.

,
CORPORATE FINANCE
STUDY GUIDE





Financial Management
Association of Australia (FMAA)
Monash
Important Notice



Prepared by: Kevin Liu and Charis Goh

The following notes have been prepared and provided as a
skeleton (sketch) of the course for this unit.


It is the responsibility of the student to make note of any changes in course
content.


These notes may exclude some topics and therefore be
inconsistent with current faculty teaching.


These notes should not be relied upon solely.


These notes should only be used to provide a basis from which students
can create an individual extensive set of notes in preparation for unit
assessments.


These notes should not be duplicated, either in part or in full, during
assessments
!"#$ &' (&)#)*+,
llnance can be summarlsed as Lhe maxlmlsaLlon of wealLh Lhrough Lhe allocaLlon of
moneLary resources Laklng lnLo accounL rlsk facLors. Pow do we lnvesL our asseLs and
manage our llablllLles ln a way LhaL glves us Lhe hlghesL reLurn?
ln corporaLe flnance, we are prlnclpally concerned wlLh corporaLe declslon-maklng ln Lerms
of evaluaLlng pro[ecLs and lnvesLmenLs, prlclng rlsk and wlLh Lhe caplLal sLrucLure of
companles.
&)-+'$./'0 (&/1' 2 1#/3+$'
llnanclal managers have a mulLlLude of roles and responslblllLles. Cne of Lhem ls maklng
flnanclal declslons on behalf of Lhe flrm. 1hese lnclude:

1hese 3 declslons should be ln allgnmenL wlLh every flrm's prlmary flnanclal ob[ecLlve ! Lo
maxlmlse shareholder's wealLh. 1hls can be done by maxlmlslng Lhe currenL value of a
company's shares.
#45678 *96:;<7=>
ln large companles, Lhere ls ofLen a separaLlon beLween managemenL and ownershlp. As a
resulL, shareholders have llLLle conLrol over managers, and Lhere ls an ongolng concern LhaL
managemenL mlghL make declslons LhaL beneflL Lhelr own self-lnLeresL raLher Lhan focuslng
on maxlmlslng shareholder wealLh.
1hls resulLs ln 'agency cosLs' (le. 1he cosLs of confllcL of lnLeresL beLween Lhe company's
owners and lLs managemenL).
ueclslons for nanclal managers
1he caplLal sLrucLure
declslons
((&)#)*&)?)
Pow should Lhe cash
requlred for
lnvesLmenLs be
made?
1he caplLal budgeung
declslons
(&)-+'$1+)$)
Pow much should Lhe
company lnvesL &
lnLo whlch asseLs?
1he worklng caplLal
managemenL
declslons
Pow should day-Lo-
day nanclal mauers
be managed?
ln order Lo reduce agency cosLs, Lhere should be some sorL of allgnmenL beLween Lhe
lnLeresLs of managemenL and shareholders. lor example, lf managemenL's compensaLlon ls
llnked Lo Lhe company's performance, Lhey wlll be lncenLlvlsed Lo make beLLer declslons on
behalf of Lhe company.
(&)#)*&#@ 1#$"+1#$&*'
$A5 =<B5 CD;E5 9: B9658
1hls ls one of Lhe mosL fundamenLal concepLs ln flnance. lL ls based on Lhe ldea of
opporLunlLy cosL. lnvesLlng money has opporLunlLy cosL ln LhaL people would raLher have
money now Lo buy Lhlngs and lnvesL.
ln oLher words, $1 Loday ls worLh $1 Lomorrow, why?
Money can be lnvesLed and lnLeresL earned on lnvesLmenL, hence money has Llme value
(and you cannoL add money amounLs aL dlfferenL polnLs ln Llme). Money musL be added aL
Lhe same polnL ln Llme.
1he formulas can be learnL from your lecLure slldes. Memorlse Lhem and make sure you
have pracLlced dolng Lhem ln your calculaLors.
1he maLhs lncludes resenL value (v) and luLure value (lv) calculaLlons:
lnLeresL on your money
o Slmple lnLeresL
o Compound lnLeresL
noLe: lf Lhe quesLlon does noL speclfy whlch Lype of lnLeresL should be applled, always apply
compound lnLeresL
lnLeresL raLes
o nomlnal and effecLlve
o nomlnal and real
AnnulLles
o Crdlnary AnnulLles
" cash flow beglns aL L=1
o AnnulLy due
" cash flow beglns aL L=0
o ueferred annulLy
" cash flow beglns laLer Lhan L=1
erpeLulLy
When pracLlclng, and ln any mld-semesLer LesLs or exams, Lry Lo use a Llme llne of Lhe cash
flows Lo avold confuslon.
lL ls also lmporLanL Lo remember Lhe dlfference beLween compoundlng (movlng cash flows
forwards) and dlscounLlng (movlng cash flows backwards), and Lo make sure you know how
Lo accounL for seml-annual or quarLer-annual paymenLs eLc.
-#@F#$&.) .( G.)H' #)H +IF&$&+'
+::<7<56= BDJK5=>
1heoreLlcally, caplLal markeLs are efflclenL. 1hls means LhaL asseLs are correcLly prlced
almosL all of Lhe Llme.
lf asseLs are correcLly prlced Lhen an lnvesLor can only hope Lo earn a normal reLurn on Lhelr
lnvesLmenL. 1hls ls Lhe reLurn whlch [usL compensaLes Lhem for Lhe rlsk Lhey are Laklng.
ln an efflclenL caplLal markeL lL should noL be posslble Lo conslsLenLly earn abnormal reLurns.
1hls ls because professlonal lnvesLors and Lraders rapldly dlgesL Lhe lmpllcaLlons of new
lnformaLlon whlch ls prlce-senslLlve and ad[usL Lhe prlce of asseLs. 1hey do Lhls by elLher
buylng lL lf lL ls under-valued or selllng lL lf lL ls over-valued. 1hey have an lncenLlve Lo do so
because Lhey wlll earn abnormal (poslLlve) reLurns Lhemselves by acLlng on Lhls lnformaLlon
before Lhe resL of Lhe markeL.
1he acLlvlLy of professlonal lnvesLors and Lraders should lead Lo 'falr value' prlces and hence
normal reLurns.
MarkeL efflclency ls lmporLanL because lL assures ALL lnvesLors LhaL Lhe securlLles Lhey buy
are prlced close Lo Lhelr Lrue, falr value.
G96L> M NAD= DJ5 =A58,
8onds are debL securlLles. 1he bond lssuer owes Lhe bond holder a debL, and dependlng on
Lhe Lerms of Lhe bond, may be obllged Lo pay lnLeresL (coupons) on Lhe debL aL cerLaln
conLracLually sLaLed Llmes.
1he value of a bond ls equal Lo Lhe presenL value of Lhe fuLure cash flows (any coupons and
Lhe prlnclpal repaymenL) dlscounLed aL Lhe markeL raLe of lnLeresL for bonds wlLh slmllar
characLerlsLlcs. As coupons occur aL regular, flxed, conLracLually sLaLed Llmes, bonds have a
flxed naLure, and are hence known as flxed lncome securlLles.
lf Lhe borrower falls Lo repay, Lhen Lhe debL holders are enLlLled Lo wlnd up Lhe flrm (or
bankrupL an lndlvldual) and sell Lhe proceeds Lo Lry and recoup as much of Lhelr debL as
posslble. A flrm musL always meeL lLs debL obllgaLlons before equlLy holders geL anyLhlng.



G96L> D6L <6=5J5>= JD=5>
8onds prlces vary negaLlvely wlLh lnLeresL raLes.
Why?
When lnLeresL raLes go up, lnvesLors seek oLher forms of lnvesLmenL ln order Lo Lake
advanLage of Lhe hlgher posslble reLurns.
1he 'yleld Lo maLurlLy' of a bond ls Lhe average raLe of reLurn obLalned by lnvesLors lf Lhe
bond ls purchased now and held unLll maLurlLy (lf Lhere ls no defaulL on any of Lhe promlsed
paymenLs). ln oLher words, lL ls Lhe raLe aL whlch you should dlscounL a bond Lo calculaLe lLs
presenL value.
Pence we have:
c = coupon raLe, l = yleld Lo maLurlLy
c = l
o bond prlce = face value
c > l
o bond prlce > face value (premlum bond)
c < l
o bond prlce < face value (dlscounL bond)
G96L> M <6=5J5>= JD=5 J<>K
All bonds have lnLeresL raLe rlsk, LhaL ls, Lhe chance LhaL lnLeresL raLes wlll change ln Lhe
fuLure, Lhereby changlng Lhe value of Lhe bond.
When Lhe lnLeresL raLe changes, cash flows of a bond are dlscounLed aL a dlfferenL raLe,
Lhereby changlng Lhe presenL value and currenL prlce LhaL should be pald for Lhe bond.
lurLhermore, when Lhe lnLeresL raLe changes, Lhe bond holder ls able Lo re-lnvesL Lhe
coupon paymenLs aL a dlfferenL markeL lnLeresL raLe.
1he deLermlnanLs of lnLeresL raLe rlsk are:
1. 1he Lerm Lo maLurlLy
LCnCL8 bonds are MC8L prlce-senslLlve Lo lnLeresL raLe
Why?
1he longer Lhe Lerm Lo maLurlLy, Lhe greaLer Lhe effecL of Lhe new
lnLeresL raLe has on Lhe prlce Lhrough compoundlng
2. 1he coupon raLe
LCWL8 coupon bonds are usually MC8L prlce-senslLlve Lo lnLeresL raLe
Why?
1he lower Lhe coupon raLe, Lhe greaLer Lhe effecL Lhe new lnLeresL
raLe has on Lhe bond prlce
G96L CD;ED=<96
1he formulas LhaL need Lo be used for calculaLlng bonds can be learnL off your lecLure slldes,
buL [usL remember LhaL:
ure dlscounL bonds ! have no coupon paymenL
Level coupon bonds ! have regular coupons (usually payable annually or seml-annually)
'ADJ5> M NAD= DJ5 =A58,
Shares are equlLy securlLles represenLlng ownershlp of a company. Shares can be lssued
prlvaLely or publlcly. lnvesLors may be able Lo buy shares ln Lhe publlc markeL aL lnlLlal
publlc offerlngs, also known as a company's 'floaL' (Lhe prlmary markeL), or ln Lhe sLock
markeL (le. 1he ASx), whlch ls Lhe secondary markeL.
1here are 2 ways of lncreaslng wealLh wlLh shares, caplLal galn (when Lhe prlce of Lhe share
lncreases), and dlvldends. ulvldends are merely a dlsLrlbuLlon of a porLlon of Lhe company's
earnlngs Lo shareholders. ulvldends and earnlngs are relaLed because a company's afLer-Lax
earnlngs musL be elLher:
(1) 8eLalned and re-lnvesLed lnLo Lhe buslness
(2) ulsLrlbuLed Lo shareholders
'ADJ5 CD;ED=<96
Share valuaLlon ls much more complex Lhan bond valuaLlon because of:
# 1he uncerLalnLy of promlsed cash flows (dlvldends)
# 1he facL LhaL shares have no maLurlLy
LxpecLed cash flows recelved from a share are [usL all fuLure dlvldends.
1here are 2 maln ways of valuaLlng a share:
(1) valuaLlon based on dlvldends ! all fuLure dlvldends are dlscounLed Lo presenL value
(2) valuaLlon based on earnlngs ! earnlngs are caplLallsed lnLo a share value uslng Lhe
prlce-Lo-earnlngs raLlo
" Larnlngs Lend Lo be more volaLlle Lhan dlvldends, so lL requlres a loL of sklll
and experlence Lo forecasL Lhem


1he formulas LhaL need Lo be used for calculaLlng shares can be learnL off your lecLure slldes.
1hese lnclude:
" ulvldend based valuaLlon
o ConsLanL dlvldend valuaLlon (a perpeLulLy)
o ConsLanL dlvldend growLh valuaLlon (Lhe 'Cordon CrowLh Model')
o varlable dlvldend growLh valuaLlon (a comblnaLlon of compoundlng
dlvldends, dlscounLlng Lhem Lo presenL value, Lhen applylng a 'Cordon
CrowLh Model')
" Larnlngs based valuaLlon
o rlce-Lo-earnlngs mulLlplled by earnlngs per share
O/.P+*$ +-#@F#$&.)
1hls Loplc ls concerned wlLh Lhe flnanclal manager's CAl1AL 8uuCL1lnC (lnvesLmenL)
declslon.
Whlch pro[ecLs should be lnvesLed ln, and whlch pro[ecLs are noL worLh lnvesLlng ln?
8emember LhaL Lhe end-goal ls Lo maxlmlse share-holders wealLh.
varlous Lechnlques are used ln order Lo evaluaLe and compare lnvesLmenL alLernaLlves.
*;D>><:<7D=<96 9: <6C5>=B56= QJ9R57=>
(1) lndependenL pro[ecLs
When Lhere are mulLlple pro[ecLs wlLh unrelaLed cash flows, and accepLlng or re[ecLlng one
pro[ecL has no bearlng on Lhe declslon on Lhe oLher
(2) MuLually excluslve pro[ecLs
When accepLlng one pro[ecL auLomaLlcally precludes Lhe oLher
(3) ConLlngenL pro[ecLs
When accepLance of one pro[ecL ls dependenL on anoLher pro[ecL (can be mandaLory or
opLlonal)
)5= OJ5>56= -D;E5 S)O-T #6D;8><>
We wanL Lo maxlmlse Lhe nv for ourselves or our flrm (dlfferenL Lo accounLlng proflL) ln
order Lo maxlmlse our shareholder's wealLh.
1herefore, for large scale professlonal declslons we musL underLake cosL-beneflL analysls Lo
make sure LhaL we can raLlonally expecL LhaL Lhls ls golng Lo happen.
We would only be wllllng Lo underLake a pro[ecL lf lLs nv ls aL leasL 0.
We wanL as much neL beneflL as posslble, we Lherefore budgeL our caplLal Lo flnd Lhe besL
use for lL Lo brlng us Lhe hlghesL nv posslble. 8emember, nv ad[usLs for rlsk and Llme vla
Lhe dlscounL raLe.
1hls nv evaluaLlon ls done vla dlscounLed cash flow analysls.
We Lake lnLo accounL all lnC8LMLn1AL cash flows ln Lhls process. 1hls means cash flows
LhaL wlll only occur lf Lhe pro[ecL ls underLaken. We care abouL cash flows and noL proflLs,
because only cash can be spenL, re-lnvesLed, and pald ouL ln dlvldends. A company's proflL,
on Lhe oLher hand, lncludes non-cash lLems such as depreclaLlon and non-operaLlng cash
lLems such as lnLeresL.
nv = dlscounLed sum of Lhese expecLed lncremenLal cash flows
1here are 3 sLeps ln nv analysls:
(1) ueLermlne cosLs of Lhe pro[ecL
(2) LsLlmaLe Lhe pro[ecL's fuLure cash flows over lLs forecasLed llfeLlme
A fuLure cash flow could be an lnflow (poslLlve) or an ouLflow (negaLlve)
We are concerned wlLh Lhe neL cash flows (lnflows less ouLflows) for each
year of Lhe pro[ecL
8emember Lo recognlse any salvage (resldual) value of Lhe pro[ecL ln lLs
Lermlnal year
(3) ueLermlne rlsklness of Lhe pro[ecL and esLlmaLe Lhe approprlaLe cosL of caplLal
CosL of caplLal = dlscounL raLe used Lo deLermlne Lhe presenL value of Lhe
fuLure cash flows
1he 8lSklL8 Lhe pro[ecL, Lhe PlCPL8 Lhe cosL of caplLal
(4) CalculaLe Lhe nv of Lhe pro[ecL
(3) Make a declslon
lf nv > 0, accepL
lf nv < 0, re[ecL
lor muLually excluslve pro[ecLs ! choose Lhe pro[ecL wlLh Lhe hlghesL nv
*D>A :;9N 5>=<BD=<96> M $A5 <67J5B56=D; 7D>A :;9N D6D;8><>
1o esLlmaLe a pro[ecL's fuLure cash flows, companles ofLen undergo an lncremenLal cash
flow analysls. 1wo alLernaLlve scenarlos are compared ln Lhls evaluaLlon, a fuLure wlLh Lhe
lnvesLmenL and a fuLure wlLhouL. ln oLher words, we focus on Lhe cash flow LhaL wlll only
occur lf you lnvesL ln Lhe pro[ecL.




1ype of cash flow

LxplanaLlon
lnclude as parL of Lhe
<67J5B56=D; cash flow
analysls?
CperaLlng cash flows Cash flow from day-Lo-day
operaLlons
$
AllocaLed cosLs Cash pald lrrespecLlve of
wheLher Lhe pro[ecL
proceeds

CpporLunlLy cosLs Cash lnflows forgone as a
resulL of Lhe pro[ecL
$
llnanclng charges Cash obLalned ln order Lo
fund Lhe pro[ecL (lncludlng
lnLeresL)

Sunk cosLs CosLs already borne by Lhe
flrm (eg. 8esearch and
developmenL)

Salvage value* 1he amounL recelved aL Lhe
end of a pro[ecL (Lhls mlghL
be a scrap value, lL mlghL be
negaLlve, and lL mlghL have
Lax lmpllcaLlons)
$
lmpacL of company Lax on
depreclaLlon
uepreclaLlon can be
deducLed ln deLermlnlng Lax
on a company's lncome
$
* lf Lhere ls a loss, apply Lhe 30 company Lax raLe on Lhe amounL losL and record Lhe Lax
savlng as a poslLlve cash flow. lf Lhere ls a galn, apply Lhe 30 company Lax raLe on Lhe
amounL galned and record Lhe Lax llablllLy as a negaLlve cash flow.
.=A5J QJ9:<=DU<;<=8 B5D>EJ5>
CLher forms of evaluaLlng declslons lnclude: accounLlng proflL, payback perlod, and lnLernal
raLe of reLurn (l88).
1hey do noL necessarlly lmply a maxlmlsaLlon of nv. ?ou should learn Lhe formulas Lo
Lhese, ln addlLlon Lo Lhe nv formula, from Lhe lecLure slldes. 1he calculaLlons requlred for
Lhls unlL ln regard Lo Lhese meLhods of pro[ecL valuaLlon are qulLe slmpllsLlc and Lhe
examples glven ln Lhe slldes cover Lhe conLenL very well.
OJ9R57=> N<=A L<::5J56= ;<C5>
1o compare pro[ecLs wlLh dlfferenL llves, we need Lo repllcaLe Lhe pro[ecLs repeaLedly over
Llme. 1here are 2 ways of dolng Lhls, one lnvolves repllcaLlng Lhe pro[ecLs enough Llmes unLll
Lhey have Lhe same flnlLe llfeLlme (Lhe ;9N5>= 79BB96 BE;=<Q;5 meLhod), and Lhe oLher
lnvolves repllcaLlng Lhe pro[ecLs lndeflnlLely lnLo Lhe fuLure (Lhe Q5JQ5=E<=8 meLhod).
1he perpeLulLy meLhod ls easler Lo use. 1here are 2 ways Lo analyse Lhls: elLher uslng Lhe
LqulvalenL Annual value meLhod or Lhe nv ln perpeLulLy meLhod. 1he flrsL Lells us Lhe
value per year (Lhe annulLy value) LhaL Lhe pro[ecL brlngs us afLer repllcaLlng lL lnLo lnflnlLy,
and Lhe second Lells us Lhe value of Lhe pro[ecL lnLo lnflnlLy.
LlLher way, Lhe ad[usLmenL allows us Lo gauge whlch pro[ecL has a hlgher nv over a slmllar,
comparable llfeLlme, and Lhus should be chosen.
.Q=<BD; J5Q;D75B56= L57<><96>
ManagemenL of a company ls ofLen faced wlLh Lhe declslon Lo reLlre (abandon) or replace
equlpmenL. 1he declslon Lo reLlre should be made when nv of Lhe cash flows < 0.
1hls can be done by:
(1) Assumlng LhaL each dlfferenL exerclsed opLlon of replacemenL ls a 'dlfferenL pro[ecL'
(2) llnd Lhe nv of each of Lhese pro[ecLs
(3) Ad[usL for Lhe facL LhaL Lhese pro[ecLs have dlfferenL llves (by uslng Lhe Q5JQ5=E<=8
meLhod)
O/.P+*$ +-#@F#$&.) !&$" /&'3
All pro[ecLs are under Lhe rlsk of obLalnlng a hlgher or lower raLe of reLurn Lhan expecLed.
1hls ls because Lhe expecLed raLe of reLurn of a pro[ecL ls a resulL of cash flow pro[ecLlons.
Lven Lhe besL professlonals wlll undergo a pleLhora of assumpLlons ln Lhelr analysls, hence
pro[ecL evaluaLlon ls almosL never correcL ln Lerms of exacL dollar amounL.
lor example, lf a company has hlgher/lower sales Lhan expecLed, cash flow pro[ecLlons wlll
be under/oversLaLed respecLlvely. 1hls ls Lhe same for cosLs.
lurLhermore, Lhere ls always uncerLalnLy as Lo whaL wlll occur ln Lhe fuLure. CfLen,
unexpecLed producLlon problems or unexpecLed economlc facLors wlll conLrlbuLe Lo Lhe
esLlmaLed cash flow Lo be dlfferenL from Lhe acLual cash flow. ?ou can only accounL for so
much rlsk.
Powever, as professlonals have reallsed Lhls over Llme, Lhey have accounLed for rlsk by
undergolng 'scenarlo analysls', whlch ls how resulLs from any flnanclal analysls change
under alLernaLlve scenarlos. 1he 2 Lypes of analysls relevanL Lo Lhls course are senslLlvlLy
analysls and slmulaLlon analysls.
'56><=<C<=8 #6D;8><>
SenslLlvlLy analysls looks Lo noL only Lhe expecLed fuLure cash flows, buL also assesses Lhe
effecL of fuLure wlLh pesslmlsLlc and opLlmlsLlc condlLlons. lL helps flnanclal managers assess
wheLher a pro[ecL ls Loo rlsky or noL. lf Lhe nv of Lhe cash flows ls hlghly senslLlve Lo any
parLlcular varlable, Lhe manager mlghL lnlLlaLe a greaLer analysls of Lhls varlable, or declde
Lo lnvesL ln anoLher pro[ecL LhaL carrles less rlsk.
'<BE;D=<96 #6D;8><>
SlmulaLlon analysls lnvolves runnlng a probablllLy dlsLrlbuLlon for Lhe ouLcome of each
varlable. lL ls slmllar Lo a senslLlvlLy analysls buL Lhere are noL dlscreLe ouLcomes for each
varlable, Lhey are spread ouL lnflnlLely ln a dlsLrlbuLlon.
H57<><96 $J55 #6D;8><>
A Lechnlque used Lo value a pro[ecL where Lhere are glven alLernaLlves wlLh expecLed
amounLs of cash flows from each alLernaLlve cholce. A declslon Lree analysls has probablllLy
of varlous evenLs occurrlng and Lhe effecL of each of Lhese evenLs.
8emember Lo label Lhe Llme each declslon occurs (L=0, L=1 eLc.) and Lo work backwards
Lhrough Lhe Lree!
/&'3 #)H /+$F/) #)H #''+$ O/&*&)?
8lsk arlses from Lhe uncerLalnLy of fuLure ouLcomes. lL ls Lhe elemenL of uncerLalnLy whlch
causes an lnvesLmenL Lo produce dlfferenL posslble reLurns for an lnvesLor. 1hls can be
measured by Lhe probablllLles LhaL are aLLached Lo dlfferenL resulLs occurrlng. WlLh hlgher
rlsk, Lhere ls more poLenLlal Lo achleve a hlgher reallsed reLurn. Powever, you also face Lhe
rlsk of recelvlng a reLurn LhaL ls lower Lhan expecLed.
1he reLurn ls Lhe LoLal galn or loss of an lnvesLmenL over a glven perlod of Llme. lor example,
lf $100 was lnvesLed ln an asseL and Lhe asseL ls subsequenLly sold for $120, Lhe dollar
reLurn ls $20. 1hls dollar reLurn ls converLed Lo a raLe of reLurn whlch ls Lhe proporLlon of
Lhe reLurn over Lhe lnvesLmenL. ln Lhls case, Lhe raLe of reLurn would be
!"
!""
= 20.
1he LoLal holdlng perlod reLurn conslsLs of Lwo componenLs: caplLal appreclaLlon and
lncome. CaplLal appreclaLlon ls Lhe caplLal galns made from an asseL whlch has appreclaLed
ln value over Llme. lncome ls cash flows recelved from an lnvesLmenL ln Lhe perlod ln whlch
lL was held. Poldlng perlod reLurns are based on pasL lnformaLlon and hence wlll noL be able
Lo predlcL or affecL fuLure prlces of securlLles.
LxpecLed reLurns allow lnvesLors Lo evaluaLe Lhe posslble reLurns LhaL Lhey could recelve ln
Lhe fuLure. lL represenLs Lhe welghLed-average of Lhe probablllLles of all posslble ouLcomes
from an lnvesLmenL.
! !" ! !" ! !"
!
!!!


WheLher an lnvesLor prefers Lo lnvesL ln asseL A or asseL 8, where boLh asseLs have Lhe
same expecLed reLurn buL dlffer ln rlsk, depends on Lhelr rlsk preferences - Lhelr aLLlLudes
Lowards rlsk. A rlsk-neuLral lnvesLor ls one who nelLher llkes nor dlsllkes rlsk. 1he uLlllLy
aLLached Lo each lncremenL of wealLh ls Lhe same or equal. More rlsk or less rlsk doesn'L
affecL hls/her uLlllLy aL all. A rlsk-averse lnvesLor ls one who demands compensaLlon for each
unlL of rlsk Laken. 1hey are wllllng Lo bear more rlsk buL musL recelve compensaLlon ln Lhe
form of hlgher expecLed reLurns Lo do so. 8lsk-seeklng lnvesLors wlll always prefer
lnvesLmenLs wlLh hlgher rlsk even lf boLh lnvesLmenLs have Lhe same expecLed reLurn. 1hey
derlve more uLlllLy wlLh each lncremenL of rlsk.
8lsk can be measured by Lhe sLandard devlaLlon of Lhe reLurn of Lhe asseL. 1he larger Lhe
sLandard devlaLlon of Lhe reLurn, Lhe more rlsky Lhe asseL ls. Pence, Lhere ls a beLLer chance
of reachlng a hlgher reLurn buL Lhls ls also accompanled by Lhe posslblllLy of sufferlng a
blgger loss.
!"# ! ! !! ! !!"! !" ! ! !
!
!
!
!!!

SLandard devlaLlon (!) ls Lhe square rooL of varlance.
lnsLead of lnvesLlng all avallable funds ln one lndlvldual asseL, lnvesLors prefer lnvesLlng
Lhelr wealLh ln a porLfollo of asseLs. 1he level of rlsk ls reduced Lo less Lhan Lhe average of
Lhe rlsks assoclaLed wlLh Lhe asseLs lndlvldually, whlle Lhe expecLed reLurn of Lhe porLfollo
remalns Lhe same. 1he porLfollo Lheory assumes LhaL reLurns from lnvesLmenLs are normally
dlsLrlbuLed and LhaL all lnvesLors are rlsk averse. Pence, lL ls expecLed LhaL lnvesLors would
requlre a well-dlverslfled porLfollo whlch would maxlmlse Lhelr uLlllLy - LhaL ls, Lhey wlll be
compensaLed for any addlLlonal rlsk Laken.
1he expecLed reLurn on Lhe porLfollo ls Lhe average expecLed reLurns of Lhe asseLs ln lL
(welghLed accordlng Lo whaL percenLage of Lhe porLfollo Lhey make up). 1he rlsk (sLandard
devlaLlon) of Lhe porLfollo ls noL slmply Lhe welghLed average as above. 1here ls also a
componenL LhaL reflecLs Lhe co-varlance of Lhe lndlvldual asseLs. 1hls reflecLs Lhe facL LhaL lf
Lhey are noL perfecLly correlaLed Lo Lhe same drlvlng facLors Lhen Lhey would noL move ln
Lhe same dlrecLlon.
1he less correlaLed Lhey are Lhe beLLer because LhaL means LhaL lL wlll be less llkely LhaL our
whole porLfollo loses value aL Lhe same Llme wlLh respecL Lo bad evenLs. 1herefore
dlverslflcaLlon across mulLlple asseLs wlLhouL perfecL correlaLlons wlll reduce our rlsk for Lhe
same expecLed reLurn.
We can Lhen flnd an opLlmal welghLlng of Lhe deslred asseLs ln our porLfollo Lo glve us Lhe
lowesL posslble amounL of rlsk for any glven level of expecLed reLurn. AlLernaLlvely, for a
deslred level of rlsk, we can opLlmlse Lhe porLfollo welghLlng of our seL of asseLs Lo provlde
Lhe hlghesL expecLed reLurn for LhaL level of rlsk. 1he equaLlon below ls Lhe porLfollo
varlance:
!!
!
! !
!
!!
!
! ! !
!
!!
!
! ! !!
!
!
!
!
!"
!
!
!
!

! ls Lhe correlaLlon coefflclenL used for rlsk ad[usLmenL Lo alLer Lhe porLfollo Lo sulL Lhe
preferences of dlfferenL rlsk-orlenLed lnvesLors.
When ! equals Lo +1, Lhe porLfollo has Lhe maxlmum level of rlsk (same magnlLude, same
dlrecLlon). When lL equals -1, all unlque rlsk ls dlverslfled (same magnlLude, dlfferenL
dlrecLlon). lf ! ls zero, Lhen Lhere ls no relaLlonshlp beLween Lhe asseLs.
*DQ<=D; #>>5= OJ<7<64 19L5;
1he caplLal asseL prlclng model aLLempLs Lo prlce asseLs by Lelllng us Lhelr LheoreLlcal
expecLed reLurn. lL holds LhaL only Lwo Lhlngs are relevanL over any one lnvesLmenL
Llmeframe: expecLed reLurn and Lhe rlsk assoclaLed ln achlevlng LhaL expecLed reLurn. lL
assumes LhaL rlsk ls sLandard devlaLlon. Cnce agaln, Lhls assumes LhaL reLurns are normally
dlsLrlbuLed.
1he efflclenL fronLler ls a graph of Lhe besL posslble expecLed reLurn posslblllLy for a glven
level of rlsk based upon our deslred seL of asseLs. 1heoreLlcally, Lhls ls usually made up of
Lhe enLlre lnvesLmenL unlverse of all of Lhe rlsky asseLs LhaL exlsL.
uslng dlverslflcaLlon and porLfollo Lheory, Lhls efflclenL fronLler ls Lhe besL we can do for
rlsky asseLs alone.
lf we can use Lhe rlsk-free asseL we can do even beLLer.
1he rlsk-free asseL ls usually Laken Lo mean some form of ulLra-low rlsk (LheoreLlcally rlsk-
free) debL.
We can choose Lo lnvesL some of our porLfollo ln lL or we can borrow Lo lncrease our
expecLed reLurn and Lhe rlsk on our money.
lL [usL so happens LhaL Lhese comblnaLlons can allow for beLLer rlsk-reLurn relaLlonshlps. 1hls
lncreases our efflclenL fronLler for all polnLs where we can elLher lnvesL or borrow wlLh Lhe
rlsk-free asseL.
1he markeL porLfollo" ls a porLfollo of all Lhe rlsky asseLs LhaL we could posslbly selecL a
porLfollo from whlch lncludes a zero welghLlng of Lhe rlsk-free asseL. l.e., lL ls [usL rlsky
asseLs ln Lhelr mosL opLlmal porLfollo welghLlng.
1he caplLal markeL llne (CML") ls slmply a new graph of expecLed reLurns as a funcLlon of
rlsk (our new and beLLer efflclenL fronLler) afLer we lnLroduce Lhe rlsk-free asseL lnLo our
porLfollo cholces.
1o reach Lhe oLher polnLs along Lhe CML we are lnvesLlng ln Lhe markeL porLfollo and Lhen
elLher borrowlng or lendlng (or oLherwlse lnvesLlng ln Lhe rlsk-free asseL).
1herefore, Lhe CML ls Lhe besL posslble seL of expecLed reLurns for any glven level of rlsk.
1he rlsk we cannoL dlverslfy away ls called sysLemaLlc rlsk. lL ls effecLlvely macroeconomlc
rlsk. 1hls ls also called markeL rlsk. unless you have a porLfollo of [usL Lhe rlsk-free asseL Lhen
you wlll have rlsk.
1he rlsk we can dlverslfy away ls called unsysLemaLlc rlsk. lL ls effecLlvely lnvesLmenL-speclflc.
We are noL compensaLed for Lhls rlsk because we can dlverslfy lL away by slmply creaLlng a
more opLlmal porLfollo as per Lhe CML.
Any prospecLlve lndlvldual lnvesLmenL musL now promlse an expecLed reLurn aL leasL equal
Lo whaL we could achleve wlLh Lhe CML slnce LhaL ls now our opporLunlLy cosL.
$A5 '57EJ<=8 1DJK5= @<65 SV'1@WT
1he only rlsk we now care abouL ls LhaL whlch we cannoL dlverslfy away. l.e., sysLemaLlc rlsk.
We Lherefore !"#$ care abouL how much sysLemaLlc rlsk an lndlvldual asseL has.
lf lL ls rlskler ln Lhls way Lhan Lhe markeL porLfollo Lhen we need an expecLed reLurn equal Lo
whaL we could achleve on Lhe CML for LhaL &'() #)*)# of sysLemaLlc rlsk.
1he graph of expecLed reLurn as a funcLlon of Lhe level of sysLemaLlc rlsk for an lndlvldual
lnvesLmenL ls called Lhe securlLy markeL llne (SML").
8eLa () ls Lhe parameLer LhaL measures senslLlvlLy Lo sysLemaLlc rlsk. 1hls ls Lherefore whaL
we ploL on Lhe x-axls of Lhe SML graph. l.e., how (sysLemaLlcally) rlsky lL ls compared Lo Lhe
markeL porLfollo.
llnally Lhls glves us Lhe CAM formula for Lhe requlred expecLed reLurn of any asseL:
! !" ! !
!"
! !
!
!!! !" ! !
!"
!
!
!"
= Lhe rlsk-free raLe for Lhe Llme horlzon ln quesLlon.
! !" = Lhe expecLed reLurn of our markeL porLfollo.
!! !" ! !
!"
! = Lhe markeL rlsk premlum.
!
!
= Lhe beLa of +,'+ asseL.
8emember, every dlscounL raLe for a rlsky asseL ls made up of Lhe rlsk-free raLe -#.& a rlsk
premlum. 1he CAM formula Lells us whaL Lhls should be.
&>>E5> N<=A *#O1
Cne blg challenge lL faces ls Lrylng Lo work ouL whaL L(8m) should be ln Lhe flrsL place. 1here
ls no ob[ecLlve way Lo do Lhls! 1hls can lnfluence Lhe our CML and SMLs a loL.
CfLen Lhe resL (flndlng or correlaLlons of lndlvldual asseLs wlLh each oLher) can be done
wlLh hlsLorlcally regresslon analysls.
1hese correlaLlons or s may change over Llme. We need Lo Lry Lo anLlclpaLe whaL Lhey wlll
be /" +,) 0.+.1) (ex-anLe) slnce LhaL ls Lhe Llme we care abouL (when we are lnvesLlng).
*#O&$#@ '$/F*$F/+
CaplLal sLrucLure ls Lhe composlLlon of caplLal whlch ls flnanclng a flrm (debL or equlLy). A
company can choose Lo be elLher unlevered (flnanclng Lhrough equlLy only) or levered (a
mlx of equlLy and debL).
Accordlng Lo Modlgllanl and Mlller roposlLlon 1: 1he value of a flrm ls lndependenL of lLs
caplLal sLrucLure provlded Lhese flve assumpLlons hold Lrue,
1) no lnformaLlon asymmeLry - managers puL shareholders' lnLeresLs flrsL and do noL
use superlor lnformaLlon Lo Lhelr own beneflL.
2) no Laxes - l.e. corporaLe Laxes
3) no LransacLlons cosLs - lL doesn'L cosL more Lo use elLher debL or equlLy for flnanclng.
We assume Lhere ls no pecklng order.
4) no agency cosLs - leverage doesn'L cause managers Lo acL ln a way LhaL would
dlsadvanLage debL holders.
3) no bankrupLcy cosLs
1hls ls because for a glven level of promlsed cash flows and a glven level of assoclaLed rlsk
we can flnd lLs presenL value (Lhe value of Lhe flrm or buslness asseLs/pro[ecLs) and Lhls wlll
noL change dependlng on how we choose Lo 0/"'"2) our purchase of Lhls buslness.
1hls ls why we separaLe Lhe flnanclng declslon (caplLal sLrucLure) from Lhe lnvesLmenL
declslon (caplLal budgeLlng). 1he laLLer looks aL Lhe besL use of our funds and Lhe former
looks aL how besL Lo obLaln Lhe funds Lo achleve our goals.
ln Lhe real world, Lhe excepLlon Lo Lhe above ls by Laklng lnLo accounL Lax and Lhe cosLs of
bankrupLcy. 1hls 3!)& mean LhaL Lhe use of debL can affecL Lhe value of Lhe flrm.




$A5 U565:<=> D6L 79>=> 9: E><64 L5U=
G565:<=> *9>=>
$DX U565:<=Y Slnce lnLeresL pald (Lo our debL
holders) ls Lax-deducLlble, Lhls 3!)&
represenL a cash flow savlngs Lo Lhe holders
of Lhe flrm. All else equal, Lhls ls good and
wlll lncrease Lhe value of Lhe flrm and hence
we would wanL as much as debL as posslble.
/5LE75> D45678 79>=>Y uebL can be used Lo
llmlL managers from uslng funds
lnapproprlaLely as Lhey are forced Lo make
good lnvesLmenL cholces LhaL wlll produce
Lhe necessary cash flows Lo fulfll lnLeresL and
prlnclpal paymenLs as Lhey fall due.
GD6KJEQ=78 79>=>Y Slnce uslng debL flnance
lnvolves Lhe rlsk of bankrupLcy Lhen Lhls ls
bad. 1he more debL we use Lhe greaLer Lhls
rlsk. 8ankrupLcy lnvolves cosLs (legal
proceedlngs, bad prlces for asseLs we have
Lo sell desperaLely Lo meeL our debL
obllgaLlons and loss of employees/morale).
&67J5D>5> D45678 79>=>Y WlLh Lhe use of
leverage, managers mlghL engage ln
behavlour LhaL wlll reduce Lhe value of
lenders' clalms as all expecLed losses are
reflecLed ln Lhe lnLeresL raLes LhaL lenders
requlre.
$JD6>D7=<96 79>=>Y AlLhough debL-flnanclng
ls cheaper Lhan Lhe lssue of new equlLy, lL
sLlll cosLs more Lhan lnLernally generaLed
funds.

(<6D67<D; /<>K
llnanclal rlsk ls Lhe rlsk borne by equlLy holders when Lhey use debL flnance.
uslng debL flnance Lo whaLever exLenL boLh lncreases an equlLy holder's expecLed reLurns
and Lhelr rlsk (addlng flnanclal rlsk).
lL lncreases Lhelr expecLed reLurn because Lhey need less equlLy Lo conLrol Lhe buslness
asseLs (Lhe debL flnances Lhe resL) and can Lherefore earn a hlgher raLe of reLurn on Lhelr
equlLy lf Lhlngs go well.
1hey have more rlsk however because now lf proflLs are noL so good Lhen Lhls represenLs a
greaLer loss relaLlve Lo Lhelr equlLy -#.& Lhere ls Lhe facL LhaL Lhe flrm musL sLlll meeL lLs debL
obllgaLlons before equlLy holders recelve anyLhlng.
llnanclal rlsk and buslness rlsk are Lherefore Lwo separaLe forms of rlsk. 8uslness rlsk ls Lhe
lnherenL rlsklness ln Lhe buslness/asseL's cash flows arlslng from lLs sysLemaLlc rlsk ().
Cnce agaln, because Lhe caplLal budgeLlng and Lhe caplLal flnanclng declslon are Lwo
separaLe declslons Lhen Lhe approprlaLe dlscounL raLe for analyslng buslness
proposals/lnvesLmenLs does noL change because of Lhe use of debL flnance. 1haL ls a
separaLe rlsk for whlch we add a separaLe rlsk premlum.

*9>= 9: *DQ<=D;
CosL of caplLal ls Lhe Lerm used by flrms Lo descrlbe Lhe raLe of reLurn requlred on an
lnvesLmenL Lo compensaLe lnvesLors.
1he cosL of caplLal ls deLermlned by Lhe rlsklness of Lhe pro[ecL - only accounLs for
sysLemaLlc rlsk as lnvesLors wlll noL be compensaLed for bearlng rlsk LhaL can be ellmlnaLed
by Lhe process of dlverslflcaLlon.
1he company's overall cosL of caplLal ls a comblnaLlon of boLh cosL of debL and cosL of
equlLy. 1he LoLal markeL value of Lhe debL and equlLy of a company ls equal Lo Lhe presenL
value of Lhe cash flows LhaL debL holders and shareholders have Lhe rlghL Lo recelve.
CosL of debL !!
!
! ls Lhe same as yleld Lo maLurlLy (l.e. lnLeresL raLe of a bond), Lhus lL can
be calculaLed uslng Lhe followlng equaLlon, where ! ls Lhe cosL of debL.
!" !
!"
!
!! !
!
! ! !
!
! !
!"
! ! !
!


CosL of equlLy !!
!
! can be measured by elLher uslng CAM or Lhe dlvldend dlscounL model.
CAM: !
!
! !
!"
! !
!
!!! !" ! !
!"
!

ulvldend dlscounL model: !
!
!
!
!
!!!
!!!
!
!
!
!!!

! !
!
!
!
!
!
!
! !
1here are llmlLaLlons Lo Lhe dlvldend dlscounL model. 1he growLh raLe !!! ls a varlable LhaL
ls based on esLlmaLlons. 1hus, mlslnLerpreLaLlons of share prlces can yleld poor esLlmaLes -
should only rely on securlLy prlces lf you belleve LhaL flnanclal markeLs are ln some sense
efflclenL. lf Lhe markeL prlce ls lnaccuraLe, Lhls may resulL ln Lhe dlvldend dlscounL model
produclng a !
!
LhaL ls dlfferenL Lo Lhe !
!
glven by CAM.
!#**
Modlgllanl and Mlller roposlLlon 2 assumes LhaL Lhe cosL of caplLal wlll noL change lf Lhe
caplLal sLrucLure changes.
WACC ls Lhe welghLed average cosL of caplLal.
WACC = CosL of LqulLy * L / v + CosL of uebL * u / v.
CosL of LqulLy = Lhe requlred raLe of reLurn Lo equlLy holders.
CosL of uebL = Lhe requlred raLe of reLurn Lo debL holders.
L = Lhe markeL value of Lhe flrm's equlLy.
u = Lhe markeL value of Lhe flrm's debL.
v = L + u = Lhe LoLal value of Lhe flrm.
WACC ls Lhe dlscounL raLe for any proposed lnvesLmenL/pro[ecL made by Lhe flrm.
8ecause Lhe flrm musL have Lhe same value lrrespecLlve of how lL ls flnanced Lhen WACC
musL also sLay Lhe same ln order for Lhe flrm Lo have Lhls same value.
CosL of equlLy can however become greaLer Lhan WACC due Lo Lhe requlred addlLlonal rlsk
premlum for Laklng on 0/"'"2/'# 1/&4 lf Lhe flrm uses debL flnance.
H&-&H+)$ O.@&*Z
ulvldends lndlcaLe shareholder wealLh as Lhe value of a company ls deLermlned by Lhe
presenL value of Lhelr fuLure dlvldends. Shareholders recelve Lhelr reLurns every year elLher
ln Lhe form of caplLal galns (buy backs) or dlvldends. 1he way Lhelr reLurns are packaged ls
deLermlned by dlvldend pollcy.
ln a perfecL caplLal markeL where Lhere are no Laxes and LransacLlon cosLs, shareholders
would be lndlfferenL as Lo how Lhelr annual reLurn was packaged beLween dlvldends and
caplLal galns. 1hus dlvldend pollcy wouldn'L maLLer and ls lrrelevanL Lo shareholder's wealLh.
Powever, ln Lhe real markeL seLLlng boLh Laxes and LransacLlon cosLs exlsL hence dlvldend
and share repurchase declslons can affecL shareholder's wealLh.
1ransacLlon cosLs - shareholders have Lo bear Lhls lf Lhey wanL caplLal galns.
1axaLlon - lf personal marglnal Lax raLe ls less Lhan Lhe corporaLe Lax raLe Lhen dlvldends are
more deslrable as Lhe resulLlng Lax credlLs can offseL agalnsL Lhelr personal dlvldend Lax
llablllLles.
lurLhermore, Lhe lrrelevanL perspecLlve ls challenged by,
1) 8esldual perspecLlve
2) Slgnalllng perspecLlve
3) ulvldend - cllenLele perspecLlve
4) Agency perspecLlve
1hese vlews suggesL LhaL Lhere are oLher cosLs LhaL may cause a relaLlonshlp Lo exlsL
beLween dlvldend pollcy and shareholders' wealLh.

!"#$%&$'() +,)$"#$%&$'()
H<C<L56L> 1) ALLracLlng lnvesLors who prefer
dlvldends. 5/*/3)"362#/)"+)##)
2) Sendlng a poslLlve slgnal Lo Lhe
markeL concernlng Lhe company's
fuLure prospecLs. 7/8"'##/"8
3) Pelplng Lo provlde managers wlLh
lncenLlves Lo manage Lhe company
more efflclenLly. 98)"2$
4) Pelplng Lo manage Lhe company's
caplLal sLrucLure. 98)"2$
1) A shareholder wlll have Lo pay
Laxes on dlvldends lf personal
marglnal Lax raLe ls hlgher Lhan
Lhe corporaLe Lax raLe. :';'+/!"&
2!&+&
GE8[UD7K 1) lnvesLors have a cholce of selllng
Lhelr shares back Lo Lhe company aL a
Llme LhaL sulLs Lhem besL - when value
of shares are hlgh and Lax cosLs are
low.
2) ManagemenL have more free cash Lo
lnvesL raLher Lhan seLLlng a porLlon
aslde for dlvldend paymenLs.

1) lf Lhere ls lnformaLlon
asymmeLry, share repurchase can
glve way Lo managers who may
acL ln a way LhaL beneflLs Lhe
remalnlng shareholders aL Lhe
expense of Lhe selllng
shareholders.