valuable. Therefore c increases with r
f

6.2 Binomial option pricing model


6.2.1 Replicating portfolio approach
6.2.1.1 Given information
Current stock price = P
0
= 40
Price in the up state = P
u
= 50
Price in the down state = P
d
= 32
Call option strike price = K = 35
6.2. BINOMIAL OPTION PRICING MODEL 129
Risk free rate = r
f
= 8%
Time to expiration = 1 year = 365 days
40
50
32
Figure 6.1: Stock price tree
130 CHAPTER 6. FINANCIAL OPTIONS
c_0
15
0
unknown
Figure 6.2: Call option value
6.2.1.2 Replicating portfolio and option value
A portfolio is constructed using the underlying stock and risk free borrowing such that the portfolio
value is the same as the option value in all states (initial, up, and down). The replicating portfolio
is formed by purchasing N shares of stock and borrowing B dollars at r
f
.
We attribute positive values to the long position (purchase of stock) and negative values to the
short position (borrowing at r
f
). The value of the portfolio in each of the three states is computed
6.2. BINOMIAL OPTION PRICING MODEL 131
as follows:
V
0
= 40N B = c
0
(6.1)
V
u
= 50N
_
1 +
0.08
365
_
365
B = 15 (6.2)
V
d
= 32N
_
1 +
0.08
365
_
365
B = 0 (6.3)
Note
_
1 +
0.08
365
_
365
1.0833 and we now have three equations with three unknowns (N, B, c
0
).
Graphically:
40N-B
50N-1.0833B
32N-1.0833B
Figure 6.3: Option replicating portfolio
132 CHAPTER 6. FINANCIAL OPTIONS
Rearranging equation (6.3):
32N 1.0833B = 0
32N = 1.0833B (6.4)
Substituting (6.4) into (6.2):
50N 32N = 15
18N = 15
N = 0.8333 (6.5)
Substituting (6.5) into (6.4):
32(0.08333) = 1.08333B
B = 24.62 (6.6)
Substituting (6.5) and (6.6) into (6.1):
V
0
= 40(0.8333) 24.62 = 8.71
V
0
= c
0
= 8.71
Therefore the true or fundamental value of the call option is $8.71.
QUESTION: What are the time and intrinsic values of this option?
6.3
6.2. BINOMIAL OPTION PRICING MODEL 133
6.2.1.3 What if the market price is c
0
= 9.71?
We know that the true value is lower (8.71). Therefore, we can construct an arbitrage position:
i.e., a portfolio that (1) requires no investment, (2) has no risk, and (3) has positive returns. To do
so:
Sell option for 9.71 (short position)
Buy replicating portfolio for 8.71 (long position). Note this portfolio replicates the value of
the call option.
Invest remaining 9.71 8.71 = 1 in r
f
(long position)
Cash ows in the up state:
The option you sold at time 0 will be exercised and you will lose $15 -15.
The replicating portfolio you purchased at time 0 will be worth $15 +15.
You also invested $1 at time 0 in the risk free asset and now it is worth 1(1.0833) = 1.0833
+1.0833
Net cash ow (up) = 15 + 15 + 1.0833 = 1.0833
Cash ows in the down state:
The option will not be exercised 0
134 CHAPTER 6. FINANCIAL OPTIONS
Replicating portfolio = option value = 0
$1 investment now worth 1.0833
Net cash ow (down) = 0 + 0 + 1.0833 = 1.0833
Therefore, when the options market price is greater than the true option prince one can arbitrage:
No initial investment: Proceeds from option sale (short position) used to purchase both the
replicating portfolio (long position) and risk free asset (long position).
No risk: Whether we are in the up or down state the payo is the same, 1.0833.
Positive returns: 1.0833 > 0 and you used $0 to get it!
This scenario can not occur (not for long at least):
Selling of option drives the market price of the option down from 9.71 to true 8.71.
Purchasing of portfolio drives the market price of the stock up, which reduces the intrinsic
value (K P), which in turn drives the market price of the option down from 9.71 towards
true 8.71.
6.2.1.4 What if the market price is c
0
= 7.71?
We know the true value is higher (8.71). We can construct an arbitrage portfolio as follows:
6.2. BINOMIAL OPTION PRICING MODEL 135
Short sell the replicating portfolio. In eect, you are short selling N shares of stock and lending
(investing) B dollars at the risk free rate. +8.71
Buy (long position) 1 option at 7.71. -7.71
Invest 8.71 7.71 = 1 at the risk free rate. Note, this is in addition to the B dollars invested
at the risk free rate.
Cash ows in the up state:
Exercise the option purchased at t = 0 and receive $15 +15.
Close the short position on the replicating portfolio. In eect, you spend 50N = 50(0.83333) =
41.67 to purchase stock and return to owner but receive 1.0833B = 1.0833(24.62) = 26.67
from investing B dollars at the risk free rate. Therefore 41.67 + 26.67 = -15.
Receive 1.0833 from the $1 investment.
Net cash ow (up) = +15 - 15 + 1.0833 = 1.0833.
Cash ows in the down state:
Do not exercise the option 0.
Close the short position. Spend 32N = 32(0.8333) = 26.67 to purchase stock and return to
owner but receive 1.0833B = 1.0833(24.62) = 26.67 from investing B dollars at the risk free
rate 0.
136 CHAPTER 6. FINANCIAL OPTIONS
Receive 1.0833 from the $1 investment 1.0833.
Net cash ow (down) = 0 + 0 + 1.0833 = 1.0833.
As before we have an arbitrage scenario:
No initial investment: proceeds from the short sale of the replicating portfolio used to purchase
option and invest $1 at the risk free rate.
No risk: Whether we are in the up or down state the payo is the same, 1.0833.
Positive returns: 1.0833 > 0 and you used $0 to get it!
This can not occur for long:
Purchasing of option drives the market price of the option up from 7.71 to true 8.71.
Shorting of portfolio drives the market price of the stock down which increases the intrinsic
value of the call option, which in turn drives the market price of the option up from 7.71 to
true 8.71.
6.2.2 Riskless hedge approach
A portfolio that will earn the risk free rate regardless of what the stock does. Consider the binomial
approach for Acme corp. Let S
0
= 40. Consider option with value c (unknown at the moment),
strike price K = 35, time until expiration t = 1 year, and risk free rate r
f
= 8%. We are going to
construct a risk-less hedge buy purchasing N shares of the stock and selling 1 call option.
6.3. THE BLACK-SCHOLES OPTION PRICING MODEL 137
QUESTION: What happens if call price were higher?
6.4
QUESTION: What happens if call price were lower?
6.5
Clearly, it is dicult to know (guess) up and down states one year from now, but it is less
dicult 6 months, 3 months, 1 month from now
This leads to the binomial lattice (or tree).
Simply repeat exercise of before on each branch
A simple calculation that can be handled by recursive computer algorithm
QUESTION: Where do the new P
u
and P
d
values come from?
6.6
As the number of levels approaches the binomial option value converges to the Black-Scholes
option value
6.3 The Black-Scholes option pricing model
6.3.1 Assumptions
1. No dividends.
2. No transaction costs or taxes.
138 CHAPTER 6. FINANCIAL OPTIONS
3. Constant r
f
.
4. Can borrow at r
f
.
5. Short selling allowed.
6. European option.
QUESTION: What does this mean?
6.7
7. Random stock price movement with continuous trading.
Derivation of B-S OPM based on riskless hedge.
Formulas for the value of a call option
c = P (N [d
1
]) Xe
r
f
t
(N [d
2
]) (6.7)
d
1
=
ln[P/X] +
_
r
f
+

2
2
_
t

t
(6.8)
d
2
= d
1

t (6.9)
with
6.3. THE BLACK-SCHOLES OPTION PRICING MODEL 139
Variable Description
c current call option value
P current price of underlying stock
N[] probability
e 2.7183
r
f
continuously compounded risk free rate
ln natural logarithm

2
variance
Think of the left hand term P (N [d
1
]) as the expected present value of the stock price given
P
t
> X (option will be exercised).
Think of the right hand term Xe
r
f
t
(N [d
2
]) as the present value of the exercise price given
the option will be exercised.
Derivation is dicult, use of model is not.
Traders use this formula and actual prices are about the same as predicted by the formula.
6.3.2 OPM illustration
Let P
0
= 20, X = 20, t = 3 months (0.25 year), r
f
= 6.4%, and
2
= 0.16.
140 CHAPTER 6. FINANCIAL OPTIONS
1. Compute d
1
and d
2
d
1
=
ln[P/X] +
_
r
f
+

2
2
_
t

t
=
ln[20/20] +
_
0.064 +
0.16
2
_
0.25
0.4

0.25
= 0.180
d
2
= d
1
0.4

0.25
= 0.020
2. Use fancy calculator, table, or NORMSDIST in excel to obtain:
N [d
1
] = N[0.180] = 0.5714
N [d
2
] = N[0.020] = 0.4920
3. Compute value of option
c = 20(0.5714) 20e
0.064(0.25)
(0.4920) = 1.74
6.4. PUT OPTIONS 141
6.3.3 OPM factors and option value
If factor ___ increases... Then call option value...
P increases
X decreases
t increases
r
f
increases

2
increases
6.4 Put options
The value of put options can be obtained from the put-call parity relationship. Construct two
portfolios
Portfolio A Portfolio B
action buy put, buy stock buy call, invest PV of X
cost p + P
0
c + Xe
rt
payo at expiration PO
A
PO
B
For portfolio A, if P
t
X, you will exercise your put option and sell high at X. If P
t
> X
you will not exercise the put option for if you did you would be selling low (but you still have
P
t
).
For portfolio B, P
t
X, you will not buy high at X, therefore you will be left with X. If
P
t
> X, you will buy low at X and have an asset worth P
t
.
142 CHAPTER 6. FINANCIAL OPTIONS
Note both payos are the same. Therefore
PO
A
= PO
B
=
_
X P
t
X
P
t
P
t
> X
Therefore both portfolios must have the same cost. We arrive at the put-call parity relation:
p + P
0
= c + Xe
r
f
t
(6.10)
p = c + Xe
r
f
t
P
0
(6.11)
6.5 Corporate nance applications
6.5.1 Real options
How much is the option to develop cell phone software one year from now?
Up state: Market looks good, invest 30M in development (X), PV of prots=100M (i.e.,
exercised the real option).
Down state: Market looks bad, do not invest 30M, PV of prots=0. (do not exercise).
May be valued using techniques similar to those discussed earlier.
6.5. CORPORATE FINANCE APPLICATIONS 143
6.5.2 Risk management
Plant currently under construction, will issue 400M in bonds 6 months from now to pay for it
If rates remain the same (or fall) the plant will be protable.
If rates rise the plant will be unprotable.
Purchase put option on T-bond index.
If rates go up, company must issue high interest rate bonds (bad) but oset this with gains
from put option (good).
If rates go down, company issue low interest rate bonds (good) but eats the cost of the put
option (bad).
6.5.3 Capital structure decisions
Lets say a rm has debt with principal payment of 60M due in one year.
If the value of the rm is 61M at expiration, then make the principal payment (exercise option
to buy rm for 60M, net 1M).
If the value of the rm is 59M at expiration, do not make principal payment, allow bankruptcy
to happen, and the value to shareholders is zero.
How much is the option to buy the asset (the rm) worth?
144 CHAPTER 6. FINANCIAL OPTIONS
QUESTION: Where is the debt vs equity decision?
6.8
6.5.4 Compensation plans
FASB2004 requires options to be reported as an expense. What is the value of those options?
B-S or binomial OPM can be used to value those option grants
Chapter 7
Risk and return
Overview
Why look at investment returns? Concepts related to returns of securities also apply to
investments in projects.
QUESTION: What concepts might those be?
7.1
Section 1: Return and risk from a stand-alone perspective.
Section 2: Return and risk from a portfolio perspective.
Section 3: Ecient portfolios and portfolio selection.
Section 4: Asset pricing models.
145
146 CHAPTER 7. RISK AND RETURN
7.1 Stand alone return and risk
7.1.1 Basic return measures
Total return Typically applied to an individual security, measures the total return which includes
the yield component and capital gain component.
TR =
(P
1
P
0
) + CF
P
0
(7.1)
Note that total return may be positive or negative.
Relative return It is often to convenient to express return as a relative measure, hence the name
relative return:
RR =
P
1
+ CF
P
0
(7.2)
Can anyone relate RR to TR? .
An example...
Additional explanations can be found in Brigham and Daves (2010) pages 29 to 30.
7.1.2 Risk
Risk is the dispersion of returns (could be measured by standard deviation, range, downside
risk, Pr[r < 0], coecient of variation, etc).
Stand-alone risk is the risk faced if holding only one asset.
7.1. STAND ALONE RETURN AND RISK 147
7.1.2.1 Probability distribution
Denition: Outcomes and probabilities of these outcomes.
An example:
Demand Probability R
TechCo
R
FoodCo
strong 0.3 100% 40%
normal 0.4 15% 15%
weak 0.3 -70% -10%
QUESTION: Which stock is more risky and why?
7.2
QUESTION: What should probabilities add up to?
7.3
Now the calculations...
7.1.2.2 Expected rate of return
Given a discrete probability distribution:

R = E[R] =
n

i=1
Pr
i
R
i
(7.3)
148 CHAPTER 7. RISK AND RETURN
QUESTION: What are

R
TechCo
and

R
FoodCo
?
7.4
When given historical data you can compute:
Arithmetic mean:

R = E [R
i
] =
1
n
n

i=1
R
i
(7.4)
Geometric mean:
G =
_
n

i=1
RR
i
_
1/n
1 (7.5)
Arithmetic mean is typically used to estimate future returns (statistically, it is an unbiased
estimator) and Geometric mean is used to measure the realized compound rate of return.
A quick example...
7.1.2.3 Quantifying stand-alone risk: standard deviation
Given a discrete probability distribution:
variance =
2
=
n

i=1
_
R
i


R
_
2
Pr
i
(7.6)
standard deviation =

variance = (7.7)
7.1. STAND ALONE RETURN AND RISK 149
Note: (7.7) applies to both discrete and continuous distributions. For an example see Brigham
and Daves (2010) page 32 and 35.
When given historical data there are are three types of continuous distribution variance esti-
mates. These estimates are based on whether or not you have observed the entire population
(N) or just a sample of the population (n):
1. Input: population, output: population variance.

2
=
1
N
N

i=1
_
R
i


R
_
2
(7.8)
2. Input: sample, output: sample variance.
s
2
n
=
2
=
1
n
n

i=1
_
R
i


R
_
2
(7.9)
3. Input: sample, output: unbiased estimate of population variance.
s
2
=
1
n 1
n

i=1
_
R
i


R
_
2
(7.10)
We will primarily use (7.10) and call it
2
. For an example see Brigham and Daves (2010)
pages 37 and 38.
QUESTION: Has anyone heard of six-sigma quality?
7.5
150 CHAPTER 7. RISK AND RETURN
7.1.2.4 Coecient of variation
Another measure combines risk and return into a single number. This is called the coecient of
variation (CV). CV measures risk per unit of expected return.
CV =

R
7.2 Portfolio return and risk
Consider a portfolio with n securities. Let the percentage of a portfolio invested in security i be
represented by the portfolio weight w
i
. Note 0 w
i
1.
QUESTION: What does this mean?
7.6
Therefore
n

i=1
w
i
= 1
7.2.1 Portfolio return
The expected return on a portfolio p can be calculated as:

R
p
= E [R
p
] =
n

i=1
w
i
E [R
i
] (7.11)
7.2. PORTFOLIO RETURN AND RISK 151
where w
i
is the weight of security i and E [R
i
] is the expected return of security i obtained from Eq.
(7.4) or Eq. (7.3).
An example...
7.2.2 What portfolio risk is not
Portfolio risk can not be calculated by simply taking a weighted average of individual risks:

2
p
=
n

i=1
w
i

2
i
(7.12)
But this is a good thing. In reality, the portfolios risk will be less.
7.2.3 Analyzing portfolio risk
If all securities have the same risk
2
i
=
2
, and these risks are independent of each other, then
the standard deviation of the portfolio is given by:

p
=

n
1/2
(7.13)
In reality, everything is related to some extent, so such a simple formula can not be used.
152 CHAPTER 7. RISK AND RETURN
7.2.4 Diversication
Diversication is critical to managing risk.
The simplest diversication is called random or naive diversication. This is accomplished by
randomly picking securities from what is available.
7.2.5 Modern portfolio theory
The inequality in equation (7.12) is due to relationships between the movement of stocks
Modern portfolio theory (MPT) is essentially the derivation of a portfolio risk measure that
accounts for
1. weighted individual security risks, and
2. weighted co-movements between securities returns.
7.2. PORTFOLIO RETURN AND RISK 153
Figure 7.1: Portfolio risk vs. number of securities
154 CHAPTER 7. RISK AND RETURN
7.2.6 Measuring co-movements in security returns
7.2.6.1 Correlation coecient
The relative relationship between co-movements of returns of returns is measured by the cor-
relation coecient :
=
_

_
+1.0 perfect positive correlation
0 no correlation
1.0 perfect negative correlation
Nothing is perfect.
QUESTION: Intel / Dell positive or negative? American Airlines and Exxon?
7.7
7.2.6.2 Covariance
The absolute measure of co-movement is called covariance
AB
.
To compute covariance using a discrete probability distribution:

ab
=
n

i=1
_
R
ai


R
a
__
R
bi


R
b
_
Pr
i
(7.14)
To compute covariance using historical data:
cov[a, b] =
ab
=
1
n 1
n

i=1
_
R
ai


R
a
__
R
bi


R
b
_
(7.15)
7.2. PORTFOLIO RETURN AND RISK 155
Covariance and correlation are related in the following manner:

ij
=

ij

j
(7.16)
7.2.7 Calculating portfolio risk
7.2.7.1 Two-security case
For the two-security case portfolio risk
p
is calculated as:

2
p
= w
2
1

2
1
+ w
2
2

2
2
+ 2w
1
w
2

12

2
(7.17)
An example...
156 CHAPTER 7. RISK AND RETURN
7.2.7.2 The n-security case
In general,

2
p
=
n

i=1
w
2
i

2
i
+
n

i=1
n

j=1
i=j
w
i
w
j

ij
(7.18)
=
n

i=1
n

j=1
w
i
w
j

ij
(7.19)
=
n

i=1
n

j=1
w
i
w
j

ij

j
(7.20)
Therefore three variables determine portfolio risk:
1. Individual variances,
2
i
2. Covariances,
ij
3. Weights, w
i
Note: as the number of securities increases, the importance of each securitys variance decreases.
QUESTION: Why?
7.8
7.3. EFFICIENT PORTFOLIOS AND PORTFOLIO SELECTION 157
7.2.8 Markowitz portfolio model
The set of portfolios generated by the Markowitz portfolio model, i.e., feasible portfolios obtained
by varying w
i
and w
j
in:
E [R
p
] =
n

i=1
w
i
E [R
i
] (7.21)

2
p
=
n

i=1
n

j=1
w
i
w
j

ij
(7.22)
7.3 Ecient portfolios and portfolio selection
Now that we know how to construct all feasible portfolios, which is best?
7.3.1 Building a portfolio using Markowitz principles
The Markowitz technique for optimal portfolio selection has two steps.
1. Identify optimal risk-return combinations from available risky assets.
2. Choose optimal portfolio from ecient frontier based on investors risk preferences.
The Markowitz portfolio selection model (how investors should act to diversify) is based on three
assumptions:
158 CHAPTER 7. RISK AND RETURN
A1 Only a single investment period is considered.
A2 There are no transaction costs.
A3 Preferences are based only on expected return and risk
7.3.2 Individual utility
Ecient frontier The set of portfolios generated by the Markowitz portfolio model. These port-
folios have the highest return for a given level of risk.
Indierence curves Curves describing investor preferences for risk and return
Risk averse If given a choice, you will not take a fair gamble (gamble that has equal probabilities
of gain or loss).
7.3.3 Generating the ecient frontier
Given the following inputs,
estimates of expected return for each security (n estimates) r
i
,
estimates of risk for each security (n more estimates)
i
, and
correlation of securities (some more estimates)
ij
,
a computer program varies portfolio weights until the return is maximized for a given level of risk.
7.3. EFFICIENT PORTFOLIOS AND PORTFOLIO SELECTION 159
7.3.4 Summary of the Markowitz model
1. The model is a two-parameter model (expected return and risk).
2. Portfolios on a given indierence curve are equally good.
3. The model does not incorporate risk-free assets.
4. Model input estimation varies.
5. Model is cumbersome. As n increases, the number of required estimates increases according
to:
number of estimates =
n(n + 3)
2
(7.23)
Elaborating on (7.23), lets look at the number of estimates required for a 3 security case. The
covariance matrix is:
_
_

11

12

13

21

22

23

31

32

33
_
_
However, we know
ii
=
2
i
and
ij
=
ji
. Therefore:
_
_

2
1

12

13

12

2
2

23

13

23

2
3
_
_
Finally, the number of estimates required for the Markowitz model includes 3 variances, 3 covariances,
and 3 expected returns for a total of 9 estimates.
160 CHAPTER 7. RISK AND RETURN
7.3.5 Alternative method of obtaining the ecient frontier: Excel solver
7.4 Asset pricing models
7.4.1 Capital market theory
CMT is a set of predictions concerning equilibrium expected returns. It is based on some simplifying
assumptions.
1. All investors can borrow or lend money at R
F
.
2. Investors have homogeneous expectations based on expected return, variance of returns, and
correlations.
3. All investors have the same one-period time horizon.
4. There are no transaction costs.
5. There are no taxes.
6. There is no ination.
7. No single investor can aect the price of a stock.
8. Capital markets are in equilibrium.
QUESTION: What did we say equilibrium was?
7.9
7.4. ASSET PRICING MODELS 161
It is important to note that although these assumptions may seem unrealistic, a true measure of a
models worth is its explanatory power.
All models are wrong, some are useful.
Introduction of the risk free asset
QUESTION: What is a risk free asset?
7.10
7.4.2 The capital market line
Capital Market line: The trade o between expected return and risk for ecient portfolios.
Instead of RF, A, and B, the CML is the straight line when applied to the Markowitz ecient
portfolio. Now for a picture...
Market portfolio: The portfolio of all risky assets
Under CMT, all investors will hold some combination of the risk free asset and the market
portfolio.
QUESTION: Why?
7.11
Separation theorem: The decision of which portfolio of risky assets to hold is separate from the
decision of how to allocate investable funds between the risk-free asset and the risky asset.
162 CHAPTER 7. RISK AND RETURN
7.4.3 The security market line
The CML represents the risk/return trade o for combinations of risk free asset and ecient portfolio.
The SML represents the risk/return trade o for individual securities or inecient portfolios.
Beta: A measure of a securitys risk relative to the market.
CAPM: Capital asset pricing model. Relates the required rate of return for a security given its
level of risk as measured by beta.
Note the required rate of return is the risk free rate plus a risk premium. The CAPM equation
is simply the equation of the SML:
E[R
i
] = R
f
+
i
(E[R
m
] R
f
) (7.24)
More information on the inputs to the CAPM model are found in Section 11.4.1. Now for an
example...
7.4.4 Estimating SML (CAPM)
Market Model Linear relationship between the return on each stock to the return on the market.
The SML (collection of /E[R
i
] relationships, is often estimated using standard OLS regression:
R
it
=
i
+
i
R
mt
+
it
(7.25)
7.5. TESTS OF THE CAPM 163
In this model, the total return measurement is used. Because all models are wrong and some are
useful, observations will be observed above and below the tted line. You can estimate beta via the
regression above or the following equation:

i
=

im

2
m
=
im
_

i

m
_
(7.26)
7.5 Tests of the CAPM
The conclusions are of CAPM are sensible:
1. Return and risk are positively related - greater risk should carry greater return.
2. The relevant risk for a security is a measure of its market (systematic) risk.
An obvious question is: how well does the model match reality? Extensive research has been done
by academics and by practitioners. There is some consensus on conclusions:
1. The SML appears to be linear.
2. The intercept term is generally higher than RF.
3. The slope of CAPM is generally less steep than posited by the theory.
4. No persuasive case has been made that non systematic risk commands a risk premium. That
is the ratio of risk/return is not better for a highly risky company and therefore investors are
rewarded only for assuming systematic risk.
164 CHAPTER 7. RISK AND RETURN
7.6 Stock market equilibrium
Consider stock with = 2, R
f
= 8%, and

R
m
= E[R
m
] = 12%.
QUESTION: What is the required return of the stock?
7.12
You expect constant growth of 5%, the last dividend was $2.8571, and the current price is $30.
QUESTION: Should you buy, sell, or hold the stock?
7.13
Thus, in equilibrium, R
s
=

R
s
and P
0
=

P
0
, with

R
s
and

P
0
set by the marginal investor.
7.6.1 Changes in equilibrium prices
Of course stock prices change day-to-day, minute-to-minute... why?
Consider the following changes:
Variable Old New
R
f
8% 7%
E[R
m
] 12% 10%
2 1
g 5% 6%
D
0
2.8571 2.8571
P
0
27.27 ?
7.6. STOCK MARKET EQUILIBRIUM 165
QUESTION: What is the new price?
7.14
Stock prices adjust to changing conditions and expectations
7.6.2 Ecient Markets Hypothesis (EMH)
Market always in equilibrium: R
s
=

R
s
and P
0
=

P
0
.
One can not consistently beat the market.
7.6.3 Levels of market eciency
Weak form All past price and volume information are fully reected in current prices. You can
not nd a pattern.
Semi-strong form Weak plus public information (earnings reports, management changes, etc.)
Strong form Semi-strong plus private information
7.6.4 Implications
Cant beat the market: tests support weak and semi-strong EMH but corporate ocers can
do better than market.
A quote from Brigham and Daves (2007)
166 CHAPTER 7. RISK AND RETURN
some investors may be able to analyze and react more quickly...these investors may have
a temporary advantage.
This does not include any of us gathering data from Yahoo nance, crunching numbers with
excel, and then making a trade.
If market is strong form ecient management decisions based on under- or over-valuation do
not make sense.
QUESTION: Why?
7.15
7.6.5 Actual stock prices and returns
Generally expected and realized prices (returns) dier
Investing in international stocks
May improve diversication.
QUESTION: What is missing in the chapter to support this claim?
7.16
Dont forget about exchange rate uctuations. Swiss stocks gained only 4.78% in 2004 in their
local currency but 14.18% in USD!
7.6. STOCK MARKET EQUILIBRIUM 167
Stock market reporting
You can obtain detailed real time info from Bloomberg for a pretty steep fee of course.
Still not fast enough to beat those with expensive computers moved next door to NYSE or
Nasdaq servers.
168 CHAPTER 7. RISK AND RETURN
Part II
Corporate valuation
169
Chapter 8
Managerial accounting
Overview
Topic covered in this chapter...
There are three basic nancial statements.
QUESTION: What are they?
8.1
Relevant information on those statements
How income is inated and debt is hidden
Modifying nancial statements for use by managers and investors: Net income, EPS, EBITDA,
NOPAT, FCF, MVA, EVA
171
172 CHAPTER 8. MANAGERIAL ACCOUNTING
Taxes from company and investor perspectives
8.1 Financial reports
Include quantitative (what happened) and verbal (why it happened) information
Provides a picture of operations, the nancial position, and outlook
8.2 Balance sheet (BS)
The balance sheet is a snapshot of current nancial position (often includes historical infor-
mation).
The balance: Assets = Liabilities + shareholders equity
QUESTION: What order are assets listed in?
8.2
QUESTION: What order are liabilities and shareholder equity listed in?
8.3
Where a lot of operating capital measures are derived from.
Assets are typically reported at [depreciated] book value.
Assets were purchased via liabilities (debt, accounts payable and accruals, or deferred taxes)
and equity (money initially invested by owners and retained earnings).
8.2. BALANCE SHEET (BS) 173
Remember the beer equation A = L + E
Lets look at Table 8.1 line-by-line.
4. Current assets
Inventory accounting as LIFO or FIFO impacts the balance sheet and the income statement.
Current assets are assets that can be converted to cash within one year.
QUESTION: What are some examples of current assets?
8.4
5-8. Long-term assets and liabilities
While short-term liabilities are typically used to nance current assets, long-term assets tend
to be funded by long-term liabilities and equity.
QUESTION: Can anyone think of personal nance analogues?
8.5
Long-term assets can be tangible or intangible.
7. Tangible: Net PP&E, vehicles, subsidiaries
8. Intangible: patents, copyrights, licensing agreements, customer lists, goodwill, etc.
174 CHAPTER 8. MANAGERIAL ACCOUNTING
Table 8.1: Balance sheet
I. Assets
1. Cash
2. Inventories
3. Other Current Assets
4. Total Current Assets: #1 + #2 + #3
5. Property, Plant, and Equipment
6. Less: Accumulated Depreciation
7. Net PP&E: #5 - #6
8. Goodwill and Other Assets
9. Total Assets: #4 + #7 + #8
II. Liabilities
10. Accounts Payable and Accruals
11. Notes Payable
12. Accrued Taxes
13. Total Current Liabilities: #10 + #11 + #12
14. Long-Term Debt
15. Total Liabilities: #13 + #14
III. Equity
16. Preferred Stock
17. Common Stock
18. Additional Paid In Capital
19. Total Paid In Capital: #17 + #18
20. Retained Earnings
21. Treasury Stock
22. Total Stockholders Equity: #16 + #19 + #20 + #21
23. Total Liabilities and Equity: #9 = #15 + #22
8.2. BALANCE SHEET (BS) 175
QUESTION: What is Net PP&E?
8.6
QUESTION: What is Goodwill?
8.7
As Ross Perot said, stu breaks, their value declines over time. Net PP&E is the initial
cost less accumulated depreciation.
There are choices on how much to depreciate each year: straight-line, double declining balance,
sum-of-years digits, accelerated schedules, etc.
Long term liabilities include debt with maturities > greater than one year, pension obligations,
and...
QUESTION: What else?
8.8
13. Current liabilities
Current liabilities are liabilities due within one year.
QUESTION: What are some examples of current liabilities?
8.9
16. Equity: preferred stock
Preferred Stockholders receive a xed dividend payment
The Board of Directors can stop dividend payments. However, when times are good again,
typically the missed preferred dividends must be paid before any common stockholders can
pay dividends.
176 CHAPTER 8. MANAGERIAL ACCOUNTING
17. Equity: common stock
Common stock holders have voting rights, pre-emptive rights, dividend rights, and residual
value rights.
To explain the distinctions between common stock, additional paid-in capital, and total paid-in
capital consider a rm started with $100,000 (the total paid in capital). The rm raised the
$100,000 by issuing 1,000 shares with a par value of $1, but a market value of $100. Given the
$1 par value, the common stock account item on the balance sheet is $1 x 1,000 = $1,000 and
the additional paid-in capital is 100,000-1,000=$99,000
Interpretation: The par value is arbitrary and meaningless. What really matters is total paid-in
capital.
20. Equity: retained earnings
Earnings that are not distributed to common stockholders as dividends are retained earnings.
Earnings = Cash.
QUESTION: Why not?
8.10
21. Equity: treasury stock
Companies that repurchase their own stock account for those holdings as Treasury Stock.
The prudence of repurchasing stock is debatable. One theory is market timing by rm man-
agement.
8.2. BALANCE SHEET (BS) 177
Market and book values
QUESTION: What is the dierence between market value and book value?
8.11
One advantage of market value is the current representation of true nancial position.
A disadvantage is the diculty in Marking to market for illiquid assets and liabilities.
Assets
The book value (reported value) of current assets tends to be close to the market value.
The book value of longer-term assets (such as equipment depreciated on an accelerated schedule
or land purchased some time ago that has had substantial appreciation) can vary signicantly
from the market value.
Liabilities
The book value of long term liabilities such as long-term bonds will dier from the market
value as interest rates and default risk varies.
Equity
The book value of equity provides little information on the value of the rm.
178 CHAPTER 8. MANAGERIAL ACCOUNTING
However, if all assets and liabilities were marked-to-market, the resulting equity value would
be a more informative measure, albeit incorrect, measure of market value.
This points to the very important concept of synergy.
QUESTION: Does anyone want to take a guess at how synergy applies to a larger
true market value of common stock than the estimated market value from a
marked-to-market ALE equation?
8.12
8.3 Income statement (IS)
Performance during the period (cash and non-cash items included)
EBITDA: Earnings before interest, taxes, depreciation and amortization
QUESTION: What is the distinction between depreciation and amortization?
8.13
Net income = net income available to common stockholders = revenues - expenses - taxes -
preferred dividends = the bottom line
The income statement is a statement of protability over a period of time (one quarter or one
year).
8.3. INCOME STATEMENT (IS) 179
Table 8.2: Income statement
1. Net Sales (Revenues) REV
2. Cost of Goods Sold CGS
3. Selling, General, and Administrative SGA
4. Earnings Before Interest, Taxes, Depreciation,
and Amortization
EBITDA
5. Depreciation and Amortization DA
6. Earnings Before Interest and Taxes EBIT
7. Interest Expense I
8. Earnings Before Taxes EBT
9. Taxes T
10. Net Income NI
11. Common Stock Dividends CSD
12. Additions to Retained Earnings ARE
The high-level equation for the income statement is:
NI = R E
(net income equals revenues less expenses).
Lets look at Table 8.2 line-by-line.
180 CHAPTER 8. MANAGERIAL ACCOUNTING
1. Revenues: Revenues are obtained from the sale of goods (e.g., cars) or services (e.g., consulting
or air travel.
QUESTION: Do you remember what was said about revenue recognition and the
matching principle?
8.14
2. Cost of Goods Sold: Includes the variable costs of labor, supplies, utilities, etc.
3. Selling, General, and Administrative: Includes costs not directly related to the production of
goods and services such as marketing, advertising, oce building (net factory) lease, bonus
checks, etc.
4. EBITDA: Represents earnings from operations
EBITDA = REV CGS SGA
5. Depreciation and Amortization:
(a) Both of these are non-cash expenses.
(b) Firms tend to use accelerated depreciation schedules when reporting to the IRS and
straight-line when reporting to the SEC and shareholders.
QUESTION: Why?
8.15
(c) Depreciation is associated with tangible assets while Amortization is associated with
intangible assets.
8.3. INCOME STATEMENT (IS) 181
QUESTION: Does it make sense that an intangible asset (such as patents)
is depreciable?
8.16
6. EBIT = EBITDA DA
7. Interest Expense. Just as your mortgage has both interest and principle (hopefully), the
interest is tax deductible.
QUESTION: Where is the principal repayment accounted for?
8.17
8. EBT = EBIT I
9. Taxes: Firm must pay Uncle Sam based on EBT.
QUESTION: Why not based on EBIT?
8.18
10. NI = EBT T
11. Common Stock Dividends: If any common stock dividends are paid during the income state-
ment period they are reported here.
12. Additions to Retained Earnings: All income that is not distributed to stockholders is an
addition to retained earnings.
ARE = NI CSD
QUESTION: What if NI < 0?
8.19
182 CHAPTER 8. MANAGERIAL ACCOUNTING
8.3.1 Statement of retained earnings (SoRE)
Retained earnings: portion of earnings that has been saved (could be cash, short-term nancial
instruments, long-term nancial instruments, equipment purchases, etc.)
The statement
retained earnings
t
= retained earnings
t1
+ net income
t
dividends
t
8.3.2 Net cash ow
Net income (a.k.a., accounting prot) includes non-cash items, net cash ow does not:
net cash ow (NCF) = net income noncash rev. + noncash charges
net income + depreciation and amortization
QUESTION: Why add non cash charges and subtract non cash revenues?
8.20
QUESTION: Why the sign?
8.21
Non cash revenues: changes in deferred revenues
Non cash expenses: depreciation, amortization, goodwill
8.4. STATEMENT OF CASH FLOWS (SOCF) 183
8.4 Statement of cash ows (SoCF)
cash
t
= cash
t1
+ net income
t
because...
preferred dividends
non cash adjustments
changes in working capital: increase in inventories decrease cash, decrease in accounts
payable reduction of cash
purchase/sale of xed assets
issue stock raises cash; buyback stock or repay debt reduces cash
All of the above are reected in SoCF
QUESTION: What are the three categories in the SoCF?
8.22
Three hints:
1. Category one includes net income and non cash adjustments; changes in current assets and
liabilities (accounts payable, receivables, inventories, accruals)
2. Category two includes the purchase/sale of xed assets.
3. Category three includes the sale/issue of short/long term debt, sale/issue of stock.
184 CHAPTER 8. MANAGERIAL ACCOUNTING
Net cash ow from operating activities is perhaps the most important item in all of the nancial
statements.
1. Net income can be manipulated and presented as positive all the way to bankruptcy.
2. It is more dicult to lie about cash.
3. If net cash ow is negative your operations (core business) is not generating cash.
4. With negative cash ows comes borrowing and/or liquidation of short term investments
so watch the trend.
Lets walk through the statement of cash ows, Table 8.3, line-by-line.
Operating activities
Line 1. Net income. This is directly from the income statement and includes numerous non-
cash expense deductions (e.g., depreciation and amortization) and non-cash income additions
(e.g., increase in accounts receivable)
Line 2. Depreciation and Amortization. This is a non-cash deduction from EBITDA that is
reversed by adding it back.
Line 3. Increase in Accounts Payable. Some of the items in CGS are materials used for
production but purchased on credit. Thus, the deduction from revenues in the amount of
AP was a noncash expense that is reversed by adding AP to NI.
8.4. STATEMENT OF CASH FLOWS (SOCF) 185
Table 8.3: Statement of cash ows
I. Operating activities
1. Net Income
Additions (Noncash Expenses)
2. Depreciation and Amortization
3. Increase in Accounts Payable
4. Decrease in Other Current Assets
5. Increase in Accrued Income Taxes
Subtractions (Noncash Income)
6. Increase in Accounts Receivable
7. Increase in Inventories
8. Net Cash From Operating Activities
II. Investing activities
9. Property, Plant, and Equipment and Other Assets
10. Increase in Goodwill and Other Assets
11. Net Cash From Investing Activities
III. Financing activities
12. Increase in Notes Payable
13. Increase in Long-Term Debt
14. Common Stock Dividend Payments
15. Purchase of Treasury Stock
16. Net Cash From Financing Activities
IV. Cash reconciliation
17. Net Increase in Cash and Marketable Securities
18. Beginning Cash and Marketable Securities
19. End of Period Cash and Securities
186 CHAPTER 8. MANAGERIAL ACCOUNTING
Line 4. Decrease in other Current Assets. Other current assets are current assets other than
accounts receivable inventories, cash, marketable securities, bank loans, and notes payable.
Suppose oce supplies were purchases last year but not yet used (you got 10,000 reams of
paper at a huge discount). This year, the year of reporting, the company uses $3,000 of paper.
This triggers, or impacts the balance sheet via a reduction in other current assets of $3,000
and impacts the income statement as a noncash expense included in SG&A. Since this noncash
expense was deducted from revenues via SG&A, it is reversed by adding the decrease in other
current assets to NI. As an example:
3.3 Cash llows
CperaLlng AcLlvlLles
3. lncrease ln AccounLs ayable. Some of Lhe lLems ln CCS are maLerlals used for producLlon buL
purchased on credlL. 1hus, Lhe deducLlon from revenues ln Lhe amounL of AA was a noncash expense
LhaL ls reversed by addlng AA Lo nl.
4. uecrease ln CLher CurrenL AsseLs. Suppose offlce supplles were purchases lasL year buL noL yeL used
(you goL 10,000 reams of paper aL a huge dlscounL). 1hls year, Lhe year of reporLlng, Lhe company uses
$3,000 of paper. 1hls Lrlggers, or lmpacLs Lhe balance sheeL vla a reducLlon ln oLher currenL asseLs of
$3,000 and as a noncash expense lncluded ln SC&A. slnce Lhls noncash expense was deducLed from
revenues vla SC&A, lL ls reversed by addlng Lhe decrease ln oLher currenL asseLs Lo nl. As an exemple:
$70 ln SC&A
$100 ln prepald asseLs, use $70
CLher currenL asseLs reduced by $70
3. lncrease ln Accrued lncome 1axes. nl lncludes Laxes owed (1) on earnlngs before Laxes (L81) for LhaL
perlod. Powever, Lhe check Lo Lhe l8S wlll noL be malled unLll nexL perlod. ln addlLlon Lo appearlng on
Lhe lncome SLaLemenL, Lhe amounL of Laxes owed (1) ls also added Lo Lhe 8alance SheeL llablllLy
Accrued lncome 1axes." 1herefore an lncrease ln accrued Laxes represenLs a noncash expense LhaL was
deducLed from revenues LhaL ls reversed by addlng Lhe lncrease ln Accrued lncome 1axes Lo nl.
7. lncrease ln lnvenLorles. An lncrease ln lnvenLory ls noL expllclLly accounLed for ln Lhe lncome
SLaLemenL yeL may be necessary as parL of rouLlne operaLlons. lor example, an lncrease ln lnvenLory
may be Lhe resulL of preparaLlon for sales ln Lhe nexL perlod. 1he addlLlonal lnvenLory may have been
purchased wlLh cash ln whlch case Lhe deducLlon of AlnvenLory from nl ls obvlous. 1he addlLlonal
lnvenLory could have been purchased on credlL ln whlch Lhe lncrease ln lnvenLory would be offseL by Lhe
lncrease ln AccounLs ayable.
Line 5. Increase in Accrued Income Taxes. NI includes taxes owed (T) on earnings before
taxes (EBT) for that period. However, the check to the IRS will not be mailed until next
period. In addition to appearing on the Income Statement, the amount of taxes owed (T) is
also added to the Balance Sheet liability Accrued Income Taxes. Therefore an increase in
accrued taxes represents a noncash expense that was deducted from revenues that is reversed
by adding the increase in Accrued Income Taxes to NI.
Line 6. Increase in Accounts Receivable.
8.4. STATEMENT OF CASH FLOWS (SOCF) 187
QUESTION: Why is this a non-cash income?
8.23
Line 7. Increase in Inventories. An increase in inventory is not explicitly accounted for in the
Income Statement yet may be necessary as part of routine operations. For example, an increase
in inventory may be the result of preparation for sales in the next period. The additional
inventory may have been purchased with cash in which case the deduction of Inventory from
NI is obvious. The additional inventory could have been purchased on credit in which the
increase in inventory would be oset by the increase in Accounts Payable.
Line 8. Net cash from Operating Activities.
Investing activities
Line 9. PP&E and Other Assets. This includes the purchase (use of cash - negative number)
or sale (source of cash - positive number) of long-term tangible assets.
QUESTION: What if PP&E were purchased via long-term debt?
8.24
Line 10. Increase in Goodwill and Other Assets. Indicates the purchase (use of cash, negative
number) or sale (source of cash, positive number) of intangible assets.
Line 11. Net Cash Used in Investing Activities. The sum of #9 and #10.
188 CHAPTER 8. MANAGERIAL ACCOUNTING
Financing activities
Line 12. Increase in notes payable.
QUESTION: Does an increase in notes payable reect cash received or cash
spent by the company?
8.25
Line 13. Increase in Long-Term Debt. Some deal as notes payable.
Line 14. Common Stock Dividend. Dividend payments are cash expense.
Line 15. Purchase of Treasury Stock. Cash is required to purchase treasury stock.
Line 16. Net Cash Flow from Financing Activities. The sum of #12 to #15.
Cash reconciliation
Line 17. Net increase in cash and marketable securities. The sum of #8, #11, and #16.
Line 18. Beginning cash and securities. Self explanatory.
Line 19. End of period cash and securities. The sum of #7 and #18.
8.5 Modifying accounting data
Thus far data presented for creditor, tax collector, SEC, and accounting consultant perspective.
Now we modify the data for use by managers and investors.
8.5. MODIFYING ACCOUNTING DATA 189
8.5.1 Operating assets and total net operating capital (TNOC)
Firms and divisions dier in nancial structure, tax situation, and mix of operating and non-
operating assets.
To make apples-to-apples comparisons, you want to look at what a manager generates (oper-
ating income, EBIT) with what he/she has (operating assets).
First modication: Total assets
Non operating assets: cash and short-term investments in excess of that required for
normal operations, land held for future use, etc.
Operating assets: necessary to operate business
long-term operating assets: plant and equipment
current operating assets (a.k.a., operating working capital): inventory, cash, accounts
receivable
Where are we going with this? Money from investors (stockholders, bondholders, banks who
gave loans) is used to acquire capital. too much capital lower ROI for investors.
Note: not all capital is paid for by investors.
QUESTION: Where does the rest come from?
8.26
190 CHAPTER 8. MANAGERIAL ACCOUNTING
Capital acquired with investor-supplied funds
NOWC = OCA OCL (8.1)
where NOWC is Net Operating Working Capital, OCA is Operating Current Assets, and
OCL is Operating Current Liabilities
General rule of thumb: if item is a discretionary choice it is not an operating current asset nor
a operating current liability.
QUESTION: Can anyone think of some examples?
8.27
Thus, in general:
OCA = cash + accounts rcv. + inventories (8.2)
OCL = accounts pay. + accruals (8.3)
Now, add operating long-term assets (OLTA) (typically net PP&E) and you have Total Net
Operating Capital (TNOC, aka, operating capital, net operating assets, capital)
TNOC = NOWC + OLTA (8.4)
An example...
Things to look for
8.5. MODIFYING ACCOUNTING DATA 191
1. Trend of capital relative to revenue (from income statement)
2. Are we increasing capital but not increasing revenue?
3. How are capital increases nanced (investor money or suppliers/employees)?
8.5.2 Net operating prots after taxes (NOPAT)
If two companies dier only in amount of debt the company with more debt would have higher
interest expenses and therefore lower...
QUESTION: ...What?
8.28
This is where NOPAT comes in:
NOPAT = EBIT (1 ) (8.5)
where is the tax rate
Things to look for
1. The trend in NOPAT relative to EPS. Increase in NOPAT with decrease in EPS
decrease in EPS not due to decrease in operating prot.
2. NOPAT/NOWC: How good is the company at managing operating cash, suppliers, and
accruals: more prots with less investor-supplied capital?
192 CHAPTER 8. MANAGERIAL ACCOUNTING
8.6 Free cash ow (FCF)
Free cash ow is the cash ow available after necessary xed asset and working capital invest-
ment to sustain ongoing operations. The investment to sustain ongoing operations could be
viewed as the investment required to maintain the current sales growth rate.
QUESTION: What is another way to interpret FCF?
8.29
8.6.1 Calculating FCF
1. Compute the net investment in operating capital.
TNOC
t
= TNOC
t
TNOC
t1
(8.6)
2. Compute FCF
FCF = NOPAT TNOC (8.7)
An example...
QUESTION: Interest expense is used to lower taxable income and tax expense. Does
that mean that net income will increase with interest expense due to the lower tax
expense?
8.30
8.6. FREE CASH FLOW (FCF) 193
8.6.2 Uses of FCF
Essentially two: (1) invest in capital (tangible and intangible) for growth or (2) return to
investors (debt repayment, pay dividends, pay interest, repurchase stock).
Some evidence exists that associates high levels of FCF with lower rm value. This could be
due to wasteful spending with all that extra money (overpaying for acquisition).
8.6.3 FCF and corporate value
Again, FCF is cash available to distribute to stakeholders.
This takes into consideration necessary investment (e.g., ongoing operations or investment to
maintain g).
Value = discounted value of future FCF discounted at WACC.
We will see how to forecast FCFs in future chapters and connect this with a model to arrive
at rm value.
8.6.4 Evaluating FCF, NOPAT, and operating capital
What to look for
1. If FCF < 0, investors had to provide additional money via cash, debt issuance, or equity
issuance to maintain operations.
194 CHAPTER 8. MANAGERIAL ACCOUNTING
2. If FCF > 0 and growing: need to make some decisions on what to do with the money.
Is FCF < 0 necessarily bad?
If NOPAT < 0 it could be bad.
If NOPAT > 0 could be a high growth company that requires additional investment to
achieve the desired growth level.
QUESTION: How can a rm have positive FCF yet negative NOPAT?
8.31
Okay, additional money from investors is used for growth, but is this growth protable enough?
Insert the Return on Invested Capital (ROIC):
ROIC =
NOPAT
TNOC
(8.8)
We will see in Section 8.7.2 if ROIC > WACC then the growth is protable
An example...
8.7 MVA and EVA
Thus far we have not mentioned stock price.
Managers should be maximizing shareholder value.
8.7. MVA AND EVA 195
MVA and EVA can be used to assess managerial and rm performance.
8.7.1 Market Value Added (MVA)
Let MVS = market value of stock.
MV A = MV S equity
= (common shares outstanding)P total common equity (8.9)
where P is the current stock price.
Note: MVA is based on the time frame of company inception to the present.
To assess current management we turn to EVA.
8.7.2 Economic Value Added (EVA)
EVA is the dierence between after-tax prots and after-tax cost of all capital.
The cost of debt capital is fairly straightforward: the interest rate agreed to
The cost of equity represents the opportunity cost: the rate the investor could have earned
elsewhere.
196 CHAPTER 8. MANAGERIAL ACCOUNTING
EVA computation:
EV A = NOPAT TNOC(WACC)
= TNOC(ROIC WACC) (8.10)
QUESTION: Where did the second equation come from?
8.32
Thus, if ROIC < WACC, further investment of free cash ows reduces the value of the rm.
EVA is used for structuring compensation packages and can be applied at the division level as
well as the rm-level.
MVA incorporates the stock price and is based on expectations about the future.
Managers are typically evaluated and compensated based on what they have done (EVA)
rather than what they are expected to do (MVA).
8.8 Federal tax considerations
In valuing an asset, we are concerned about usable income.
This means income after taxes (e.g., NOPAT and FCF).
In the U.S. there are corporate taxes and personal income taxes.
8.8. FEDERAL TAX CONSIDERATIONS 197
8.8.1 Corporate income taxes
Fairly easy to calculate. If you get fancy, you could setup a single formula in Excel.
An example...
8.8.1.1 Interest and dividend income
Corporations may own stock (including its own) and receive dividends.
Corporations may own interest-bearing nancial instruments.
Interest is taxed at regular corporate tax rate.
Dividends are not. A signicant portion is excluded prior to applying corporate tax rate:
Ownership % Exclusion
OWN< 20% 70%
20% OWN < 80% 80%
OWN 80% 100%
The dierent tax rates impact the managers decision to invest FCF in bond investments, stock
investments, or internal projects.
Example: GE has $100,000 in FCF. Assume GE has two choices
198 CHAPTER 8. MANAGERIAL ACCOUNTING
1. Bonds that pay 8% coupons annually ($8,000 per year)
2. Preferred stock that pays 7% dividends ($7,000 per year)
QUESTION: Which should they purchase?
8.33
8.8.1.2 Interest and dividend payments
Finance operations with debt pay interest (which can be deducted from income)
Finance operations with equity pay dividends (not deductible)
Again, this impacts a managers decision: how should I nance the rm or project?
Consider the pre-tax income required to pay $1 in dividends.
pre-tax income to pay $1 dividend =
1
1
(8.11)
An example...
8.8.1.3 Corporate capital gains
Corporate capital gains are taxed at same rate as operating income.
8.8. FEDERAL TAX CONSIDERATIONS 199
8.8.1.4 Corporate loss carry back and carry forward
Carry back: an operating loss in 2008 can be applied to 2007 or 2006 to recover taxes paid in
those years (2 year limit).
Carry forward: an operating loss in 2008 can be used to reduce taxable income in 2008 2028
(20 year limit).
Another means to minimize tax payments (read: another loophole).
8.8.1.5 Improper accumulation to avoid dividend payments
QUESTION: Why would a corporation want to avoid dividend payments?
8.34
Retained earnings (i.e., unpaid dividends) in excess of $250,000 must be proven to be necessary
to meet the reasonable needs of the business.
8.8.1.6 Consolidated corporate tax returns
If parent company owns more than 80% it can consolidate and uses losses from one company
to oset income of another
Allows losses associated with risky new ventures to oset income from core business (read:
another loophole).
200 CHAPTER 8. MANAGERIAL ACCOUNTING
8.8.1.7 Overseas income
Foreign earnings reinvested overseas are not subject to U.S. taxes.
When foreign earnings are returned to the U.S., a credit is applied for foreign taxes paid prior
to computing U.S. tax due.
The result: fewer dollars taxed at the higher U.S. rate (read: another loophole).
8.8.2 Taxation of small businesses: S-corps
Thus far we have talked about normal corporations, aka, C-corps
S-corp may elect taxation as proprietorship/partnership or C-corp
Advantageous for companies that pay 100% of income as dividends.
QUESTION: Why?
8.35
S-corp also allows for limited liability.
8.8.3 Personal taxes
Ordinary income includes wages, prots from partnership/proprietorship, investment income.
8.8. FEDERAL TAX CONSIDERATIONS 201
With a progressive tax system the more you make the larger percentage
1
. Sometimes referred
to as a marginal tax rate that increases with income.
Most municipal bond interest income is not subject to federal taxes.
Capital assets (real estate, stocks, bonds):
Long-term (held more than 1 year) gains tax: lower rate, 15%
Short-term (held less than 1 year) gains tax: higher rate, ordinary income
As of 2003 dividends were taxed at capital gains rate.
1
dont forget there are many deductions, i.e., loopholes, to get around this
202 CHAPTER 8. MANAGERIAL ACCOUNTING
Chapter 9
Financial statement analysis
Overview
Topic covered in this chapter...
Why analyze nancial statements?
1. To enable fair performance comparisons.
2. To evaluate and identify trends in nancial position. This is useful for management
decision making.
Dierent ratios, who uses them, and what for
Actions that impact ratios
203
204 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
Using ratio analysis and the DuPont system to maximize rm value
Ratio sensitivity to seasonality, debt/equity position, sales stimulation eorts, etc.
Establishing norms or target ratio values
9.1 Why ratio analysis?
Firm A Firm B
total debt 5,248,760 52,647,980
interest charges 600,000 3,000,000
QUESTION: Which rm is stronger?
9.1
9.2 Liquidity ratios
Liquidity ratios provide insight on a rms ability to pay for short term ( 1 year) liabilities.
9.2.1 Current ratio
current ratio =
current assets
current liabilities
(9.1)
Current assets include cash, marketable securities, accounts receivable, and inventories.
9.3. ASSET MANAGEMENT RATIOS 205
Current liabilities include accounts payable, short-term notes payable, current maturities of
long term debt, accrued expenses (taxes, wages, etc.).
QUESTION: Do you want the number to be high or low?
9.2
Although in general you would work towards the industry average there are a couple reasons
why you would not.
QUESTION: Why?
9.3
9.2.2 Quick or acid test ratio
quick ratio =
current assets inventories
current liabilities
(9.2)
Maybe those inventories are not so liquid...
As either liquidity ratio approaches unity the company may be unable to meet current liabili-
ties.
9.3 Asset management ratios
How ecient is rm at managing assets?
206 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
If asset levels (inventories) are too low the rm may miss sales opportunities. Have you ever
been to the store, wanting to buy something, it wasnt there, so you bought something else?
If asset levels are too high the rm may be wasting free cash ow (rm value). Also, reduced
free cash ow translates into lower rm value.
9.3.1 Day sales outstanding (DSO)
DSO =
receivables
average daily sales
(9.3)
where average daily sales is sales 365.
Days sales outstanding is also known as average collection period (ACP) and days sales in
receivables (DSR).
DSO represents the average time from sale to receiving cash for that sale.
QUESTION: What do we need to be mindful of the revenue recognition method
when considering this denition of DSO?
9.4
Compare with stated credit policies (sales terms) .
QUESTION: By the way, where does one nd a companys sales terms?
9.5
If DSO > sales terms customers are not paying on time
9.3. ASSET MANAGEMENT RATIOS 207
If DSO sales terms they are
1
Watch the trend!
9.3.2 Inventory turnover ratio (ITR)
ITR =
sales
inventories
(9.4)
Represents the number of times per year (or quarter) inventory turns (restocked)
If number is signicantly below industry average the rm may have obsolete products (large
denominator) or poor sales force (small numerator).
Dell...
QUESTION: High or low ITR?
9.6
If ITR is low, then current ratio is questionable.
QUESTION: Why?
9.7
Important: Sales are reported at market prices but inventory at cost. If you were to be precise,
substitute cost of goods sold for sales.
1
maybe you could charge a little more?
208 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
Days sales in inventory
DSI =
inventories
average daily sales
How long does inventory sit around?
9.3.3 Fixed assets turnover ratio (FATR)
FATR =
sales
net xed assets
(9.5)
Net xed assets = gross xed assets - cumulative depreciation
Compare with industry averages
QUESTION: When comparing companies within an industry, does it matter when
they purchased their production equipment?
9.8
9.3.4 Total asset turnover ratio (TATR)
TATR =
sales
total assets
(9.6)
Can be interpreted as a combination of ITR and FATR.
QUESTION: Why?
9.9
9.4. DEBT MANAGEMENT RATIOS 209
9.4 Debt management ratios
As we saw in earlier chapters, the use of debt, now called nancial leverage, can magnify gains
and losses.
In the presence of nancial leverage equity holders still have control. However, creditors are
mindful of risks involved in supplying credit. More equity less risk lower interest rates.
QUESTION: Does this sound familiar to any common real world debt/equity
arrangement?
9.10
Lets look at some ratios used by creditors to assess risk...
9.4.1 Debt ratio
debt ratio =
total liabilities
total assets
(9.7)
If > 50% then the majority of nancing from borrowed funds.
If high it may be more dicult (read: costly) to obtain additional funds.
9.4.2 Times interest earned (TIE)
TIE =
EBIT
interest charges
(9.8)
210 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
Similar to a liquidity ratio (ability to pay current liabilities) with a focus on interest charges
A measure of ability to pay interest charges from operating income
If low (e.g., below industry average) it may be more dicult (read:costly) to obtain additional
funds.
9.4.3 EBITDA coverage ratio (ECR)
ECR =
EBITDA + lease payments
interest + principal payments + lease payments
(9.9)
A measure of ability to service debt
Two problems with TIE
1. Must repay principal too! Also, some rms lease equipment.
2. EBIT does not represent available cash since the non cash charge of depreciation was
removed.
QUESTION: Why have lease payments in the numerator?
9.11
QUESTION: Long-term lenders focus on TIE, short term lenders on ECR. Why?
9.12
9.5. PROFITABILITY RATIOS 211
9.5 Protability ratios
9.5.1 Prot margin on sales (PM)
PM =
net income available to common stockholders
sales
(9.10)
Low PM could be due to
1. High costs related to inecient operations
2. Higher debt higher interest expense smaller numerator
QUESTION: Is higher debt necessarily bad?
9.13
9.5.2 Basic earning power (BEP)
BEP =
EBIT
total assets
(9.11)
The ability to convert assets into earnings, without considering interest or taxes.
9.5.3 EBITDA Margin
EBITDA margin =
EBITDA
sales
212 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
EBITDA margin does not include impact of capital structure and taxes.
EBITDA margin is a more direct measure of operating protability.
9.5.4 Return on total assets (ROA)
ROA =
net income available to common stockholders
total assets
(9.12)
If low, check BEP:
BEP low company not converting assets into earnings
BEP high may have high interest (more debt)
9.5.5 Return on equity (ROE)
ROE =
net income available to common stockholders
common equity
(9.13)
The bottom line ratio
When comparing to industry averages, look at both ROA and ROE. For instance if ROA
i
<
ROA but ROE
i
ROE then the rm is using debt. More on this later.
9.6. MARKET VALUE RATIOS 213
9.6 Market value ratios
9.6.1 P/E ratio
Price per share divided by earnings per share, same as before
High P/E ratios may represent high growth prospects.
QUESTION: Why?
9.14
Low P/E may represent riskier rm.
QUESTION: Why?
9.15
9.6.2 Price/cash ow ratio
Cash ow = net income + depreciation and amortization
Could also use price/sales, price/EBITDA, and so on
What works on Wall Street calls the Price/Sales ratio the king of value ratios.
QUESTION: Any idea why?
9.16
214 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
9.6.3 Market/book ratio (M/B) or book/market (B/M) ratio
Book value per share (B) = common equity / shares outstanding
Let P = M = market value per share
Therefore the Market-to-Book ratio is M/B... simple huh?
Represents how much (M) investors are willing to pay for $1 in accounting (book, B) value
Typically M/B > 1.
QUESTION: Why?
9.17
High M/B (low B/M) lower risk
Low M/B (high B/M) distressed company
Related to Fama-French 3-factor model factor: HML:
HML = R
high B/M
R
low B/M
9.7 Trend, common size, and percent change analysis
9.7.1 Trend analysis
Plot ratios vs. time for company and industry average and interpret results. For example:
9.7. TREND, COMMON SIZE, AND PERCENT CHANGE ANALYSIS 215
Table 9.1: ROE interpretations
ROE
i
ROE (industry average) Interpretation
decreasing steady or increasing x something!
steady steady average performance
increasing increasing average performance
increasing steady or declining pay bonuses or mgt. is cheating
9.7.2 Common size analysis
Divide all income statement items by sales
Divide all balance sheet items by total assets
Facilitates comparison of line-items across rms with varying size
Bonus: also, when doing trend analysis, dividing by sales or assets removes the eect of ination
and can make the variables stationary (i.e., usable for regression analysis). More on this when
you go get your Ph.D.!
Now for a couple examples of common size analysis...
9.7.3 Percent change analysis
Simply compute the percent change from previous year, quarter, or year-ago quarter
216 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
An example...
9.7.4 Summary
Ratios, trend, common size, percent change, and DuPont equation (next section) analysis can be
used to pinpoint areas of improvement and make the case, whatever that case may be.
QUESTION: Why use multiple ways to say the same thing?
9.18
9.8 The DuPont equation
ROA = PM TATR (9.14)
=
net income
sales

sales
total assets
Example
PM = 3.8%, i.e., made 3.8 cents for every dollar in sales
TATR, i.e., turned assets into sales 1.5 times during year
Return on assets (for the year) = 3.8 x 1.5 = 5.7%
If nanced exclusively with equity liabilities=0 assets=equity ROA=ROE
9.8. THE DUPONT EQUATION 217
If you do use debt, common equity < total assets.
QUESTION: Why?
9.19
Therefore ROE ROA. Lets go back...
ROA =
net income
total assets
(9.15)
ROE =
net income
common equity
(9.16)
If using debt common equity < total assets therefore ROE > ROA
Can connect ROA to ROE with the equity multiplier
EM =
total assets
common equity
(9.17)
therefore
ROE = ROA EM (9.18)
Now, the extended DuPont equation
ROE = PM TATR EM (9.19)
218 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
Why go through all of these algebraic gyrations? To isolate areas that impact ROE and for
what-if analyses. In equation (9.19) we see:
Operating eciency (PM)
Asset management eciency (TATR)
Financial leverage (EM)
9.9 Benchmarking
Benchmarking: comparing with leading companies in the same industry
Can benchmark with other industries also. For example, if a portion of your business sells
products online, compare that to amazon.com.
Can obtain benchmarks from D&B, RMA, Reuters, etc. Or, develop yourself:
1. Obtain data on all rms from Compustat
2. Sort on industry and ROE
3. Take the top 10% in each bin as your benchmark
9.10. CLOSING COMMENTS ON RATIO ANALYSIS 219
9.10 Closing comments on ratio analysis
9.10.1 Uses
Managers - diagnose and correct operational, investing, and nancing ineciencies
Creditors - assess risk and charge accordingly
Investors - eciency, risk, and growth analysis
9.10.2 Limitations
1. Conglomerates - what is the industry average if you do business in 5 dierent industries?
QUESTION: What can you do?
9.20
2. Dont use industry average alone: do not strive to be simply average, shoot for above average.
3. Watch out for ination - is upward trend simply due to ination?
QUESTION: What can you do?
9.21
4. Seasonality - be mindful of sowing vs. reaping season when comparing quarterly results
5. Window dressing - take 2-year loan cash now but long term liability release results
(leverage ratio lower and current ratio higher) after results release, payo debt (leverage
ratio high again)
220 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
6. Cheating with leased assets - not a debt, not on balance sheet, therefore distorts turnover and
debt ratio measures
7. What is good? - Example, does high current ratio indicate strong liquidity or excessive cash?
8. Interpretation of good and bad ratios - which are more important?
9. Accuracy/legitimacy of nancial statements
9.11 Qualitative analysis
Dont stop with ratio, trend, common size, % change analysis, and benchmarking. Consider some
qualitative factors as well.
9.11.1 Porters ve forces
1. Buyer power (customers)
2. Supplier power
3. Threat of substitutes
4. Barriers to entry
5. Competition
9.11. QUALITATIVE ANALYSIS 221
9.11.2 The AAII list
1. Are revenues spread across customers?
2. Are revenues spread across products?
3. Are multiple suppliers available?
4. Any overseas business? Political (where did our jobs go) and business issue that impacts
bottom line (shipping stu back and forth, exchange rate, etc.).
5. Competition
6. Future prospects
7. Legal environment? Do you x operations or hire lobbyists? Think about how the cell phone
companies fought vigorously against number portability.
222 CHAPTER 9. FINANCIAL STATEMENT ANALYSIS
Chapter 10
Financial statement forecasting
Overview
We will investigate the major components of strategic plan and role of pro-forma (projected)
nancial statements.
QUESTION: What is the dierence between strategy and tactics?
10.1
Forecasts using the percent of sales method given nothing more than previous nancial state-
ments
Use of industry average ratios
Impacts of forecast errors
223
224 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
Economies of scale, lumpy assets, excess capacity
Estimating required funds with the nancial statement method and AFN formula method
Sustainable growth rate: What it is and how to determine it.
10.1 Financial planning
A little philosophy:
Failing to plan is planning to fail.
A person who does not know where they are going may end up anywhere
10.1.1 Strategic plans
Corporate purpose solely technological excellence bad; solely prots bad. Do both.
QUESTION: Can you think of any examples?
10.2
Corporate scope products and customers; the market tends to value focused rms more than
diversied.
QUESTION: Why?
10.3
10.1. FINANCIAL PLANNING 225
Corporate objectives quantitative (e.g., ROE, market share, earnings growth, etc.) and qualita-
tive (e.g., successful roll-out of corporate branding)
In sum, purpose (technological excellence and shareholder value maximization) scope (e.g., soft
drinks only, but globally) objectives (market share, ROE) strategy (no-frills airline vs. high-
end)
10.1.2 Operating plans
Aka, the tactical plan
Detailed plans on how to meet corporate objectives
Typically a 5 year plan
10.1.3 Financial plan
Five steps:
1. Construct pro-forma nancial statements: reveals prot impacts of operating plan
2. Compute funding requirements
3. Break down internal (prot) and external (loans, bonds, equity issuance) funding sources
4. Connect management compensation with successful completion of operating plan (absolutely
no golden parachutes!!!)
226 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
5. Monitor and adjust
Although there are 5 steps, there are 3 components:
1. Sales forecast
2. Pro-forma nancial statements
3. External nancing plan
10.2 Sales forecast
Past is prologue
When estimating (forecasting) growth, the arithmetic average can be too high. An example...
Computing compound growth rate is problematic as well. The estimate is sensitive to beginning
and end points.
sales
0
(1 + g)
n
= sales
n
(10.1)
Regression analysis is a better approach. Assuming constant growth you need to take natural
log of sales. Behind the scenes of LOGEST function of excel:
sales
t
= (1 + g)
t
sales
0
ln [sales
t
] = t ln[1 + g] + ln [sales
0
]
= a
0
+ a
1
t (10.2)
10.3. PERCENT OF SALES FORECASTING METHOD 227
with a
0
= ln [sales
0
] and a
1
= ln[1 +g]. LOGEST estimates a
0
and a
1
and reports exp[a
1
] =
exp[ln[1 + g]] = 1 + g
An example...
In practice, you will complicate this a bit by including economic indicators (e.g., GDP), interest
rates, analysts estimates, estimates for E[R
M
], etc. Inclusion of these factors may improve
explanatory power (i.e., R
2
of regression).
The regression/LOGEST method provides a good baseline for growth rate estimation.
Accuracy is important: g higher than reality excess inventory, loans, interest, etc.; g lower
than reality not enough inventory, lose market share, etc.
10.3 Percent of sales forecasting method
Begin with sales forecast
Look at historical average and industry average ratios
Forecast
10.3.1 Analyze historical ratios
Take historical nancial statements and divide by given years sales
228 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
This approach assumes everything is proportional to sales in the past and in the future. Not
necessarily true for all nancial statements items.
For example, in the short run consider sales and PP&E.
Manufacturing rm: higher sales may come without building more plants (just run the
existing ones longer).
Retail rm: higher sales may come only from more stores (more PP&E) as opposed to
increasing daytime hours.
In the long run,sales will be related to PP&E.
10.3.2 Forecast the income statement
Keep in mind all statements are interconnected.
IS: depreciation BS: Net PP&E; IS: additions to retained earnings BS: retained earnings
10.3. PERCENT OF SALES FORECASTING METHOD 229
Table 10.1: Forecasted income statement
# Description Forecast
1. Revenues REV
t+1
= REV
t
(1 + g)
2. Cost of goods sold CGS
t+1
=
cgs
REV
t+1
3. Dep. exp. DE
t+1
=
de
PPE
t+1
4. EBIT EBIT
t+1
= REV
t+1
CGS
t+1
DE
t+1
5. Int. exp. IE
t+1
= IE
std,t+1
+ IE
ltd,t+1
IE
std,t+1
= r
std,t+1
(STD
t
STI
t
)
IE
ltd,t+1
= r
ltd,t+1
LTD
t
6. Earn. b4 tax EBT
t+1
= EBIT
t+1
IE
t+1
7. NI b4 pref. div. NIBPD
t+1
= (1 )EBT
t+1
8. Pref. div. exp. PDE
t+1
= PS
t
9. NI avail. to cs NI
t+1
= NIBPD
t+1
PDE
t+1
10. No. shareout n
cs,t+1
= n
cs,t
11. Div. per share DPS
t+1
= DPS
t
(1 + g
d
)
12. Com. div. exp. CDE
t+1
= n
cs,t+1
DPS
t+1
13. Add. ret. earn. ARE
t+1
= NI
t+1
CDE
t+1
14. Earn per share EPS
t+1
= NI
t+1
/n
cs,t+1
10.3.2.1 Comments on forecasted income statement
1. Sales (revenues) forecast: see Section 10.2
230 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
2. Cost of goods sold: use most current periods data to establish CGS multiplier
1

cgs
=
CGS
t
/REV
t
3. Depreciation expense: use most recent periods data to establish DE multiplier
de
= DE
t
/PPE
t
4. Earnings before interest and taxes: revenues less costs and depreciation expense
5. Interest expense: calculated as interest charges less interest income
With multiple debt obligations and investments with dierent maturities, interest rates,
xed, variable comes diculty in estimating interest expense. Therefore we use two
simplifying assumptions.
(a) How much debt?
Do not use beginning of year number.
QUESTION: Why not?
10.4
Do not use end of year number.
QUESTION: Why not?
10.5
The simplication: use beginning of year debt and add 0.5% to the interest rate:
STD
t+1
= STD
t
(10.3)
LTD
t+1
= LTD
t
(10.4)
1
You could also average the multipliers of the previous 5 years to estimate the multiplier for next year or use some other elaborate
estimate.
10.3. PERCENT OF SALES FORECASTING METHOD 231
Net eect: an approximation that avoids circularity and accounts for possible
increases in the amount of debt
2
.
(b) What interest rate(s)?
Specify just two: short-term and long-term
Short-term rate: rates typically oat so best estimate is usually the previous
rate. Therefore:
r
std,t+1
= r
std,t
+ 0.5% (10.5)
Long-term rate: Companies have several LT debt obligations with dierent rates.
Some LT debt may be paid o and new LT debt issued. Therefore, take average
of existing LT debt rates and new rates:
r
ltd,t+1
=
1
n + 1
_
n

i=1
r
ltd,i
+ r
ltd,t
_
+ 0.5% (10.6)
with r
ltd,i
= rate of debt obligation i and r
ltd,t
= the current market rate for a
debt with maturity equal to ?
QUESTION: Why n + 1?
10.6
.
QUESTION: Why add 0.5%?
10.7
6. Earnings before taxes: EBIT less interest expense
2
Note: year t data represents the end of year t and therefore the beginning of year t + 1.
232 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
7. Net income before preferred dividends: EBT less taxes.
QUESTION: Can anyone tell me where the equation came from?
10.8
8. Preferred dividend expense: represents the stated preferred dividend rate and PS
t
represents
the level of preferred stock
9. Net income available to common stockholders: NIBPD less PDE
10. Number of shares outstanding: adjust for any issuances or repurchases
11. Dividends per share: adjust for any increase or decrease in dividends
12. Common stock dividend expense: number of shares times DPS
13. Additions to retained earnings: NI less CDE
14. Earnings per share: easy calculation
10.3.3 Forecast the balance sheet
Sales growth assets must grow must obtain funds how much and where from?
Use percent of sales technique:

t
/sales
t
.
Assumptions for preliminary forecasts
10.3. PERCENT OF SALES FORECASTING METHOD 233
1. Short-term investments will not change.
QUESTION: Why?
10.9
2. Mature company therefore n
cs,t+1
= n
cs,t
3. Constant dividend growth rate
4. Most companies do not use preferred stock PS
t+1
= PS
t
5. No new long term bonds LTD
t+1
= LTD
t
6. Allow for short term loans via notes payable (a.k.a., commercial paper).
QUESTION: Sound familiar?
10.10
234 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
Table 10.2: Forecasted balance sheet
# Item Forecast
Assets
Current assets
1. Cash CASH
t+1
=
cash
REV
t+1
2. Short term investments STI

t+1
= STI
t
3. Accounts receivable AR
t+1
=
ar
REV
t+1
4. Inventories INV
t+1
=
inv
REV
t+1
5. Total current assets TCA
t+1
= CASH
t+1
+ STI
t+1
+ AR
t+1
+ INV
t+1
Long-term assets
6. Net PP&E PPE
t+1
=
ppe
REV
t+1
7. Long-term investments LTI
t+1
=
lti
REV
t+1
8. Total long-term assets TLA
t+1
= PPE
t+1
+ LTI
t+1
9. Total Assets TA
t+1
= TCA
t+1
+ TLA
t+1
Liabilities
Current liabilities
10. Accounts payable AP
t+1
=
ap
REV
t+1
11. Accruals ACC
t+1
=
acc
REV
t+1
12. Notes payable NP

t+1
= NP
t
13. Total current liabilities TCL
t+1
= AP
t+1
+ ACC
t+1
+ NP
t+1
Long-term liabilities
14. Long-term bonds LTB
t+1
= LTB
t
15. Total long-term liabilities TLL
t+1
= LTB
t+1
16. Total Liabilities TL
t+1
= TCL
t+1
+ TLL
t+1
Shareholders equity
17. Preferred stock PS
t+1
= PS
t
18. Common stock CS
t+1
= CS
t
19. Retained earnings RE
t+1
= RE
t
+ ARE
t+1
20. Total common equity TCE
t+1
= CS
t+1
+ RE
t+1
21. Total stockholders equity TSE
t+1
= PS
t+1
+ TCE
t+1
22. Total Liabilities and S.E.

TA
t+1
TL
t+1
+ TSE
t+1
23. Required assets RA
t+1
= TA
t+1
24. Specied sources of funding SSF
t+1
= TL
t+1
+ TSE
t+1
25. Additional funds needed AFN
t+1
= RA
t+1
SSF
t+1
* STI
t+1
and NP
t+1
adjustments equality
10.3. PERCENT OF SALES FORECASTING METHOD 235
10.3.3.1 Comments on the forecasted sheet and AFN
Aside from the standard percentage of sales and accounting calculations, a few of the forecasted
items require a little attention.
2. Short-term investments: consistent with the earlier assumption, forecasted STI is the same
as previous years STI. This may be adjusted after the preliminary forecast.
12. Notes payable: short-term loans are possible. This may be adjusted after the preliminary
forecast.
22. Total liabilities and stockholders equity: an approximation since forecasted assets does
not necessarily equal forecasted liabilities and stockholders equity.
QUESTION: Why not?
10.11
25. Additional funds needed: if positive, need to obtain external funds; if negative, need to
place extra money somewhere
AFN
t+1
> 0 NP
t+1
= NP
t
+ AFN
t+1
AFN
t+1
< 0 STI
t+1
= STI
t
+|AFN
t+1
|
This is an preliminary forecast that will be revised after comparison with operation goals (next
section)
236 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
s can be historical average, most recent ratio, or other estimate
An example...
10.3.4 Analysis of the forecast
Compare ratios to industry average
Determine ways to improve ratios
Re-forecast under dierent improvement scenarios and sales growth estimates
QUESTION: Why use dierent sales forecasts?
10.12

10.3.4.1 Observations
1. AR too high.

ar
is 20% higher than industry average
DSO = AR/avg. daily sales is high as well
Negatively impacts ROA, ROE, ROIC (which are also signicantly lower than industry
average)
10.3. PERCENT OF SALES FORECASTING METHOD 237
QUESTION: What corrective actions can be done?
10.13
2. Inventories too high

inv
is almost twice the industry average! ITR is almost half. Note: ITR = 1/
inv
Negatively impacts ROA, ROE, ROIC, and TATR (which is also signicantly lower)
QUESTION: What corrective actions can be done?
10.14
3. Debt too high
Current ratio signicantly lower than industry average
Extra debt extra interest expense lower prot margin (3.8% vs. industry average
5.0%)
QUESTION: Why did management decide to layo workers and close certain
operations?
10.15
10.3.4.2 Revised forecast
Terminating people increased NOPAT
AR policy adjustment reduced AR
238 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
Prot margin increase increased ARE
t+1
Inventory controls lower DSO, reduced inventories
Now have a negative AFN.
QUESTION: What does this mean?
10.16
ROA, ROE, and ROIC also increase

inv
,
ar
, and DSO still above industry average
10.3.4.3 Concluding remarks
In practice you will analyze dierent scenarios.
When looking at impact of changes on stock price, this is called value-based management.
Forecasting is an iterative process: a lot of what-if analyses
When facing potential layos also consider company-wide pay cuts.
10.4 The AFN formula
Although the preliminary forecast assumed constant ratios revisions may cause year t+1 ratios
to be dierent than year t.
10.4. THE AFN FORMULA 239
However, if we assume the ratios are constant (i.e., s do not change from one year to the
next) we can estimate the forecasted AFN using the AFN formula.
Also, the AFN formula breaks down funding of internal vs. external sources.
AFN
t+1
= (A

/REV
t
) REV (L

/REV
t
) REV (PM) (REV
t+1
) (RR) (10.7)
where REV
t+1
= (1 + g) REV
t
and REV = REV
t+1
REV
t
Table 10.3: AFN formula inputs
Item Description
A

Required assets. When operating at full capacity, required assets equal total
assets (A

= A) otherwise A

< A
A

/REV
t
Capital intensity ratio: level of assets used to support sales
L

liabilities that increase spontaneously with sales. Typically the sum of accounts
payable and accruals.
QUESTION: Why not notes payable?
10.17
L

/REV
t
Liabilities that increase spontaneously as a percentage of sales
PM Prot margin: net income available to common stockholders divided by
revenues
RR Retention ratio: portion of earnings that are retained (e.g., not paid out as
dividends)
REV Change in revenues, REV
t
REV
t1
240 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
Consider this a back of an envelope estimate
The nancial statement method is more accurate.
The required asset increase represented by (A

/REV
t
) REV will be paid using funds from:
1. spontaneous liability increase (L

/REV
t
) REV , and/or
2. retained earnings (PM) (REV
t+1
) (RR), and
3. external resources AFN.
An example...
AFN and growth
The maximum growth rate using internal funds is the internal growth rate:
IGR =
ROA RR
1 ROA RR
(10.8)
QUESTION: What are some examples of internal funds?
10.18
The maximum growth rate without additional equity nancing, thus with additional debt
nancing, while maintaining the same debt to equity ratio is the sustainable growth rate:
SGR =
ROE RR
1 ROE RR
(10.9)
10.5. FORECASTING WITH VARIABLE BALANCE SHEET RATIOS 241
QUESTION: What are some examples of external funds?
10.19
Note, we are using ROA
t
, ROE
t
, and RR
t
, not t + 1 values.
Equations (10.8) and (10.9) are based on end of period t data (Angell, 2011).
10.5 Forecasting with variable balance sheet ratios
10.5.1 Constant ratios
Thus far we have discussed constant ratios.
10.5.2 Economies of scale
The ratio of inventory to sales decreases with sales. Conversely, we tend to observe more sales for
each additional unit of inventory. Also, the relationship can be nonlinear.
10.5.3 Lumpy assets
When capacity can not be increased smoothly
For example, to build more cars another factory must be constructed since building 1/100th
of a factory is infeasible.
There are options available prior to making those huge investments:
242 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
1. Add more shifts to existing plants
2. Share someone elses plant
3. Take turns building plants
10.5.4 Excess capacity (capacity under-utilization) adjustments
Suppose capacity utilization was 96% while sales were $3B. To estimate sales assuming full capacity:
full capacity sales
t
=
actual sales
t
capacity utilization
t
=
3B
0.96
= 3.125B
QUESTION: Where did this formula come from?
10.20
A new target xed assets/revenues ratio can be computed. Doing so assumes the plant(s) will
be running at full capacity next period:

FA
=
FA
actual,t
REV
full,t
=
1.0
3.125
= 32%
In English the ratio of actual time t xed assets that could produce 3.125B in revenues if
operating at full capacity.
Now incorporate revenue target to determine FA

t+1
, the amount of xed assets needed to
accommodate sales forecast of REV
t+1
.
FA

t+1
=

FA
REV
t+1
= 0.32(3.3) = 1.056B
10.5. FORECASTING WITH VARIABLE BALANCE SHEET RATIOS 243
Note the preliminary forecast had this number at 1.1B, Thus at full capacity fewer xed assets
must be purchased (precisely, 1.1B - 1.056B = 44M fewer).
Therefore AFN is reduced
AFN

= AFN 44M = 118M 44M = 74M


There are at least two ways to deal with excess capacity. In other words, at least two ways to
deal with capacity under utilization.
1. Just use the nancial statement method.
2. Ignore capacity utilization and use AFN assuming full capacity to compute FA
t+1
. Next
incorporate capacity utilization and compute FA

t+1
, Then use this revised AFN formula:
AFN

t+1
= AFN
t+1
(FA
t+1
FA

t+1
) (10.10)
244 CHAPTER 10. FINANCIAL STATEMENT FORECASTING
Chapter 11
Cost of capital
Overview
Cost of capital is important when deciding whether or not to take on a project, to acquire a
company, and the structure of compensation plans.
We will examine the components of a companys cost of capital.
WACC and why it is necessary for capital budgeting.
Weights used in WACC.
Three methods for determining the cost of common equity (CAPM, DCF, BYPRP) .
Flotation costs and WACC.
245
246 CHAPTER 11. COST OF CAPITAL
Time variability of WACC.
Dierent WACCs for dierent divisions and projects.
11.1 The weighted average cost of capital (WACC)
Capital components common stock, preferred stock, and...
QUESTION: ...What else?
11.1
Component cost required rate of return for each component
WACC weighted average of component costs
Target capital structure the target weights, e.g., a 30/10/60 debt/preferred/common target.
WACC = w
d
R
d
(1 ) + w
ps
R
ps
+ w
s
R
s
(11.1)
WACC is the cost of a marginal or new dollar of capital.
The weights should be based on target capital structure. But what exactly is the target capital
structure? Many academic articles have been written on what the target structure is, is there
a target structure, does it vary over time, why does it vary over time, etc. For now we can
presume the current book value of debt, book value of preferred stock, and market value of
common stock can be used to approximate the target weights.
11.2. COST OF DEBT R
D
(1 ) 247
QUESTION: If you plan on issuing only debt in the planning period, can you get away
with WACC = R
d
?
11.2
11.2 Cost of debt R
d
(1 )
Marginal debt: new issues of debt
Embedded debt: historical or pre-existing debt
Since we are computing WACC to assess costs in the upcoming or planning period, we consider
the cost of marginal debt to be the relevant cost.
Interest payments on debt are tax deductible. Therefore the after-tax cost of debt is R
d
(1).
Flotation costs (i.e., costs associated with issuing new debt) are typically small thus we ignore
them for now.
11.3 Cost of preferred stock R
ps
Preferred dividends are not tax deductible.
Although rms legally do not have to pay preferred dividends they typically do.
QUESTION: Why?
11.3
248 CHAPTER 11. COST OF CAPITAL
Flotation costs are signicant for preferred stock, therefore these costs are incorporated into
the component cost:
R
ps
=
D
ps
P

n
=
D
ps
P
n
F
ps
(11.2)
with D
ps
is the level of preferred dividends, P

n
is the amount received after otation (under-
writing) costs F
ps
are deducted from the issue price P
n
.
An example...
11.4 Cost of common equity R
s
Common equity can be raised by
1. issuing new stock (cash enters company), or
2. retaining earnings (cash remains in company).
In either case, the investment in common equity must earn the required return R
s
.
Mature rms typically do not issue new stock for a few reasons.
1. High otation costs.
2. Negative signal.
QUESTION: What negative signal is sent with issuing new shares?
11.4
11.4. COST OF COMMON EQUITY R
S
249
3. More common stock higher supply lower price.
R
s
is also the opportunity cost, the return investors could obtain elsewhere with their cash.
There are at least three methods to estimate R
s
. Choose the method with the more reliable
data. However, you may consider taking the average of all three estimates.
11.4.1 CAPM approach
Simple four step process:
1. Estimate R
F
2. Estimate MRP = E[R
M
] R
F
3. Estimate
4. Calculate R
s
= R
F
+
i
(E[R
M
] R
F
)
11.4.1.1 Estimating the risk free rate
Nothing is truly risk free since interest rates and therefore prices and returns uctuate.
We use the long-term Treasury Bond (T-Bond) rate for R
F
for 3 reasons.
1. Most stockholders are long-term investors.
250 CHAPTER 11. COST OF CAPITAL
QUESTION: Why might this be true?
11.5
2. T-bill rates are more volatile than T-bond rates and R
s
.
3. CAPM estimate is for holding period estimate for cost of equity is for long-term project
(long-term holding period) use T-bond
The 10 year T-bond is generally used. You may also use a bond that has a similar maturity
as the project under consideration.
11.4.1.2 Estimating the market risk premium (MRP)
Historical MRP
Could use the historical number (average) from Ibbotson Associates or calculate it yourself.
But which do you use, geometric or arithmetic average?
Risk premiums vary over time therefore either average will be wrong.
Forward-looking MRP
This crystal ball will be wrong also.
Use market dividend yield to estimate E[R
M
].
QUESTION: What is the dividend yield?
11.6
11.4. COST OF COMMON EQUITY R
S
251
We have seen this before:
E [R
M
] =

R
M
=
D
1
P
0
+ g =
_
D
0
P
0
(1 + g)
_
+ g
QUESTION: Where do we obtain g?
11.7
Dividend yields and growth rates can be obtained from Reuters.com, nance.yahoo.com, or
other nancial websites.
An example...
QUESTION: Can you name two problems with using dividend growth rates?
11.8
Could also use published analysts forecasts to estimate g.
QUESTION: What are two problems with analysts forecasts?
11.9
Some evidence from academics put the forward-looking MRP in the 1% to 2.55% range
So what is the right MRP to use?
Brigham and Daves (2010) opinion: use a value between 3.5% and 6.5%.
If prices are relatively high strong demand less risk averse use value closer to 3.5%
If prices are relatively low low demand more risk averse use value closer to 6.5%
252 CHAPTER 11. COST OF CAPITAL
11.4.1.3 Estimating beta
Recall the market model:
R
i,t
= +
i
R
M,t
(11.3)
A few problems:
1. What holding period and time frame? Four to ve years of monthly returns or one to
two years of weekly data are typically used.
2. Which index? S&P500, Willshire, DJIA, World market, etc.
3. Estimated, adjusted, or fundamental beta?
4. Wide condence interval for beta estimates
5. An example...
11.4.1.4 Bringing it all together
R
s
= R
F
+ (E[R
M
] R
F
) (11.4)
11.4.2 Discount cash ow (DCF) approach
R
s
=
D
1
P
0
+ g (11.5)
11.4. COST OF COMMON EQUITY R
S
253
In the CAPM approach, we applied this formula to market returns to obtain E[R
M
] and then
R
s
via the CAPM equation.
Here we go direct using the rms dividend yield and expected growth rate to obtain R
s
.
11.4.2.1 The inputs
Historical growth rates If growth rates are relatively stable you may use historical averages
Retention growth model If historical ROE and retention ratios averages are relatively stable,
use:
g = ROE RR
Analysts forecasts Can use the median, mean, and range of analyst forecasts to obtain expected
g.
11.4.2.2 Illustration
An example...
11.4.2.3 Evaluating methods for growth rate estimation
Dividend yield is estimated fairly precisely.
QUESTION: Why?
11.10
254 CHAPTER 11. COST OF CAPITAL
The problem is g.
Believe it or not analysts forecasts are usually the best for DCF cost of capital estimates.
11.4.3 Bond-yield-plus-risk-premium (BYPRP) approach
Produces a ball park estimate
Add 3% to 5% to rms r
ltd
Therefore:
R
s
= r
ltd
+ bond risk premium
QUESTION: Where does bond risk premium come from?
11.11
BYPRP is the least precise method.
11.4.4 Estimation approach comparisons
Use judgement when evaluating varied estimates.
Most rms use CAPM (74% to 85% of the time), about 16% use DCF, and BYPRP is used
primarily by private companies.
11.5. WACC FACTORS 255
11.5 WACC factors
11.5.1 Outside of rm control
Level of interest rates Lower rates translate into lower cost of debt and equity.
Tax rates Tax rates aect that cost of debt and can also aect cost of equity.
Market risk premium The market risk premium (MRP) is a function of perceived risk and de-
gree of risk aversion. This aects the cost of equity directly and debt indirectly through a
substitution eect.
QUESTION: How so?
11.12
11.5.2 Within rm control
Capital structure policy (1) = [leverage] more leverage more risk higher R
s
; (2)
use more debt more risk higher R
s
and R
d
but potentially lower WACC.
Dividend policy More dividends less cash available for investment may have to incur more
debt or issue stock to fund projects impacts WACC
Investment policy Invest in same line of business generally no change in risk no change in
WACC. Invest in new line of business change in risk change in WACC
256 CHAPTER 11. COST OF CAPITAL
11.6 Divisional and project risk adjustments
This section deals with adjustments for dierent divisional and project risks.
11.6.1 Divisional cost of capital
Dierent divisions have dierent risk levels and therefore divisional WACC.
Assuming no debt you could use CAPM and portfolio theory:
1. Obtain divisional betas as described in Section 11.6.2.
2. Divisional betas divisional required rates of return.
3. Weighted average beta (portfolio beta) overall required rate of return.
An example: SML for divisions...
The approach applies to rms with debt as well compute divisional WACC
11.6.2 Measuring divisional betas
Pure play method Find several comparable single-product companies and average their betas
Accounting beta method Regress ROA
i,t
= + ROA
M,t
11.7. FLOTATION COST ADJUSTMENTS 257
11.6.3 Individual project cost of capital
1. Sort projects into subjective categories (high, average, and low risk)
2. Use the divisional WACC as a baseline. E.g., let the divisions WACC
div
= 10%:
Project risk WACC criterion
above average 12%
average 10%
below average 8%
11.7 Flotation cost adjustments
Privately raised debt no otation costs
Retained earnings no otation costs
Public debt or stock issue incur otation costs
258 CHAPTER 11. COST OF CAPITAL
11.7.1 Debt
Item Description
M face or par value
INT dollars of interest paid
N bond maturity
R

d
(1 ) after-tax cost of debt adjusted for otation costs
R
d
(1 ) after-tax cost of debt in the absence of otation costs
F otation percentage
M(1 F) =
N

t=1
INT(1 )
(1 + R

d
(1 ))
t
+
M
(1 + R

d
(1 ))
N
(11.6)
The (1 F) is the otation cost adjustment resulting in R

d
> R
d
.
QUESTION: Why is the after tax cost of debt adjusted for otation costs (F > 0)
greater than the after tax cost of debt when there are no otation costs
(F = 0)?
11.13
An example: = 0.40, M = 1000, F = .01, N = 30, R
d
= 0.10.
QUESTION: What is the after-tax cost of debt adjusted for otation costs?
11.14
Note: R

d
would be higher if F were higher or N were smaller. An example...
11.7. FLOTATION COST ADJUSTMENTS 259
11.7.2 Newly issued equity
For a constant growth stock
R

s
=
D
1
P
0
(1 F)
+ g (11.7)
R

s
represents the return required on funds raised with new issue when otation costs are
incorporated.
R

s
> R
s
to achieve R
s
on funds used to purchase the new stock
An example: P
0
= 23, F = 0.10, g = 0.08, D
1
= 1.24. Compute R

s
and R
s
If rm earns 14% on new funds EPS is unchanged dividends remain the same price
is unchanged
If rm earns < 14% on new funds EPS declines dividends declines stock price declines
If using CAPM to determine the cost of equity, you can follow the procedure above to obtain
R

s
R
s
, then add this amount to the CAPM estimate for R
s
for a otation cost-adjusted cost
of capital
Or, you could obtain R
s
estimates from CAPM, DCF, and BYPRP methods; compute the
average, then add R

s
R
s
260 CHAPTER 11. COST OF CAPITAL
11.8 Cost of capital estimation problems
1. Private rms: the goal not necessarily maximizing shareholder wealth; data availability;
however, in general, principles apply.
2. Small businesses: typically privately owned.
3. Measurement: recall cost of equity issues (CAPM data, g estimate, bond risk premium).
4. Project cost of capital: dicult to measure project risk.
5. Capital structure weights: establishing these weights requires eort.
11.9 Common WACC estimation mistakes
1. Never use coupon rate of existing debt. Use current market yields.
2. When computing MRP, do not mix historical average for E[R
M
] with current R
F
.
3. Do not use book value of equity when estimating capital structure weights. This is historical.
You want the target weights based on current market values.
4. Only funds from investors should be considered as capital components. Do not count accounts
payable and accruals.
11.A. EXAMPLE R
S
ESTIMATION 261
11.A Example R
s
estimation
The following calculations are based on www.reuters.com data for Intel corporation (ticker INTC)
as of 2009.10.26.
CAPM approach to R
s
estimation
R
intc
= R
f
+
intc
(E [R
m
] R
f
) (11.8)
Step 1: Dene the risk free rate as the rate on a 10 year treasury bond:
R
f
= 3.56%
Step 2: Compute the expected return of the market using data for the S&P500. You could use
data for the broad market etf V TI instead.
E [R
m
] =

R
m
=
D
1
P
0
+ g
=
D
0
1 (+g)
P
0
+ g
262 CHAPTER 11. COST OF CAPITAL
The S&P 500 dividend yield is D
0
/P
0
= 1.46% and the ve year S&P500 dividend growth rate is
g = 9.42%.
E [R
m
] = 1.46 (1.0942) + 9.42
= 11.02
Step 3: Compute the market risk premium:
MRP = E [R
m
] R
f
= 11.02 3.56 = 7.46
Step 4: Given
intc
= 1.18 compute the required return for Intel R
intc
using Eq. (11.8):
R
intc
= 3.56 + 1.18(7.46) = 12.36
DCF approach to R
s
estimation
You could go direct to obtain R
s
= R
intc
:
R
intc
=
D
0
(1 + g)
P
0
+ g
The dividend yield for intel is
D
0
/P
0
= 2.78%. The long term growth rate for Intel is g = 10.92%.
Therefore the required return for Intel is:
R
intc
= 2.78(1.1092) + 10.92 = 14.00
Chapter 12
Value based management
12.1 Overview
Distinction between operating assets and non-operating assets; net operating working capital
and net working capital
FCF, relation to value of rms operations, and the corporate valuation model (CVM)
CVM vs. DDM
Re-visit EVA & MVA and relate to value based management (VBM)
Value-based management, relationship to CVM, and VBM alternatives
Relevance of corporate governance
263
264 CHAPTER 12. VALUE BASED MANAGEMENT
Enron/Worldcom, corporate governance, options, and regulation
12.2 Corporate valuation
Basic decision process: (1) forecast nancial statements for alternatives; (2) choose alternative
which maximizes present value
Forecast using techniques of Chapter 10 on page 223. Discount free cash ows using WACC
as computed in Chapter 11 on page 245.
QUESTION: What is wrong with the DDM method from Chapter 5 in the context of
evaluating alternatives?
12.1
Insert the Corporate Valuation Model that does not depend on dividends.
12.3 The corporate valuation model
There are two types of assets:
Operating land, buildings, machines, inventory; also includes intangibles such as customer
lists, patents, reputation, know how
Non operating short-term investments, investments in other businesses
12.3. THE CORPORATE VALUATION MODEL 265
Most companies have a low percentage of non-operating assets (e.g., WalMart has about 1%
of total assets in non-operating assets). Here we focus on operating assets.
Note: Ford, in 2004, had about 8.5% of total assets in non-operating assets.
QUESTION: Do you see something wrong with this?
12.2
12.3.1 Estimating the value of operations
Three steps to obtaining the value of operations, V
op
:
1. Forecast nancial statements assuming constant growth at some point in the future
2. Compute FCF for each forecast year
3. Discount FCFs using WACC to obtain the current value of operations
12.3.1.1 Forecast nancial statements
Use the techniques of Chapter 10. Lets look at an example...
266 CHAPTER 12. VALUE BASED MANAGEMENT
12.3.1.2 Compute future FCFs
1. Compute required working capital
1
(RWC), which is similar to NOWC from Chapter 8, for
each year including the current year:
RWC
t
= (CASH
t
+ AR
t
+ INV
t
) (AP
t
+ ACC
t
) (12.1)
An example...
2. Compute required operating capital (ROC), which is similar to TNOC from Chapter 7, for
each year including the current year:
ROC
t
= RWC
t
+ FA
t
(12.2)
where FA
t
is net xed assets at time t. An example...
3. Compute free cash ows for each of the forecast years:
FCF
t
= NOPAT
t
ROC
t
(12.3)
QUESTION: What is NOPAT?
12.3
An example....
QUESTION: What does the negative FCF mean?
12.4
1
sometimes referred to as required net operating working capital
12.3. THE CORPORATE VALUATION MODEL 267
12.3.1.3 Discount FCFs
An example.... MagnaVision...
PV [FCF
2007
] = 18/(1.1084)
1
= 16.24
PV [FCF
2008
] = 23/(1.1084)
2
= 18.72
PV [FCF
2009
] = 46.40/(1.1084)
3
= 34.07
PV [FCF
2010
] = 49/1.1084
4
= 32.46
Now, use constant growth formula to obtain 2010 value of future FCFs:
V
op,2010
=
49(1.05)
0.1084 0.05
= 880.99
Note: Free cash ows grow at 5% forever after 2010. This is sometimes referred to as the horizon
value. Now discount horizon value and add to other PVs:
PV [V
op,2010
] =
880.99
1.1084
4
= 583.69
V
op,2006
= 16.24 18.72 + 34.07 + 32.46 + 583.69 = 615.26
12.3.2 Estimating share price using CVM
1. Begin with the present value of all future FCFs, V
op
268 CHAPTER 12. VALUE BASED MANAGEMENT
2. Add the value of non-operating assets, V
non-op
to obtain the total value of the rm:
V
tot
= V
op
+ V
non-op
(12.4)
QUESTION: What is V
non-op
in our example?
12.5
V
tot
calculation...
3. Obtain the value of common equity, V
CE
V
CE
= V
tot
V
debt
V
PS
(12.5)
QUESTION: What are V
debt
and V
PS
in our example?
12.6
V
CE
calculation...
4. Divide by the number of shares, shrout, to obtain the share price
P =
V
CE
shares outstanding
(12.6)
Our example...
12.3. THE CORPORATE VALUATION MODEL 269
12.3.3 A quick look at Market Value Added (MVA)
We know V
CE
= 369, and this represents the market value of equity. I.e., the market value of
common stockholders claims to future FCFs.
QUESTION: What is the implicit assumption here?
12.7
However, the book value of common equity is BV
CE
= 245
Therefore, the market value added is:
MV A = V
CE
BV
CE
For our example...
12.3.4 Establishing the share price using DDM
Recall the multi-growth discussion of Chapter 5:
V
CE
=
n

t=1
D
t
(1 + R
s
)
t
+
D
n
(1 + g)
R
s
g
1
(1 + R
s
)
n
(12.7)
Our example (with R
s
= 14%)...
270 CHAPTER 12. VALUE BASED MANAGEMENT
12.3.5 CVM or DDM?
If you care about VBM (the next section) use CVM
Mature rm already paying dividends DDM
Firm in temporary high (or low) growth mode will have to estimate future dividends anyway
DDM or CVM
Never paid dividends, new rm about to IPO, division that is going to be spun o CVM
12.4 Value-based Management (VBM)
Four factors that impact rm value as established with the CVM
1. Sales growth, g
2. Operating protability, OP = NOPAT/Sales
3. Capital requirements, CR = ROC/Sales
4. Cost of capital, WACC
Note: Required working capital RWC of this chapter is the same as net operating working
capital NOWC of Chapter 8. Also, required operating capital ROC of this chapter is the
same as total net operating capital TNOC of Chapter 8.
12.4. VALUE-BASED MANAGEMENT (VBM) 271
To see how these factors impact rm value, consider the CVM of a constant growth rm
V
op,t
=
FCF
t+1
WACC g
(12.8)
Expand the numerator
FCF
t+1
= NOPAT
t+1
ROC
t+1
= OP(Sales
t+1
) (CR(Sales
t+1
) CR(Sales
t
))
= OP(Sales
t
)(1 + g) CR(Sales
t
(1 + g) Sales
t
)
= OP(Sales
t
)(1 + g) CR(Sales
t
)(g)
Insert into (12.8)
V
op,t
=
OP(Sales
t
)(1 + g) CR(Sales
t
)(g)
WACC g
(12.9)
Examine how each factor impacts V
op,t
Sales growth Looking at (12.9) the impact of g is ambiguous.
QUESTION: Why is it ambiguous?
12.8
However, we know from Chapter 8 that growth is protable enough if ROIC >
WACC:
EV A = ROC(ROIC WACC) (12.10)
with ROIC = NOPAT/ROC. In other words, investment adds value when ROIC >
WACC. You can also think of EVA as the value added to a company by its opera-
tions in a given time period.
272 CHAPTER 12. VALUE BASED MANAGEMENT
Operating protability Clearly V
op,t
increases with OP. Intuitively, higher protabil-
ity is always better (more earnings per unit of sales is always better)
Capital requirements Lower CR subtract less in the numerator larger numer-
ator larger V
op,t
. Intuitively, a low CR means more sales per unit of operating
capital.
Cost of capital Looking at the denominator, a smaller WACC implies a larger V
op
.
Intuitively, access to cheap capital (low WACC) increases value while expensive
capital (high WACC) decreases value
These insights apply to all rms although the specic equations apply only to constant
growth rms.
VBM is the process or series of decisions that increase value by improving one or more of the
four factors.
QUESTION: Since improving g does not necessarily mean increasing or
decreasing g, how does a manager improve value as impacted by the sales
growth rate?
12.9
A four-step VBM approach
1. Assess where you are: prepare preliminary (Rev 0) nancial statement forecasts, compute
FCFs, EVA, MVA, OP, and CR.
2. Identify areas to improve value via the four value drivers.
12.4. VALUE-BASED MANAGEMENT (VBM) 273
3. Forecast nancial statements for multiple scenarios.
QUESTION: Why multiple scenarios?
12.10
4. Compute MVA, EVA, OP, CR, for each scenario and choose the value-maximizing sce-
nario.
12.4.1 Assess where you are
Compute OP, CR, ROIC, and EVA.
QUESTION: Do you need nancial statement forecasts for these measures?
12.11
Forecast nancial statements
Compute FCFs
Compute MV
A summary for our example if they stay the course:
274 CHAPTER 12. VALUE BASED MANAGEMENT
Item Memory Instruments Whole
Sales 1,000.0 500.0 1,500.0
ROC 870.0 200.0 1,070.0
NOPAT 78.6 36.0 114.6
OP = NOPAT/Sales 7.9% 7.2% 7.6%
CR = ROC/Sales 87.0% 40.0% 71.3%
ROIC = NOPAT/ROC 9.0% 18.0% 10.7%
WACC 10.5% 10.5% 10.5%
g 5% 5% 5%
EV A = ROC(ROIC WACC) -13.1 15.0 2.1
MV A = V
op
ROC -160.4 305.5 145.1
12.4.2 Identify areas to improve value
You should avoid developing a plan to boost sales growth for the memory division.
QUESTION: Why?
12.12
Reduce CR
mem
so that ROIC

mem
> WACC
Increase g
ins
since ROIC
ins
> WACC
12.4. VALUE-BASED MANAGEMENT (VBM) 275
12.4.3 Forecast nancial statements under multiple scenarios
12.4.4 Compute value parameters for each scenario and choose best
A few sample calculations...
276 CHAPTER 12. VALUE BASED MANAGEMENT
Chapter 13
Capital structure
Overview
The market value of a rm V is the sum of the market value of debt D and the market value
of equity S.
V = D + S (13.1)
QUESTION: Why?
13.1
Does the choice of debt vs. equity nancing impact the value of the rm? Is one better than
the other? These are the questions addressed in this chapter.
All items in Eq. (13.1) vary over time due to
277
278 CHAPTER 13. CAPITAL STRUCTURE
1. changes in market interest rates,
2. changes in the market risk premium, and
3. changes in the market perception of future cash ows generated by assets.
QUESTION: Can you elaborate on how these three factors impact V, D, and S in Eq.
(13.1)?
13.2
13.1 Tax free world
Dont you wish you lived in such a world?
Modigliani and Miller (1958) proposed that in the absence of taxes the choice of debt vs. equity
is irrelevant.
Proposition I: The value of the rm is not impacted by leverage.
V
L
= V
U
(13.2)
This implies
WACC
L
= WACC
U
(13.3)
QUESTION: Where did Eq. (13.3) come from?
13.3
13.1. TAX FREE WORLD 279
Proposition II: The cost of equity increases with leverage.
r
sL
= r
sU
+ (r
sU
r
dL
)
_
D
L
S
L
_
(13.4)
QUESTION: How do we know, by looking at Eq. (13.4), that r
sL
increases with
leverage?
13.4
We could derive Eq. (13.4) from Eq. (13.2), Eq. (13.3) and
WACC = w
d
R
d
+ w
s
R
s
, (13.5)
but lets move on if we are in agreement that Propositions I and II lead to Eq. (13.4).
A numerical example. Suppose UnleveredCo has EBIT of 500,000, no growth (g = 0), and
given its level of market risk r
sU
= 14%. Further suppose LeveredCo is identical to Un-
leveredCo with the exception of 1,000,000 in debt nancing at r
dL
= 8%. Taking the MM
propositions as gospel, compute and summarize w
d
, w
s
, R
d
, R
s
, WACC, D, S, and V for
both rms.

Intuitively it makes sense for the cost of equity to increase with leverage since the presence of
debt subordinates the claims of equity holders. That is, in the event of bankruptcy more of
the remaining assets must be transferred to debt holders. This leaves less for stockholders.
280 CHAPTER 13. CAPITAL STRUCTURE
13.2 A world with taxes
Modigliani and Miller (1963) extend their earlier work and note the distribution of after tax
earnings is aected by leverage.
QUESTION: How so?
13.5
The MM1963 results suggest rm value increases with debt.
QUESTION: If that is true, how should a rm nance itself?
13.6
Proposition I: The value of the rm increases with debt due to the tax deductibility of debt.
V
L
= V
U
+ t
c
D
L
(13.6)
where t
c
is the corporate tax rate.
Proposition II: The cost of equity increases with debt, but at a slower rate than a world without
taxes.
r
sL
= r
sU
+ (r
sU
r
dL
) (1 t
c
)
_
D
L
S
L
_
(13.7)
QUESTION: Why do I say at a slower rate?
13.7
13.3. SUMMARY 281
These propositions imply
WACC
L
WACC
U
In English, the weighted average cost of capital decreases as debt increases in a world with
corporate taxes. Lets prove it for fun!

Lets try another numerical example. Same as before but add t


c
= 40%. What are w
d
, w
s
, R
d
,
R
s
, WACC, D, S, and V for both the levered and unlevered rms?

13.3 Summary
No taxes With taxes
Unlevered Levered Unlevered Levered
w
d
0 28% 0% 39.33%
w
s
100% 72% 100% 60.67%
R
d
8% 8% 8% 4.8%
R
s
14% 16.33% 14% 16.33%
D 0 1,000,000 0 1,000,000
S 3,571,429 2,571,429 2,142,857 1,542,857
V 3,571,429 3,571,429 2,142,857 2,542,857
WACC 14% 14% 14% 11.80%
282 CHAPTER 13. CAPITAL STRUCTURE
Proposition II has been interpreted as: ... corporate taxes cause the cost of equity to rise less
rapidly with leverage than it would in the absence of taxes.
Part III
Project selection
283
Chapter 14
Project selection criteria
Overview
Capital budgeting is the decision process for identifying projects that maximize rms value.
Project ideas come from executives and employees.
14.1 Project classications
Several types of projects must be evaluated by management. The classications vary in the level of
analysis required and potential rewards.
285
286 CHAPTER 14. PROJECT SELECTION CRITERIA
Table 14.1: Project classications, analysis, and rewards
Classication Analysis Potential rewards
Maintenance of business DCF,simple necessary to maintain
Cost reduction DCF, detailed incremental improvement
Expansion of existing
products/markets
DCF, detailed high
Expansion into new products/markets DCF, detailed high
Safety/environmental DCF, moderate necessary
Research and development decision tree/real
options
high
Long-term contracts DCF medium-high
14.2 Decision rules
A manager is faced with multiple projects to evaluate, rank, and make accept/reject decisions. This
section describes seven methods used to rank projects for inclusion into the capital budget. Lets
begin with a couple denitions:
Independent projects Projects whose cash ows are independent of each other.
Mutually exclusive projects Projects whose cash ows are dependent on each other in the sense
that all projects can not be accepted at the same time due to constraints.
14.2. DECISION RULES 287
QUESTION: Any idea what some of those constraints might be?
14.1
14.2.1 Payback period
Payback period is the number of years required to recover original investment and is calculated as
follows:
payback = year before full recovery +
|unrecovered cost at start of recovery year|
cash ow during year
(14.1)
Consider net cash ows for two projects S (Sooner) and L (Later):
Year: 0 1 2 3 4
Project S
Net cash ow -1,000 500 400 300 100
Cumulative NCF -1,000 -500 -100 200 300
Project L
Net cash ow -1,000 100 300 400 600
Cumulative NCF -1,000 -900 -600 -200 400
QUESTION: Why is it necessary to compute the cumulative NCF?
14.2
Clearly, payback for Project S should be between 2 and 3 while payback for Project L should be
between 3 and 4. The calculation...
QUESTION: If these projects are mutually exclusive, which one would you choose?
14.3
288 CHAPTER 14. PROJECT SELECTION CRITERIA
Unfortunately, the net cash ows do not take the cost of capital into consideration (i.e., they
are not discounted).
Insert Discounted payback.
14.2.2 Discounted payback period
Same calculation as payback period but discount the net cash ows rst. Then compute the
cumulative discounted net cash ow (NCF) followed by the discounted payback.
Year: 0 1 2 3 4
Project S
Net cash ow -1,000 500 400 300 100
PV [NCF, 10%] -1,000 455 331 225 68
Cumulative PV [NCF, 10%] -1,000 -545 -214 11 79
Project L
Net cash ow -1,000 100 300 400 600
PV [NCF, 10%] -1,000 91 248 301 410
Cumulative PV [NCF, 10%] -1,000 -909 -661 -360 50
The calculation...
QUESTION: Why is the discounted payback number larger than the regular payback
calculation?
14.4
14.2. DECISION RULES 289
Both regular and discounted payback ignore cash ows after the payback period. For example,
what if project L had a positive cash ow of $5,000 in year 5 it would be the clear winner?
If you are going to discount cash ows, you might as well use...
14.2.3 Net present value (NPV)
To obtain NPV, follow ve simple steps:
1. Determine project cost (initial cash outlay).
2. Estimate future net cash ows.
3. Assess risk of project.
QUESTION: Why assess project risk?
14.5
4. Compute NPV by discounting cash ows.
5. Make an accept/reject decision.
The capital budgeting decision using NPV is straightforward:
If projects are independent accept all positive NPV projects
If projects are mutually exclusive choose higher NPV projects
290 CHAPTER 14. PROJECT SELECTION CRITERIA
To compute NPV use the following formula:
NPV =
n

t=0
NCF
t
(1 + WACC)
t
(14.2)
with NCF
t
= expected net cash ow at time t, WACC = discount rate (the cost of capital), and
n = number of periods. NPV for sooner and later... When there are many projects and many
cash ows a spreadsheet is typically used.
Interpreting NPV
NPV = 0 project earns the required rate of return and cash ows are sucient to repay
the invested capital.
NPV > 0 project earns the required rate of return, cash ows are sucient to repay the
invested capital, and provides extra cash ows that accrue to the rms stockholders.
NPV < 0 project does not earn the required rate of return.
14.2.4 Internal rate of return (IRR)
Much like nding yield to maturity with bonds, project internal rate of return can be found by
solving the NPV equation for IRR:
0 =
n

t=0
NCF
t
(1 + IRR)
t
(14.3)
14.2. DECISION RULES 291
Unfortunately, solving this equation without a nancial calculator is dicult (you would need
to solve a polynomial of order n). Without a nancial calculator you can use trial and error,
picking dierent values of IRR until equation (14.3) is satised.
Using a nancial calculator (or spreadsheet) the values for sooner and later are: IRR
s
= 14.5%
and IRR
L
= 11.8%
Interpreting IRR There are a few ways to interpret IRR:
1. IRR is the yield of a project given its cost and future cash ows.
2. IRR is the rate that equates future cash ows to the current cost.
3. IRR is the rate in which a projects NPV = 0.
Two problems with IRR
1. Just as the Y TM measure assumes future coupon payments are reinvested at Y TM, the IRR
measure assumes future cash ows are reinvested at IRR. In contrast, the NPV calculation
assumes cash ows can be reinvested at the cost of capital. The latter (cash ows can be
reinvested at the cost of capital) is a more realistic assumption.
2. If cash ows are non-normal, IRR will produce multiple results. Specically, one result for
each change in sign. In this case the IRR accept/reject decision can conict with the NPV
method.
292 CHAPTER 14. PROJECT SELECTION CRITERIA
What to do with the IRR number
Independent projects: accept all projects with IRR > WACC (the project earns a return in
excess of the capital used to fund it).
Mutually exclusive projects: Use NPV method instead.
QUESTION: Why?
14.6
14.2.5 NPV proles
NPV proles are obtained by varying the discount rate (required rate of return) in the NPV equation
(14.2). Lets take a look at a spreadsheet example...
QUESTION: Where does the NPV conict with IRR occur?
14.7
As you can see the NPV rankings are a function of the cost of capital.
QUESTION: So what if the cost of capital is exactly equal to the crossover point (i.e.,
both projects have the same NPV)?
14.8
14.2.6 Modied IRR
Examples thus far have been based on normal cash ows (conventional cash ows),. That is,
cash ows that have only one change in sign (negative at beginning to reect outows, then
positive after payback period)
14.2. DECISION RULES 293
Non-normal cash ows are cash ows with more than one change in sign and can produce
multiple IRRs.
To illustrate, consider project M...
MIRR has two advantages over IRR
1. It avoids the possibility of obtaining multiple IRRs
2. It uses a better cash ow reinvestment rate assumption: cash ows are reinvested at the
cost of capital k.
MIRR is computed by solving the following equation for MIRR:
n

t=0
COF
t
(1 + WACC)
t
=
_
n

t=0
CIF
t
(1 + WACC)
nt
_

1
(1 + MIRR)
n
(14.4)
where COF = cash out ows, CIF = cash in ows, and k = cost of capital. A few observations
about this equation:
The left hand side represents the present value of costs.
The right hand side represents the present value of the terminal value, with the terminal value
represented by the future value of cash inows invested at the cost of capital rate.
QUESTION: How is discounting the terminal value by MIRR not assuming cash ows
are reinvested at MIRR?
14.9
294 CHAPTER 14. PROJECT SELECTION CRITERIA
An example (Project M)... So how does MIRR compare with NPV when evaluating mutually
exclusive projects?
Equal size and same life: NPV and MIRR are equivalent.
Equal size and dierent lives: ll in zeroes for shorter-life project then NPV and MIRR are
equivalent.
Dierent sizes: NPV and MIRR may conict.
14.2.7 Protability index
Yet another project project evaluation method is the protability index:
PI =
PV of future cash ows
initial cost
=

n
t=1
CF
t
(1+r)
t
CF
0
For project Sooner:
PI
S
=
1, 078.82
1, 000
= 1.079
Provides a relative measure: for Project Sooner, each $1 invested produces $1.079.
Independent projects: accept all with PI > 1.
Mutually exclusive projects: higher PI is better but rankings may conict with NPV.
14.3. IMPLEMENTATION OF CAPITAL BUDGETING METHODS 295
14.3 Implementation of capital budgeting methods
14.3.1 Comparison of methods
Referring to Table 14.2:
Payback We saw how $5,000 cash ow in post analysis period is not accounted for in Section 14.2.2
NPV Consider two projects, Small and Big with cash ows:
Year 0 1
Project Smallz -10,000 16,500
Project Biggie -100,000 115,500
QUESTION: If WACC = 0.10, what is the NPV for each of the projects?
14.12
However, project Big is more risky since 10X more capital is required. Also, if reality
does not match expectations in the future, project Small has more of a safety margin.
To illustrate, consider a 33
1
3
% drop in future cash ows for project Small and a 4.76%
drop in future cash ows for project Big.
QUESTION: What is the NPV of both projects?
14.13
IRR/MIRR Now compute IRR for projects Big and Small: IRR
big
= 15.5% and IRR
small
=
65.0%. Thus two projects with the same NPV (5,000) can be ranked using IRR, and IRR
gives a better indicator of project risk.
296 CHAPTER 14. PROJECT SELECTION CRITERIA
Table 14.2: Capital budgeting method matrix
Method What it measures Drawbacks
payback risk and liquidity does not consider cash ows beyond payback
period nor the cost of capital
PV[payback] risk and liquidity does not consider cash ows beyond payback
period
NPV dollar benet to shareholders unable to rank mutually exclusive projects with
identical NPVs, may conict with IRR/MIRR
when ranking mutually exclusive projects.
QUESTION: When does the conict
occur?
14.10
IRR rate of return earned on
invested capital
assumes cash ows are reinvested at IRR, can
have multiple IRRs, and may conict with NPV
when ranking mutually exclusive projects
QUESTION: When do multiple IRRs
occur?
14.11
MIRR rate of return on invested
capital
can conict with NPV when ranking mutually
exclusive projects
PI bang for the buck can conict with NPV when ranking mutually
exclusive projects
14.3. IMPLEMENTATION OF CAPITAL BUDGETING METHODS 297
QUESTION: Unlike stocks, how can higher IRR be interpreted as lower risk?
14.14
14.3.2 In practice
Since computing time is cheap, you should compute all of the measures (perhaps avoid IRR
unless you are looking for a quick calculation of a normal cash ow project).
Do not rely solely on the quantitative measures.
Be skeptical of high NPV projects. Positive NPV projects imply you are earning a return
greater than your cost of capital. This happens only if you have some competitive advantage
in an ecient market or you are running a monopoly or oligopoly.
Keep in mind how long these competitive advantages will last (patentable vs. non-patenable,
replaceable vs. non-replaceable).
Firms in the real-world use the methods discussed in this chapter. The following data is from
Biermans 1992 study of Fortune 500 industrial companies (B) and the Parrino and Kidwell
(2010) textbook (PK).
298 CHAPTER 14. PROJECT SELECTION CRITERIA
Table 14.3: Capital budgeting methods used in industry
Item 1955 (B) 1981 (PK) 1992 (B) 1999 (PK)
DCF methods 4% ? 100% ?
payback most important 5% 84% 56.7%
NPV ? 16.5% 85% 74.9%
IRR ? 65.3% 99% 75.7%
Small rms use these methods less (21% for DCF methods) and it is hypothesized this is due
to (1) more concerned about liquidity, (2) do not know how to use these methods, and (3)
belief that small projects will not benet from DCF analysis.
QUESTION: What do you think?
14.15
14.3.3 Post-audit
At this point, managers have two choices:
1. Make the capital budgeting decision and let the projects ride.
2. Make the decision but follow up (herein called the post-audit). Post audit compares actual
results with expected results and explains why dierences occurred.
14.4. SPECIAL APPLICATIONS 299
The post-audit comparisons and explanations serve three primary purposes:
1. Improve forecasts: would be nice if they were more accurate!
2. Improve operations: maybe forecasts are accurate but employee and capital productivity could
be improved to meet those forecasts
3. Improve protability via termination of projects that are no longer economically viable (i.e.,
no longer likely to obtain the required return).
14.4 Special applications
14.4.1 Unequal lives
There are two approaches: the equivalent annual annuity approach and the replacement chain
(common life) approach. We will look at the common life approach here and the equivalent
annual annuity approach in Chapter 16.
A common life approach example (r = 11.5%)...
QUESTION: Which project would you choose and why?
14.16
When to use common-life analysis
1. If projects are mutually exclusive and have very dierent lives
300 CHAPTER 14. PROJECT SELECTION CRITERIA
2. High probability that the project will be repeated in the future
Problems with common-life analysis: ination and technological improvements will impact
future cash ows
14.4.2 Economic vs. physical life
Physical life how long project can operate
Economic life how long project should operate to maximize NPV
Sometimes it is better to terminate a project and receive the salvage value of equipment rather
than run the equipment until salvage value is zero.
An example...
QUESTION: What is the economic life of the project? What is the physical life?
14.17
14.5 The optimal project mix
Denition: the set of projects that maximizes rm value.
In theory, all projects with positive NPVs should be accepted, but you may be unable to accept
all due to constraints:
14.5. THE OPTIMAL PROJECT MIX 301
1. The marginal cost of capital increases.
2. You may have to ration capital
14.5.1 Increasing marginal cost of capital
The more capital you require, the more expensive each additional dollar becomes.
Larger projects may require additional funding increases WACC may reduce NPV such
that NPV

< 0 can not accept project


14.5.2 Capital rationing
1. Reluctance to issue new stock (or debt)
Lazy approach: choose articial limit to capital expenditures out of concern of increasing
WACC.
QUESTION: Why might a manager do this?
14.18
Better approach: estimate NPVs with WACC

> WACC with WACC

= new cost of
capital given additional debt or equity issuance. Then make accept/reject decision.
2. Do not have enough non-monetary resources (e.g., people)
Lazy approach: set articial limit.
302 CHAPTER 14. PROJECT SELECTION CRITERIA
Better approach: Do some more analysis (such as linear programming) to nd optimum
combination of projects.
QUESTION: What else?
14.19
3. Do not trust project managers estimates
Lazy approach: add a little to WACC or require project managers to use higher WACC
QUESTION: What is wrong with this?
14.20
Better approach: Use real numbers and post-audit.
14.A Another look at IRR vs. MIRR plus incremental IRR
14.A.1 Standard IRR
Before exploring IRR lets revisit NPV :
NPV =
n

t=0
NCF
t
(1 + WACC)
t
(14.5)
Note that Eq. (14.5) is similar to the bond price equation:
PV =
n

t=1
C
(1 + Y TM)
t
+
FV
(1 + Y TM)
n
(14.6)
14.A. ANOTHER LOOK AT IRR VS. MIRR PLUS INCREMENTAL IRR 303
In the bond price equation, Eq. (14.6), we start at t = 1 in contrast to the NPV Eq. (14.5) where
we start from t = 0. If we set NPV = 0 and rearrange Eq. (14.5) we have an equation nearly
identical to Eq. (14.6):
NCF
0
=
n

t=1
NCF
t
(1 + IRR)
t
(14.7)
Just as you use your nancial calculator to solve for Y TM in the bond pricing equation Eq. (14.6),
you can solve for the internal rate of return IRR in Eq. (14.7). Well, not exactly. You need to use
the CF buttons instead of PV , PMT, and FV since the period cash ows CF are not identical.
At the risk of being redundant, let me rewrite Eq. (14.5) using NPV = 0:
0 =
n

t=0
NCF
t
(1 + WACC)
t
(14.8)
You can see that Eqs. (14.6), (14.7), and (14.8) all require the t = 0 cash ow, either PV or NCF
0
,
to be entered as negative numbers in your nancial calculator. This leads to three interpretations of
IRR:
1. IRR is the yield of a project given its cost and future cash ows.
2. IRR is the rate that equates future cash ows to the current cost.
3. IRR is the rate that makes a projects NPV = 0.
There are two problems with IRR:
304 CHAPTER 14. PROJECT SELECTION CRITERIA
1. Just as the Y TM measure assumes future coupon payments are reinvested at Y TM, the IRR
measure assumes future cash ows are invested at IRR.
2. If cash ows are non-normal IRR will provide multiple results, specically, one for each change
of sign.
14.A.2 Modied IRR
MIRR is calculated in a three step process:
1. Discount cash outows to time 0 using WACC.
2. Compute the terminal value (ending value) of all cash inows using WACC.
3. Set PV equal to the result of step 1 (negative number!), FV equal to the result of step 2, N
to the number of periods, and the resulting interest rate, that equates FV to PV , is MIRR
Example 14.1. WACC = 10%, CF
0
= 1.6, CF
1
= +10.0, CF
2
= 10.0. What is MIRR?
To compute MIRR we are converting the problem to a zero-coupon bond. For fun, calculate the
MIRR and NPV of this project.
14.A.3 Incremental IRR
Consider the following cash ows for project Biggie and Smallz:
14.A. ANOTHER LOOK AT IRR VS. MIRR PLUS INCREMENTAL IRR 305
Project CF
0
CF
1
Biggie -100,000 120,000
Smallz -10,000 16,500
Incremental -90000 103,500
In other words, it costs an additional 90,000 to receive an additional 103,500 when choosing
project Biggie over project Smallz. For fun, complete the following table:
Project NPV IRR
Biggie
Smallz
Incremental
306 CHAPTER 14. PROJECT SELECTION CRITERIA
Chapter 15
Estimating project cash ows
Overview
In this chapter we will look at:
The role of externalities and sunk costs.
The impact of depreciation approaches.
The impact of ination.
Estimating project risk.
Incorporating project risk in decision analysis.
307
308 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
Real options and capital budgeting.
15.1 Who estimates cash ows?
Estimates come from teams, not just one person.
Marketing, engineering, cost accountants, and sales make up that team.
Make sure all team members use consistent and realistic assumptions.
15.2 Relevant cash ows: incremental free cash ow
Use cash ows, not accounting income.
We are concerned about incremental cash ows provided by a project: the additional FCF
generated by a project vs. not taking the project.
15.2. RELEVANT CASH FLOWS: INCREMENTAL FREE CASH FLOW 309
15.2.1 Project cash ow vs. accounting income
Begin with the Chapter 8 construction of the free cash ow measure:
NOWC = OCA OCL
TNOC = NOWC + OLTA
= (OCA OCL) + OLTA
TNOC
t
= TNOC
t
TNOC
t1
NOPAT = EBIT (1 )
FCF
t
= NOPAT
t
TNOC
t
Next assign specic balance sheet items to OCA, OCL, and OLTA:
RWC = OCA OCL
= (Cash + AR + Inventory) (AP + ACC)
ROC = RWC + FA
ROC
t
= RWC
t
RWC
t1
NOPAT = EBIT (1 )
FCF
t
= NOPAT
t
ROC
t
Equation (13-3) in Brigham and Daves (2010) relates accounting income to cash ow as:
FCF = Operating cash ow Gross xed asset expenditures Change in working cap
(15.1)
310 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
But how does one arrive at Eq. (15.1)? I will show you:
FCF
t
= NOPAT
t
TNOC
t
= EBIT
t
(1 ) ((OCA
t
OCL
t
+FA
t
) (OCA
t1
OCL
t1
+FA
t1
))
= EBIT
t
(1 ) ((FA
t
FA
t1
) + (OCA
t
OCA
t1
) (OCL
t
OCL
t1
))
= (EBIT
t
(1 ) +DEP
t
) (FA
t
+DEP
t
+ OCA
t
OCL
t
)
= (EBIT
t
(1 ) +DEP
t
)
. .
(FA
t
+DEP
t
)
. .
(OCA
t
OCL
t
)
= Operating cash ow Gross xed asset expenditures Change in working cap
I add deprecation in operating cash ow but subtract it again in the gross xed asset expenditures.
The net eect of my depreciation inclusions is zero.
QUESTION: In the context of cash ow, why add depreciation to EBIT (1 ) and to
FA?
15.1
Costs of xed assets
Although xed asset costs are not included in accounting income calculations they are included
in capital budgeting calculations.
Costs include shipping and installation; this total cost is used as the depreciable basis
1
.
The salvage value matters when computing operating income the year the xed asset is sold.
1
this is used later on to calculate the amount of depreciation expense we use in (??)
15.2. RELEVANT CASH FLOWS: INCREMENTAL FREE CASH FLOW 311
Non-cash charges Even though depreciation is a non cash expense and has an impact on after-tax
cash ows, it is not a cash ow.
Changes in required working capital New project new inventories, accounts payable, re-
ceivables, etc.
Exclusion of interest expenses
Note we begin with earnings before interest and taxes.
Interest expense is already accounted for in WACC.
Accounting income (net income) is the income available to stockholders.
Project income (free cash ow) is the income available to all investors (stakeholders).
15.2.2 Incremental cash ows
Three issues to keep in mind when determining incremental cash ows provided by a project:
1. Sunk costs
Denition: cash that has already been spent.
Do not include sunk costs in incremental cash ow calculations.
312 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
E.g., research and development already performed, marketing survey purchased last year,
land purchased last year, etc.
2. Opportunity costs
Denition: cash ows that could be generated with existing assets that are required by
the new project
Market value of this asset is the cost that should be treated as a negative cash ow (a
cost).
E.g., land that could be sold for $X but is needed to start a new project is considered an
opportunity cost of $X associated with the new project
3. Externalities
Denition: a side eect or consequence of taking on project
Positive: opening a suburban bank branch could increase trac (and therefore revenue)
at both the suburban and downtown branches. Be sure not to double-count transfers
from the old (downtown) branch to the new (suburban) branch.
Negative: if Nautica decides to open a web-store, sales at retail outlets may decline. The
revenue from online operations must exceed the [likely] lost sales at retail outlets.
15.2. RELEVANT CASH FLOWS: INCREMENTAL FREE CASH FLOW 313
Timing of cash ows
Daily cash ow computations would be nice but it is impractical
Typically assume cash ows occur at the end of the year (or quarter)
An example of incremental cash ow computations: Replacement project
Decision: to replace, or not to replace, that is the question
Will cost $100,000 to replace existing equipment but:
1. Output will increase
2. Sales will increase
3. Unit costs will decrease
4. Will have larger tax write o.
QUESTION: Why?
15.2
5. Will receive income from sale of old equipment
The ultimate question: do benets outweigh the costs?
QUESTION: What is assumed when suggesting increased sales?
15.3
An example...
314 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
15.3 Tax eects
15.3.1 Overview of depreciation
Companies can and do use dierent depreciation methods for investors than for tax reporting.
These methods include straight-line (pre 1954), double-declining balance and sum-of-years
digits (1954 to 1981), accelerated cost recovery system (1981 to 1986), MACRS (1986 to
1993), others (1993+).
QUESTION: Why dierent reporting methods?
15.4
For stockholder reporting, subtracting the salvage value lowers the depreciation expense; we
do not do this for tax reporting purposes.
Tax laws are complicated and change often: contact the IRS or an expert for up-to-date
information.
15.3.2 Tax depreciation life
Before: depreciable life = estimated useful life fully depreciated at end of useful life
After: MACRS shortens depreciable life and allows for larger depreciation expenses earlier in
an assets life
Note: Real estate must be depreciated using the straight-line method.
15.3. TAX EFFECTS 315
Half-year convention Asset is put into service in the middle of the rst year recovery period
is extended one year beyond asset life of the particular class.
Depreciable basis is the cost of equipment plus shipping and installation
Sale of depreciable asset If asset is sold the dierence between the sale price (salvage value) and
depreciated or book value is added to operating income.
Depreciation illustration
Cost of equipment = $150,000
MACRS class life = 5 years
Delivery and installation = $30,000
Date placed into service = October 15, year t = 0
Year t Depreciation expense
1 0.2(180, 000) = 36, 000
2 0.32(180, 000) = 57, 600
3 0.19(180, 000) = 34, 200
4 0.12(180, 000) = 21, 600
5 0.11(180, 000) = 19, 800
6 0.06(180, 000) = 10, 800
total = 180, 000
QUESTION: What happens if equipment is sold at the end of year 3 for $90,000?
15.5
316 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
15.4 Capital budgeting project example
Up to now: factors that impact cash ows
Now: how cash ow analysis impacts the budgeting decision
Two broad categories for projects:
1. Expansion project: invest to increase sales
2. Replacement project: replace existing asset to increase net cash ows.
QUESTION: What is net cash ow?
15.6
What to include in project cash ows
1. Initial investment (more than just FA invest, you must include initial RWC investment
also)
2. Periodic (annual) cash ows: include depreciation but exclude interest
3. Terminal cash ows adjusted for taxes
Example This example illustrates (1) how cash ow estimates are obtained by the various team
members and (2) the cash ow analysis for making a decision to accept or reject a project.
Marketing (Sales estimates)
15.4. CAPITAL BUDGETING PROJECT EXAMPLE 317
Price per unit = $3,000
Annual sales (units) = 20,000
Annual sales (dollars) = $60,000,000
Growth rate of price (aka, ination) g
price
= 2%
Growth rate of unit sales g
units
= 0%
Engineering (Resource requirements)
Additional manufacturing space (building) needed
When building will be needed (December 31, 2007)
Equipment needed
Production (May be part of engineering and/or accounting)
Per-unit variable cost = $2,100
Fixed overhead = $8,000,000 per year excluding depreciation
Growth rate of variable costs g
vc
= 2%
Growth rate of xed costs g
fc
= 1%
Accounting (cost accountants)
Marginal federal plus state tax rate = 40%
318 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
WACC = 12%
Manufacturing space (building) cost = $12,000,000
Equipment cost including and shipping and installation = $8,000,000
Deprecation schedule of building MACRS 39-year class
Depreciation schedule of equipment MACRS 5-year class life
Book value of building in year 4 BV
bldg,4
= 10, 908, 000
Book value of equipment in year 4 BV
equip,4
= 1, 360, 000
QUESTION: How are year 4 book values obtained?
15.7
Management (CEO, board of directors, perhaps others)
Economic life estimate = 4 years.
QUESTION: How was the projects economic life estimated? How would you
verify?
15.8
Same risk as average project therefore use WACC as the discount rate for project cash
ows
Market value of building in year 4 MV
bldg,4
= 7, 500, 000
Market value of equipment in year 4 MV
equip,4
= 2, 000, 000
QUESTION: How are year 4 market values obtained?
15.9
15.4. CAPITAL BUDGETING PROJECT EXAMPLE 319
15.4.1 Part 1 - Input data
A summary of all the team inputs
RWC/Sales = 10%, an estimate of how much working capital needs to be on hand to support
sales (more on this in Part 4)
15.4.2 Part 2 - Depreciation schedule
Building uses straight line depreciation with year 1 depreciation
1
2
100%
39
1.3%, year 2 through
39 depreciation
100%
39
2.6%, and year 40 depreciation
1
2
100%
39
1.3%
Equipment depreciation based on MACRS 5 year class life.
15.4.3 Part 3 - Cash ows associated with building and equipment dis-
posal
QUESTION: Why is the market value of the building in 2011 less than the book
value?
15.10
The loss on the building sale provides a tax credit of $1,363. In other words, the company will
pay $1,363 less in taxes since the loss of $3,408 is deducted from income.
320 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
15.4.4 Part 4 - Compute projected cash ows
The crystal ball applies more to the marketing departments inputs: units sold and sales
price.
QUESTION: Why suggest the other forecasts require less magic?
15.11
The tax savings from interest expenses are ignored in this example. See footnote on page 227.
15.4.5 Part 5 - Key output and making the decision
NPV > 0 good
Payback period=3.22 good or bad?
IRR > WACC and MIRR > WACC good
What if project is riskier than average? To be continued...
15.5 Ination adjustment
recall r
nom
r
real
+IP. See page 61 of Brigham and Daves (2007) or page 58 of Brigham and
Daves (2010).
In general, WACC = WACC
nom
15.5. INFLATION ADJUSTMENT 321
QUESTION: Why?
15.12
Must ensure net clash ows are expressed in the same terms (nominal or real) as WACC
Two methods of ination adjustment
1. Use real NCFs and adjust WACC to reect WACC
real
(therefore you need to adjust, or
are implicitly adjusting R
d
, R
s
, and R
ps
2. Leave WACC alone (assuming it is a nominal value) and incorporating ination into NCFs
Method #2 is preferred since Method #1 either assumes R
d
, R
s
, and R
ps
are aect by ination
in the same way. or requires that they be adjusted separately
An example of incorporating ination...
322 CHAPTER 15. ESTIMATING PROJECT CASH FLOWS
Chapter 16
Equivalent annual cost
Overview
Allow me to rename Equivalent Annual Cost of Ross et al. (2010) to Annualized Equivalent
Cost (AEC).
Up to this point capital budgeting (accept/reject) decisions were based on NPV, IRR, MIRR,
and other measures.
Potential problems with the prior approach:
1. Revenue forecasts are a source of signicant error in capital budgeting analysis. Who has
the best crystal ball?
323
324 CHAPTER 16. EQUIVALENT ANNUAL COST
2. It may be dicult to attribute revenues to one particular machine under consideration.
3. When looking at projects with unequal lives NPV can be misleading.
The annualized equivalent cost (AEC) approach bypasses revenue forecasting and revenue
attribution by focusing on costs. The AEC approach also accommodates projects with unequal
lives.
AEC is useful for replacement and make vs. buy decisions.
16.1 The AEC procedure and interpretations
16.1.1 General procedure
Step 1: Compute net present cost (NPC) which includes initial cash outlay, opportunity costs,
and future production costs.
Step 2: Compute AEC as
AEC =
NPC
PV A[r, n]
(16.1)
where PV A[r, n] is the present value annuity factor with interest rate r and n years. Note:
PV A[r, n] =
1 (1 + r)
n
r
(16.2)
16.2. ACME INC. EXAMPLE 325
QUESTION: Can anyone think of an easy way to obtain PV A[r, n]?
16.1
Step 3: Divide AEC by number of units and compare resulting per-unit costs.
16.1.2 Interpretation
AEC represents the annual cost of the project in todays dollars.
This approach expands on NPC by spreading out the initial cash outlay over the life of the
project.
QUESTION: Why would you want to do this?
16.2
Although this formulation presumes level production (same # of units per year) it can be
modied to accommodate unlevel production.
16.2 Acme Inc. example
Acme is considering replacing an existing (old) machine.
The old machine still works and will last another 10 years.
The proposed new machine will reduce direct production costs from $26,000 to $20,000 annu-
ally.
326 CHAPTER 16. EQUIVALENT ANNUAL COST
The cost of capital is 14% and the marginal tax rate is 34%.
Assume 10,000 units of production annually, straight-line depreciation, and 10 years of opera-
tion.
Should the new project be accepted? Justify the answer with relative cash ow approach (NPV
of incremental cash ows) and absolute cash ow approach (AEC per unit w/ old vs. new).
16.2.1 Scenario 1: Zero book, zero salvage value
QUESTION: What does zero book / zero salvage value tell you?
16.3
Relative [incremental] cash ow approach Keep in mind these calculations represent the
incremental cash ow from replacing the machine.

QUESTION: Should Acme purchase the new machine?


16.4
Absolute (AEC) approach

QUESTION: Should Acme purchase the new machine?


16.5
QUESTION: If the widget produced by this machine could be purchased rather than
manufactured, what is the max Acme should pay?
16.6
16.2. ACME INC. EXAMPLE 327
16.2.2 Scenario 2: Nonzero book value, zero salvage value
Now assume the book value of the old machine is 8,000 and annual deprecation would be 800
per year for 10 years if the old machine is retained. Salvage value is still zero.
QUESTION: How will a non-zero book value for the old equipment impact our
calculations?
16.7
Relative [incremental] cash ow approach Keep in mind these calculations represent the
incremental cash ow from replacing the machine.

QUESTION: Should Acme purchase the new machine?


16.8
QUESTION: What is the seemingly counter-intuitive implication of the higher book
value?
16.9
Absolute (AEC) approach

QUESTION: Should Acme purchase the new machine?


16.10
QUESTION: If the widget produced by this machine could be purchased rather than
manufactured, what is the max Acme should pay?
16.11
328 CHAPTER 16. EQUIVALENT ANNUAL COST
16.2.3 Scenario 3: Nonzero book, nonzero salvage value
Now machine has a salvage value (t = 0) of 4,000 and book value of 8,000 (also t = 0).
Assume salvage value after 10 years is zero
Annual deprecation is 800 per year for 10 years if the old machine is retained.
QUESTION: How will a non-zero salvage value for the old equipment impact our
calculations?
16.12
Relative [incremental] cash ow approach I.e., what if we did replace the equipment.

QUESTION: Should Acme purchase the new machine?


16.13
QUESTION: What is the seemingly counter-intuitive implication of the higher salvage
value?
16.14
Absolute (AEC) approach

QUESTION: Should Acme purchase the new machine?


16.15
QUESTION: If the widget produced by this machine could be purchased rather than
manufactured, what is the max Acme should pay?
16.16
16.3. SUMMARY 329
16.3 Summary
AEC provides a means to evaluate replacement projects and make vs. buy decisions.
AEC avoids problematic revenue forecasting.
A couple tax accounting concepts reinforced.
1. After tax impact of write-o = writeo.
2. After-tax impact of cost reduction = after-tax impact of revenue increase = (1 )
cost reduction.
The more valuable the old equipment (salvage and book value) the more benecial it is replace
it, provided the replacement has signicantly lower annual expenses.
This lecture prompted me to trade in my 2007 Inniti G35S for a 2009 Honda Civic (not a
Porsche 911)!
330 CHAPTER 16. EQUIVALENT ANNUAL COST
Chapter 17
Project risk analysis
Overview
In the previous three chapters we looked at criteria for project selection. This chapter expands the
analysis by incorporating project risk. The chapter concludes with an introduction to managing,
rather than just analyzing, project risk.
17.1 Project (stand-alone) risk
Sales and unit numbers are really expected values.
QUESTION: What does this imply?
17.1
331
332 CHAPTER 17. PROJECT RISK ANALYSIS
PDFs + correlations of cash ows NPV PDF
A goal: to determine appropriate discount rate for a given projects cash ows
17.1.1 Sensitivity analysis
Begin with base case, the case using expected values
Change values (by some percentage) and tabulate NPV
The steeper the line, the greater the sensitivity
QUESTION: What is missing in this analysis?
17.2
17.1.2 Scenario analysis
Overcomes two of the shortcomings of sensitivity analysis.
QUESTION: Any idea which two?
17.3
A quick way to see the best and worst case.
Procedure
1. For each of the key variables, have team members provide best and worst case numbers
17.1. PROJECT (STAND-ALONE) RISK 333
2. Assign probabilities of 25% to the best case, 50% to the base case, and 25% to the worst
case.
QUESTION: What did we just do, in a mathematical (statistics) sense?
17.4
3. Calculate three NPVs: NPV
best
, NPV
base
, and NPV
worst
4. Calculate E[NPV ],
NPV
, and CV [NPV ]:
E [NPV ] =
n

i=1
Pr
i
NPV
i
(17.1)

NPV
=
_
n

i=1
Pr
i
(NPV
i
E [NPV ])
2
_1
2
(17.2)
CV [NPV ] =

NPV
E [NPV ]
(17.3)
QUESTION: Why are the AVERAGE() and STDEV() functions of Excel
inappropriate in this case?
17.5
5. Calculate CV [NPV ]
An example...
334 CHAPTER 17. PROJECT RISK ANALYSIS
17.1.3 Monte Carlo simulation
Technique originates from work on the Manhattan Project (rst atomic bomb) and named
Monte Carlo because it employed the mathematics of gambling (how many people are going
to die, on average?)
Improves on scenario analysis by
1. Utilizing continuous distributions as opposed to discrete
2. Incorporates correlation among inputs
Basic process
1. Dene random variables for each input (incorporate correlations if available)
2. Generate random value for each input based on info in step #1
3. Compute NPV based on these simulated values
4. Repeat steps #2 and #3 a thousand or so times, recording input variable and NPV values
for each try
5. Compute E[NPV ],
NPV
, and CV [NPV ] =
NPV
/E[NPV ] using simulated NPVs from
step #4
Input variable denition (key variables):
Sales price Normal distribution with = 3.00 and = 0.35
17.2. INCORPORATING PROJECT RISK 335
QUESTION: What if you sell to businesses (e.g., oil) and have price
agreements in place?
17.6
Variable costs Triangular distribution with lower bound 1.40, most likely value = 2.10, and
upper bound of 2.50. Existing labor contracts and supplier relationships have limited the
variability of variable costs.
QUESTION: How is this PDF limited?
17.7
Unit sales Triangular distribution. Purchase agreements with customers enable lower limit
of 15,000; manufacturing capacity sets upper limit of 30,000
Sales growth Normal distribution with = 0%, = 15%, and correlated with unit sales.
QUESTION: What is the intuition behind sales growth correlation with unit
sales?
17.8
An example...
E[NPV ] > 0, but CV [NPV ] >> 1.0, the average CV of the rm.
QUESTION: What does this mean?
17.9
17.2 Incorporating project risk
Risk can be incorporated via the certainty equivalent approach (not discussed here) or the
risk-adjusted discount rate approach (what we have been eluding to)
336 CHAPTER 17. PROJECT RISK ANALYSIS
Essentially, if project risk (CV) is greater than the rms average risk (CV), increase WACC.
Brigham and Daves (2010) suggest there is no good way of specifying exactly how much and it
is necessarily judgmental. However, I oer a suggestion: If the CV of the project is x% higher
(lower) than the rms average CV, then raise (lower) the projects discount rate (project
WACC) by x%
QUESTION: After you adjust WACC, then what?
17.10
17.3 Phased decisions and risk management
Rather than go all in, you can phase in your investments for some projects.
Doing so enables the manager to reduce risk rather than just measure it.
Eligible projects and be evaluated with decision trees.
The basic decision tree
The project: produce industrial robot. See page 475 of Brigham and Daves (2010) .
What is going on
Node 1 Pay 0.5M (t = 0) for marketing study. The outcome of the study has two branches
large market exists continue with prototype (go to Node 2)
17.4. REAL OPTIONS INTRODUCTION 337
small market exists drop the project
Node 2 Market exists, now spend 1M (t = 1) to build prototype. Two outcomes are possible
engineers approve of the prototype continue with production (go to Node 3)
engineers say it is junk terminate project
Node 3 Market exists, engineers approve prototype, invest 10M (t = 2) and build factory.
Three outcomes are possible:
High market acceptance 18,000 income in t = 3 continue another two years
Medium market acceptance 8,000 income in t = 3 continue another two years
Low market acceptance 2,000 loss in t = 3 terminate project (go to Node 4)
For each path, compute joint probabilities and NPV using rm average WACC
Compute E[NPV ],
NPV
, and CV [NPV ] =
NPV
/E[NPV ]
If CV
proj
> CV , adjust WACC, recompute E[NPV ]
From the footnote on page 467: Although a single WACC was used, with dierent phases
comes dierent WACCS (risk levels).
17.4 Real options introduction
Before: determine possible outcomes, embark on positive NPV project, no inuence on out-
comes
338 CHAPTER 17. PROJECT RISK ANALYSIS
After: managerial/real/strategic options opportunities for managers to make decisions that
inuence outcomes
17.4.1 Growth options
Consider some time before the Blue-Ray HD-DVD battle was resolved.
Sony had an option: invest to ramp up production of Blue-Ray DVD players (in the event
demand during the holiday season will be high) or maintain then-current production levels (in
the event the nancial crisis dampens consumer discretionary spending this holiday season)
If investment is avoided now: can invest elsewhere but competitors may establish market share
If gains from investing elsewhere exceed losses due to decreased market share, this option is
valuable
Like nancial options the real option value increases with r
f
17.4.2 Investment timing option
Introduce product now or wait until you can assess market size
Similar reasoning as growth option
17.4. REAL OPTIONS INTRODUCTION 339
17.4.3 Abandonment options
GM is locked into agreements with suppliers to purchase specied quantities at specied prices
1
.
In hindsight (and foresight if their management had any), an option to abandon those agree-
ments would be of value.
Capacity reduction and temporary suspension options can be valuable as well.
17.4.4 Flexibility options
BMW South Carolina plant: pay extra (the option premium) for a plant that can produce
more than just Z4s rather than a Z4-only plant
17.4.5 Valuing real options
Each of the real options just described has a cost (value)
Option Cost (value)
Growth pay more to increase capacity
Investment timing investment now
Abandonment option higher price or volume requirement
Flexibility option incremental cost of exible vs. focused plant
1
at least until they le bankruptcy
340 CHAPTER 17. PROJECT RISK ANALYSIS
Chapter 18
Real options
Overview
We are now armed with the tools to value options. In this chapter we look at a few applications of
nancial option valuation to real options.
18.1 Real option valuation
Project that expands opportunity set an option has positive value
While exact value of real option may be elusive, the estimate obtained can aid in the ac-
cept/reject decision
341
342 CHAPTER 18. REAL OPTIONS
Dealing with real options:
1. Use DCF and ignore option
2. #1 + qualitative assessment of real option value
3. Decision tree analysis to provide quantitative assessment of real option value
4. Apply B-S nancial option model to real option scenario
5. Use nancial engineering to make up your own model
18.2 Investment timing option
18.2.1 Approach 1: DCF ignoring the option
QUESTION: How was the expected annual cash ow computed?
18.1
Note how risky the project is:
if the $22 million changes to $21.5 million, the NPV becomes negative
25% chance that revenues are only $5 million NPV = -$38 million
Thus, although the expected NPV >0, the project is risky and at this point we have not fully
quantied the risk nor done anything to mitigate it.
18.2. INVESTMENT TIMING OPTION 343
18.2.2 Approach 2: DCF and qualitative analysis
Let c = option price: if c > 1.08M then wait (purchase the option), if c < 1.08M do not
wait (do not purchase the option)
Is the option to wait valuable? Consider what makes options valuable:
1. High current price: NPV of future cash ows 51.08.
QUESTION: Where did this number come from?
18.2
2. Time to maturity: one year is relatively long
3. Risk: project is quite risky
In sum, these qualitative factors suggest the option has value.
Since value > 0, then do the analysis to see if value > 1.08
18.2.3 Approach 3: Decision tree
Part 1 Forget the option, implement project today.
E[NPV ] = 1.08,
npv
= 24.02, CV = 22.32
high risk! but positive NPV. You could conclude that since E[NPV ] > 0 you [mis-
takenly] proceed immediately
344 CHAPTER 18. REAL OPTIONS
Part 2 Wait one year, then use scenario analysis/decision tree to yield
E[NPV

] = 9.36,

npv
= 8.57, CV

= 0.92
Higher E [NPV ] with lower risk therefore the option to wait is valuable.
QUESTION: Should a higher or lower discount rate be used in Part 2?
18.3
The appropriate discount rate for the delay decision is dicult to quantify.
You could discount year two through four cash ows at 14% while discounting costs by
R
F
= 6%.
Result: lower NPV but still greater than immediate 1.08.
What you can do when you can not dene the appropriate discount rate: sensitivity
analysis.
18.2.4 Approach 4: Black-Scholes model
To use the B-S model 5 inputs are needed
1. Risk free rate: in this example, use 1-year T-bill rate of 6%
2. Time to expiration: one year
3. Exercise price $50M
18.2. INVESTMENT TIMING OPTION 345
4. Current price of stock: The underlying asset for this real option is the delayed project
with current price equal to the present value of all expected cash ows excluding the
50M exercise price
5. Variance of the projects return. Three methods:
(a) Use educated guess based on variance of companys stock which should be lower than
the variance of average projects.
2
avg stock
= 12%, 18
2
avg project
30%
QUESTION: Why?
18.4
(b) Direct method: calculate variance of returns of each outcome. Use the PV at time
0 to compute returns. Note: (1) we are not using the IRR; (2) E[R] = WACC
because PVs were discounted by WACC.
(c) Indirect method: Use CV of delayed project (excluding the exercise price) in this
formula:

2
=
ln
_
CV
2
+ 1

t
(18.1)
Note: use expected value and standard deviation at the option expiration date to
compute CV. Why? You must read the article that derived the formula!
Which variance to use? Use judgment.
QUESTION: Any other suggestions?
18.5
Conclusion: option to wait is worth more than proceeding immediately therefore wait.
Lets look at how how sensitive the option value is to ...
346 CHAPTER 18. REAL OPTIONS
18.2.5 Approach 5. Financial Engineering
Use this approach when decision trees or B-S models do not map directly to the real option
Includes making up a new model customized to the particular project
18.3 Growth option
Before this chapter we looked at decisions as either accept or reject. In the previous section the
decision was immediate or delay. Here we look at the option to grow or not to grow.
18.3.1 Approach 1. DCF ignoring the option
In this case we are only considering running this project once
Expected net cash ows are:
E[NCF] = 0.25(34) + 0.5(20) + 0.25(2) = 19
The expected NPV is 1.29
QUESTION: What about risk of the project vs. risk of project with the option?
18.6
18.3. GROWTH OPTION 347
18.3.2 Approach 2: DCF and qualitative analysis
Is the option to produce more (the follow on project) valuable? If so, do not ignore the option
(i.e., throw it away).
18.3.3 Approach 3: Decision tree
Ignore option: E[NPV ] = 1.29,
npv
= 18.70, CV = 14.54 positive E[NPV ] but very
risky
Consider option: E[NPV

] = 4.70,

npv
= 24.62, CV

= 5.24 less risk


E[NPV

] > E[NPV ] the option is valuable


Since CV

< CV we may need to adjust the discount rate sensitivity analysis (Note: costs,
since they are known, are discounted at R
F
18.3.4 Approach 4: Black-Scholes model
t = 2 years, R
F
= 6%, X = 30
S
0
= current stock price = PV of future cash ows of second generation project = 24.07
QUESTION: What does S
0
< X imply?
18.7

direct
= 17.8%,
indirect
= 15.3%, both of which are greater than 12% of the average stock
return. Thus consistent with the benets of diversication
348 CHAPTER 18. REAL OPTIONS
Judgement: 15
true
20 but will use sensitivity analysis.
value >> 0 accept project
18.4 Use of real options
Real options are being used more and more for project evaluation.
Real options impact risk and therefore the appropriate discount rate.
Given the large number of nancial derivatives, you should be able to nd a nancial derivative
analogous to your seemingly obscure real option case.
When you can not: insert nancial engineering.
Chapter 19
Change Log
Second Edition
1. More examples are included throughout the text.
2. A list of tables and a list of gures has been added for easy lookup.
3. Numerous typos have been corrected.
4. Expanded illustrations and explanations have been included in chapter appendices 5.A, 5.B,
11.A, and 14.A.
5. Greatly expanded Chapter 8, managerial accounting.
349
350 CHAPTER 19. CHANGE LOG
Bibliography
Angell, R. J. (2011). A note on the calculation of sustainable growth rates in nance texts. Journal
of Economics and Finance Education, 10(1):4144.
Brigham, E. F. and Daves, P. R. (2007). Intermediate Financial Management. Thomson South-
Western, ninth edition.
Brigham, E. F. and Daves, P. R. (2010). Intermediate Financial Management. Thomson South-
Western, 10th edition.
Modigliani, F. and Miller, M. (1958). The cost of capital, corporation nance, and the theory of
investment. American Economic Review, 53:261297.
Modigliani, F. and Miller, M. H. (1963). Corporate income taxes and the cost of capital: a correction.
American Economic Review, 53(3):433443.
Parrino, R. and Kidwell, D. (2010). Fundamentals of Corporate Finance. John Wiley & Sone, Inc.,
New Jersey.
351
352 BIBLIOGRAPHY
Ross, S. A., Westereld, R., and Jaee, J. (2010). Corporate Finance. Mcgraw-Hill Irwin, New York,
NY, ninth edition.
Wildsmith, J. R. (1974). Managerial Theories of the Firm. Dunellen, New York.
Chapter 20
Answers to embedded questions
Answers
1.1
accounting, pollution, price gouging, employee treatment, OSHA. Googles dont be evil.
1.2
product quality and choices
1.3
increase the size, reduce the time, and reduce the risk of FCFs
1.4
Intrinsic value since the market will eventually catch on.
1.5
God
1.6
Long term, of course.
1.7
Sales data and forecasts, truthful or revised accounting statements, R&D info, clinical trial results, trades between companies, etc.
1.8
current assets less current liabilities
1.9
Limited to their initial investment
1.10
Corporation Advantages: Limited liability. Corporation disadvantages: Double taxation, disperse control
1.11
Its easy. Just look at income statements and after-tax cash to owner/worker.
1.12
No. Talk about why not, conict of interest, etc.
1.13
These guys and gals are golng buddies, their children go to the same expensive private schools, they live in the same expensive
neighborhoods, etc.
353
354 ANSWERS
1.14
Internal auditor deals with nancial statements while the C&E director deals with state and federal regulations as well as ethical
conduct
2.1
(1) long-run allows time for the true nancial statements to come out and (2) managers not encouraged to inate next quarters
numbers
2.2
(1) How do you measure performance? (2) How much of that performance is due to managers decisions? (3) Short-term goals induce
cooked books while long-term goals can limit managers short-term pay
2.3
Not so much...
2.4
They also received money from the POFs they were auditing for other consulting contracts
2.5
Investment banks who employed the analysts also did other business with POFs
2.6
That is your decision but be mindful of the consequences.
2.7
Entrenched, egotistical, and greedy management
2.8
Could be a golng buddy, board member may have consulting company therefore disagreement may result in a loss of a consulting
contract. Finally, could be interlocking boards
2.9
With cumulative voting you can concentrate your votes.see footnote on page 377 of Brigham and Daves (2007) or second paragraph
on page 387 of Brigham and Daves (2010).
2.10
A shift in ownership from a large number of small investors who are inactive to a smaller number of large investors who are active
2.11
Should Wall Street executives have received any performance-based bonuses for 2008?
2.12
Your ownership accrues 25% per year typically. Executives work accelerated vesting into their contracts.
2.13
Illiquid due to exercise restrictions
2.14
Communism since employees (the workers) have more power than investors
2.15
Good question. I would venture more prevalent with larger companies due to the cost of initial setup and executing the plan. For
more information see The National Center for Employee Ownership
2.16
Who knows? Take a look at the International corporate governance green box on pages 380 and 381 of Brigham and Daves (2007)
or pages 394 and 395 of Brigham and Daves (2010).
3.1
With Option 2 you make three payments of $12,000. If CD rates are 3% this translates into an NPV of -33,943. This means it is
more expensive to nance the car than to purchase it cash. If CD rates are 7% this translates into an NPV of -31,492. Therefore it is
cheaper to nance the car at 0% and invest your $32,679 in 7% CDs.
3.2
Due to peoples impatience and risk aversion.
3.3
Try not paying your credit card o every month!
3.4
9 years
3.5
2, 4, 12, 365.25,
3.6
It should, it is Eq. (3.3) rearranged.
3.7
Typically cash deposited today is out-of-pocket and treated negative. The withdrawal in the future is cash into your pocket and
treated positive. It is just a matter of perspective, but you must be mindful of the perspective.
ANSWERS 355
3.8
You choose the option with the highest present value.
3.9
We need a couple volunteers in class to demonstrate.
3.10
That is a good deal for the lender given the high interest. However, there is a risk of being repaid zero.
3.11
Presuming those are end of year numbers there are a total of N = 39 years with PV = 203, 211, 926 and FV = 309, 162, 581.
Therefore i = g = 1.08%.
3.12
To determine if you have the resources to support the sales growth and to determine if the growth is protable
3.13
Remember the ACE method: artwork, calculator, equation.
3.14
(1) Dont mixing banking and friendship. (2) There is no interest associated with this loan.
3.15
Lower interest rates are generally better. You may want to look at total interest dollars over the life of the loan. This could make an
interesting extra credit assignment. At what loan amount, interest rate, term combination are you better o paying a higher rate?
3.16
ACE method
3.17
8%
3.18
N = 5, I = 1.9/12
3.19
No. The longer term translates into more interest and a higher interest rate paid.
3.20
$276.10
3.21
The second approach looks easier to me.
3.22

3.23
$500 million in dividends every year forever. Sounds like a good deal to me.
3.24
We will answer this in class
3.25
Otherwise PV A would be negative. If i < g then we would use another model
3.26
We will work this out in class.
3.27
Lender B has the lowest APR at 10.90%
3.28
This could make a good extra credit assignment
4.1
Corporations and governments issue bonds to nance projects
4.2
Bond is selling at a premium therefore the current market yield must be less than 10%
4.3
Perform calculation using a nancial calculator
4.4
We will do this in class
4.5
To reissue new bonds at the new and lower market rate
4.6
Callable yield should be a little bit higher than non callable.
4.7
Fewer bonds to mature less money required
4.8
Duration matching can be used to hedge interest rate and reinvestment rate risk.
4.9
Via restrictive covenants such as dividend and additional debt restrictions
4.10
I am not a lawyer, but perhaps this solidies specic bondholder claims
4.11
Corporations issue bonds with yields lower than normal since they are tax free. Think corporate welfare here
356 ANSWERS
4.12
The credit worthiness of the insurance company. E.g., AIG.
4.13
Think about how AAA ratings were given to junky securities
4.14
Yes!
4.15
Uncle Sam!
4.16
U.S. Treasury Bonds are more marketable and therefore will have lower yields.
4.17
The risk that their bond will be called in at a time when they can purchase only lower yield bonds
4.18
The rate corresponding to the compensation necessary for one to postpone consumption.
4.19
It gets complicated, but, a downward sloping yield curve suggests the Fed will be lowering rates in the future. Why does the Fed
lower rates? When there is an economic slowdown. This is related to the expectations hypothesis to be covered in advanced nance
courses.
4.20
Also note the slope and shape of the demand curve is dependent on the set of available projects.
4.21
When a positive technology shock occurs the return on investment will be higher, therefore a company will be willing to pay a little
more to take on project with new technology.
4.22
To the right.
4.23
It should not be. The nominal rate is a combination of the real rate and expected ination.
4.24
It depends on what you believe rates will be next year. You can infer that information from the yield curve and application of the
expectations hypothesis.
4.25
r

= r
RF
IP and thus you can obtain the ination premium from quoted yields on non-indexed (nominal) T-bonds and indexed
(TIPS) T-bonds
4.26
Prior to the dysfunctional Congress there was no default risk. I dont know what to say now.
4.27
Gold can be sold real quick (go to any pawn shop or jeweler). However, there are signicant transaction costs. Therefore gold is
highly liquid but with low marketability.
4.28
Short term bonds must be reinvested in the future at then-current market rates whereas long-term bonds keep on paying the same
coupon. Thus, if rates fall in the future, long-term bond prices will rise more than short-term and pay better coupons to the new
short-term bonds
5.1
Someone (management or fellow disgruntled outside investor) who you grant permission to vote on your behalf
5.2
With voting rights but how much more depends on level of shareholder protection. The value of the voting right diminishes with the
quality of shareholder protection. Less shareholder protection voting is more important. Voting shares are about 4% to 6% higher in
value than non-voting shares in the U.S.
5.3
Inferior risk-adjusted returns
5.4
Capital gains
5.5
Buying and selling would occur until it did. Note the marginal investor sets the price
5.6
g again!
5.7
R
s


R
s
, in equilibrium R
s
=

R
s
, R
s
could be anything
ANSWERS 357
5.8
Because if you buy the stock today you will not receive D
0
5.9
No. If you sell the stock in a couple years the sales price will include all expected future cash ows from year 2 onward
5.10
Two ways to look at this. First (1 +g)
t
/ (1 +R
s
)
t
> 1 t therefore stock price is innite. Second, R
s
g < 0 and the stock price is
negative. Both ways are nonsensical In this case you would use a dierent model.
5.11
23.00
5.12
No. Increasing dividends can have a negative impact of future growth. E.g., not investing in new equipment or R&D.
5.13
24.84
5.14
1. For liquidity reasons. 2. To partake in growing dividends, 3. To realize some capital gains. 4. To obtain voting rights. In sum:
to make more money.
5.15
V
ps
=
Dps
Rps
6.1
Unlimited. When you write a call you expect the stock price to go down and the option never exercised. However, if the price goes
up you or obligated to sell it cheap. If this is a naked call, you have to buy the stock on the open market then sell it cheap. Ouch!
6.2
Think of investing at r
f
to have cash in the future.
6.3
The intrinsic value is $5.00 and the time value is $3.71
6.4
Investors would sell options at this higher price until 8.71 were reached
6.5
Investors would construct opposite portfolio: short stock and buy option. buying would drive price from low value to higher 8.71
6.6
Related to volatility of stock. would need to get into lognormal returns and CDF to elaborate.
6.7
Exercisable only on expiration date
6.8
Repay the debt or have no equity. More in chapters 16 and 20 of Brigham and Daves (2010)
7.1
Risk, return, diversication
7.2
Since both stocks have the same expected return, it is clear sale.com has more risk. However, if you used Pr [R < 0] as your measure
the results may be dierent.
7.3
Probabilities should add up to 100% and we will see this later in the course when estimating future cash ows. E.g., when your
marketing VP provides demand estimates.
7.4
15%
7.5
If the underlying returns are normally distributed, 99.730020% of the observations are with +/ 3
7.6
No short selling
7.7
Intel/Dell positive, American/Exxon negative (or less positive).
7.8
w
i
gets smaller, and therefore w
2
i
gets even smaller
7.9
When fundamental equals market value. Also, in economic terms, when supply equals demand.
7.10
An asset that has guaranteed returns. Example: U.S. Treasury bill.
7.11
Because it oers the optimum risk-return trade o.
7.12
16%
358 ANSWERS
7.13
Sell.
7.14
75.71
7.15
Managers info already in price
7.16
International correlation information
8.1
Balance sheet, income statement, statement of cash ows, and sometimes statement of retained earnings
8.2
Liquidity but IFRS is opposite?
8.3
The order in which they must be paid
8.4
Cash, marketable securities, short term investments
8.5
Credit cards (short term) to buy food. Home mortgages (long term) to buy homes.
8.6
Net of accumulated depreciation.
8.7
The amount paid for a company in excess of the book value, thus an intangible asset
8.8
Pay packages for executives?
8.9
Revolving line of credit and accrued expenses such as employee bonuses.
8.10
All of the accounting trickery that happens on the income statement after (and including) Sales.
8.11
Market value represents the present value of expected future cash ows. Book value represents the liquidation value of a company
based more on historical costs and accumulated depreciation.
8.12
The question almost answers itself. Synergy is where 1 plus 1 equals 3. Having the right equipment and the right people can facilitate
a higher market value than the sum of the parts.
8.13
Depreciation refers to tangible assets while amortization applies to intangible assets
8.14
Revenues have to be recognized in the same fashion as costs are recognized.
8.15
To tell the IRS I did not make any money (and avoid taxes) and tell the shareholders I made lots of money (pay my bonus please).
8.16
For one they legally last only a nite time. Second, disruptive technologies will replace your fancy patented product soon anyway.
8.17
Balance sheet reduction in debt
8.18
Because interest is tax deductible
8.19
Then ARE is also negative. In this scenario a company has reduced common equity via a reduction in assets.
8.20
Because non cash charges were taken out of net income and non cash revenues were added
8.21
(1) depreciation and amortization are typically the largest non cash items and (2) the smaller items typically cancel each other out.
Use nance.google.com to illustrate NCF calculation
8.22
Operating, Investing, Financing
8.23
An increase in AR could be due to sales that have been made but cash not received.
8.24
The issuance of long term debt triggers an increase in cash. That cash is used to purchase PP&E. Therefore an increase in PP&E is
a use of cash.
8.25
Cash received.
8.26
Operating current liabilities: suppliers (accounts payable) and employees (accruals)
ANSWERS 359
8.27
New building facade, computer upgrades, perquisites.
8.28
Taxes and net income.
8.29
Cash available to invest in growth or distribute to investors
8.30
Net income is reduced 0.40 () for every additional dollar of interest expense
8.31
By selling assets to oset operating losses.
8.32
See the ROIC equation.
8.33
The alternative with the highest after-tax cash ow. In this case the preferred stock with the (mostly) tax-deductible dividend income
8.34
(1) Dividends are not deductible from operating income and (2) shareholder has to pay taxes on them
8.35
Only single taxation.
9.1
It depends. We need to compare debt-to-asset and income available for interest payment ratios. If looking at just average interest
rates, Firm A: 11.4%, Firm B: 5.7%
9.2
It depends. creditor: high rm is able to repay; shareholder: low using your cash for growth rather than leaving it in cash and
marketable securities
9.3
(1) industry may have it all wrong and (2) might be something unique to your company (e.g., relationship with bank)
9.4
Is revenue recognized when invoiced, shipped, or cash received?
9.5
In their nancial statement lings, perhaps in the footnotes. You may also nd the sales terms in internal documents.
9.6
High due to their JIT manufacturing process
9.7
Inventories are not moving too fast... therefore not current. You might be better o using the acid test ratio
9.8
Yes. older more depreciation lower cost; newer higher price due to ination
9.9
Total assets includes current assets such as inventory (ITR) and log term assets such as PP&E (FATR)
9.10
Yes. home ownership
9.11
Lease payments are typically(?) deducted when calculating EBITDA.
9.12
Depreciation is a non-cash expense. Therefore whatever is depreciated can be considered cash available to repay short-term obligations.
Thus short-term lenders care about ECR. In the long term, these funds must be reinvested to maintain growth. Thus long-term investors
care about the measure that excludes depreciation funds (TIE)
9.13
Philosophically yes, the borrower is servant to the lender. Financially, it could magnify gains. We will see the impacts of debt on
ROE while discussing the DuPont equation
9.14
P includes expectations of future FCFs, E is what they have now
9.15
P represents discounted future cash ows. higher risk higher discount rate.
9.16
Less manipulated or adulterated.
9.17
B=cumulative value of what stockholders invested; M=present value of expected FCFs
9.18
To make the case. Some criticisms of Method X may not be present for Method Y, but if both say the same thing... Management
may prefer or require Method X. Also, people like to complicate things.
9.19
A = L + S.E.
360 ANSWERS
9.20
Benchmark divisions
9.21
Deate numbers or scale by assets or sales
10.1
strategy: a careful plan or method, tactic: a device for accomplishing an end
10.2
tech: apple newton (op), prot: SUV (kill the environment, etc.) What happened to Tucker, Edsel, and betamax?
10.3
I (the investor) will handle diversication, you (the rm) do what you do best
10.4
assumes debt is constant for entire year
10.5
(1) charges full year of interest on debt that may have been incurred in November (2) circularity in spreadsheets
10.6
n bonds plus 1 current market yield
10.7
Because we are using beginning of year debt levels
10.8
Just a little algebra.
10.9
Treated as backup for times when there is a cash shortfall
10.10
Related to nancial crisis of 2008-2009 when rms were unable to obtain short term loans or any loans for that matter. On 2009.10.21
NPR morning radio had small business owner speaking of diculty or inability to meet payroll due to unwillingness of banks to dish out
small business loans. Her business has been around 19 years and now it is the banks fault she can not make payroll. The rm may have
to close its doors. Do you buy that?
10.11
An artifact of the percent of sales method. varies; some assets and liabilities are unchanged (i.e., have no ).
10.12
Sales impacts everything via s and the sales forecast could be wrong
10.13
Better screening, hire repo-man, change credit terms, accept other forms of payment.
10.14
Talk to Dell about proper inventory management, read Chapter 21 of Brigham and Daves (2010)
10.15
Brigham and Daves (2010) says to reduce operating costs, but costs were already in-line with industry average. There may be other
undocumented reasons. Just be sure you dont use the hatchet when a scalpel is needed.
10.16
Increased short-term investments
10.17
NP involves and action between the rm and creditor. AP and accruals are between the rm and customer
10.18
Prots from sales, cash, and short term investments.
10.19
Stocks and bonds.
10.20
REVactual,t
Uactual,t
=
REVfull,t
1
11.1
Debt
11.2
Debt will be invested in a project and everyone (past creditors, current creditors, and current stock holders) all have a claim to the
cash ows generated by that project. The returns on the project should satisfy all stakeholders, not just the new bondholder.
11.3
(1) can not pay common stock dividends until preferred are paid; (2) dicult to raise additional funds; and (3) preferred stock holders
may be able to seize control of the rm
11.4
(1) Management thinks stock is over-valued or (2) rm needs to raise cash. But what about Cisco back in the day?
11.5
401k, pension funds, mutual funds, etc.
ANSWERS 361
11.6
DY=D/P
11.7
Historical dividend growth rates or analysts forecasts
11.8
(1) they vary over time; (2) some rms repurchase stock instead of paying dividends
11.9
(1) accuracy and truthfulness (analysts and the earnings numbers) and (2) dierent opinions dierent estimates. Now is a time
for mentioning Wisdom of Crowds
11.10
Based on info available today: D
0
/P
0
11.11
Out of the air. could use historical averages...
11.12
Scared of stocks buy bonds drives up price (lowers yield) of bonds
11.13
Because the rm receives less money for each bond when F > 0
11.14
PMT=60, FV=1000, PV=-990, N=30 I=6.07
12.1
(1) not everyone pays dividends; (2) dicult to trace increase in dividend to a project if the rm has multiple projects and therefore
multiple cash ows.
12.2
As a shareholder, I want Ford to focus on building cars or give that extra money for me to invest. Recall the required return from
the previous chapter. However, they appear to have weathered the market meltdown well.
12.3
EBIT(1 )
12.4
(1) to have assets necessary to support forecasted sales growth, MagnaVision needs 69M dollars, 51M of which will come from prots.
The remainder from investors, and in MagnaVisions case, from increased NP, LTD, and PS. Funds are raised via debt and preferred stock
to maintain a constant capital structure (see Chapter 15). I believe retained earnings could also be reduced via the sale of marketable
securities.
12.5
Marketable securities which are reported at their market value (approximately)
12.6
V
debt
= NP +LTD, V
PS
is obvious
12.7
In equilibrium, the market values common equity the way we just described! This is my value add... that statement is not in the
book, I believe.
12.8
Look at CR(Sales
t
)(g).
12.9
By increasing ROIC or reducing WACC. Regarding the former, ROIC can be increased by reducing required operating capital or
increasing NOPAT
12.10
(1) may not have funds to improve all deciencies at the same time; (2) some improvements may have little (or adverse) aects on
MVA
12.11
no
12.12
Since ROIC < WACC for the memory division
13.1
Eq. (13.1) is essentially a market value balance sheet.
MV A = MV L +MV E
362 ANSWERS
In English, assets are purchased with money raised from debt and stock issuances.
13.2
Market interest rates impacts the market value of debt D. The market risk premium impacts the cost of equity S. And the market
value of the rm V is based on the expected future cash ows. More precisely, V should be referred to as the market value of assets.
13.3
In general, V
0
=
FCF1/WACCg. So if FCF and g are the same for the levered and unlevered rm then WACC
L
= WACC
U
.
13.4
(1) leverage = D/S and it increases when D increases. (2) r
sU
> r
dL
since equity is more risky than debt.
13.5
Interest payments are tax deductible but dividends are not. Therefore a rm nanced with debt will have more after tax cash ow.
That is, the rm will have a lower tax bill than a comparable rm nanced by equity.
13.6
100% debt!
13.7
Because of the (1 t
c
) in Eq. (13.7) that is not present in Eq. (13.4)
14.1
money, people, more on this later
14.2
so we can establish the year before full recovery
14.3
Shorter payback is better, therefore choose project S.
14.4
If you discount cash ows, it takes longer to recoup the current costs
14.5
To determine the appropriate discount rate.
14.6
Better cash ow reinvestment assumption. In reality, you will use a combination of metrics and throw in some judgment
14.7
When r < crossover
14.8
Could choose the one with the higher IRR but ultimately some judgment will be needed. We will discuss a little bit more later.
14.9
Think zero-coupon bond!
14.10
When WACC < crossover rate
14.11
When there are multiple changes of sign in cash ows. That is, when cash ows are non-normal.
14.12
NPV
small
= 5, 000 and NPV
big
= 5, 000
14.13
11,000 and 1110,000
14.14
higher IRR, NPV more likely to be > 0
14.15
Quit being lazy, be thorough, do the calculation, it is not that bad with Excel, are you a survivor or an achiever?
14.16
In this example, I would not have bothered with the common life calculation since IRR
F
> IRR
C
14.17
Economic life is 2 years while physical life is 3
14.18
If they are compensated based on EVA, lower WACC means more money in their pocket
14.19
Perform further analysis with more employees
14.20
Managers will still inate their results, perhaps even more
15.1
Depreciation is a non-cash expense that was removed prior to arriving at EBIT and in the long run equipment must be replaced and
maintained.
15.2
Larger depreciation expense
15.3
That demand for additional units exists
ANSWERS 363
15.4
Simply, to minimize tax liability and maximize reported earnings. The manager wants to report lower expenses (lower depreciation)
to increase income to shareholders but higher expenses (higher depreciation) to decrease taxable income for tax reporting
15.5
Operating income for year 3 is adjusted by 90, 000 0.29 (180, 000) = +37, 800
15.6
The net eect of cost reductions and/or additional sales
15.7
Depreciation schedule
15.8
Estimated based on past experience (read: a guess). Could verify by projecting cash ows beyond 4 years (including revenues, costs,
and salvage values) and checking if NPV is larger
15.9
Input from marketing, engineering, accounting, etc.
15.10
Somehow, the company must retain the land the building is sitting on, but sells the building. Cisco did something like this in Cisco
City in Santa Clara. Step 1: buy the land and build a building. Step 2: Use the building until book value exceeds market value. Step
3: sell the building (at a loss) and then lease from the company you just sold the building to (tax deduction)
15.11
Costs and depreciation are fairly straightforward sans costs that are heavily impacted by commodity price uctuations (such as oil).
The marketing inputs are forecasts of what will people will do, which may be more dicult. Maybe if we take some advanced marketing
classes we can nd the marketing estimates to be more reliable than accounting estimates of costs
15.12
Quoted bond rates are nominal and computations of R
s
and R
ps
typically based on nominal values
16.1
PMT=1, N=n, I=r, FV=0, PV=-PVA[r,n].
16.2
You may have to obtain some nancing for project and would be dicult to explicitly specify the dollar costs of debt and equity
nancing. Thus with AEC you obtain a picture of the annual cost of capital in dollar amounts.
16.3
Machine has been fully depreciated and pretty reliable since it is worthless and can run 10 more years
16.4
Yes
16.5
Yes
16.6
-2.5735, not -2.60
16.7
8,000 lost write-o right o the bat (market value of zero is larger than the book value of 8,000) but 800 less in incremental depreciation
16.8
Yes
16.9
The more valuable the old machine (i.e., the higher the book value), the more likely you are to replace it
16.10
Yes
16.11
Good example to do in class
16.12
According to our qualitative counter-intuitive statement, the better the old equipment the more likely to replace it... therefore higher
NPV and per-unit dierential.
16.13
Yes
16.14
The better the old machine (i.e., the higher the salvage value), the more likely you are to replace it
16.15
Yes
16.16
Another good example to do in class
17.1
They are random variables and therefore have some sort of distribution (PDF)
364 ANSWERS
17.2
(1) correlation among the inputs, (2) ability for more than one input to change, (3) what is the probability of a 20% price decline?
17.3
(2) ability of multiple inputs to change simultaneously; (3) incorporates probability
17.4
Dene a discrete PDF
17.5
This is a discrete distribution
17.6
Either price is xed or distribution is altered
17.7
normal distributions have no limits whereas the triangular distribution does
17.8
The number of units sold today gives some indication of the number of units to be sold next year
17.9
More risk therefore use higher discount rate (WACC)
17.10
Recalculate NPV for base case, perhaps re-run Monte-Carlo and check Pr[NPV 0] and E[NPV ]
18.1
E [CF] =

PR
i
CF
i
18.2
Estimate adding the $50M initial cost back in
18.3
Lower since there is less uncertainty (demand is either average or high). Perhaps we should discount the investment at the risk free
rate since the amount is known and the cash ows at something less than 14%
18.4
Diversication
18.5
Use range of values in sensitivity or Monte Carlo analysis
18.6
A good in-class example
18.7
The option is out of the money, in other words, has no intrinsic value