Chapter One Introduction to Corporate Finance

Chapter One Introduction to Corporate Finance
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Organisation 1.1 Corporate Finance and the Financial Manager
1.2 The Statement of Financial Position and Corporate Financial Decisions 1.3 The Corporate Form of Business Organisation 1.4 The Goal of Financial Management 1.5 The Agency Problem and Control of the Corporation 1.6 Financial Markets and the Corporation 1.7 The Two-period Perfect Certainty Model 1.8 Outline of the Text 1.9 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the basic idea of corporate finance.
Understand the importance of cash flows in financial decision making. Discuss the three main decisions facing financial managers. Know the financial implications of the three forms of business organisation. Explain the goal of financial management and why it is superior to other possible goals. Explain the agency problem, and how it can be can be controlled and reduced. Outline the various types of financial markets. Discuss the two-period certainty model and Fisher’s Separation Theorem. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

What is Corporate Finance?
Corporate finance attempts to find the answers to the following questions: What investments should the business take on? THE INVESTMENT DECISION How can finance be obtained to pay for the required investments? THE FINANCE DECISION Should dividends be paid? If so, how much? THE DIVIDEND DECISION Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Financial Manager Financial managers try to answer some or all of these questions. The top financial manager within a firm is usually the General Manager–Finance. Corporate Treasurer or Financial Manageroversees cash management, credit management, capital expenditures and financial planning. Accountantoversees taxes, cost accounting, financial accounting and data processing. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Investment Decision
Capital budgeting is the planning and control of cash outflows in the expectation of deriving future cash inflows from investments in non-current assets. Involves evaluating the: size of future cash flows timing of future cash flows risk of future cash flows. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Size Accounting income does not mean cash flow.
For example, a sale is recorded at the time of sale and a cost is recorded when it is incurred, not when the cash is exchanged. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Timing A dollar today is worth more than a dollar at some future date. There is a trade-off between the size of an investment’s cash flow and when the cash flow is received. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Timing Which is the better project? Future Cash Flows Year
Project A Project B 1 $0 $20 000 2 $10 000 3 Total $30 000 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Risk The role of the financial manager is to deal with the uncertainty associated with investment decisions. Assessing the risk associated with the size and timing of expected future cash flows is critical to investment decisions. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Risk Which is the better project? Future Cash Flows
Pessimistic Expected Optimistic Project 1 $ $ $ Project 2 $ $ $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Capital Structure A firm’s capital structure is the specific mix of debt and equity used to finance the firm’s operations. Decisions need to be made on both the financing mix and how and where to raise the money. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Working Capital Management
How much cash and inventory should be kept on hand? Should credit terms be extended? If so, what are the conditions? How is short-term financing acquired? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dividend Decision Involves the decision of whether to pay a dividend to shareholders or maintain the funds within the firm for internal growth. Factors important to this decision include growth opportunities, taxation and shareholders’ preferences. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Corporate Forms of Business Organisation
The three different legal forms of business organisation are: sole proprietorship partnership company. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Sole Proprietorship The business is owned by one person.
The least regulated form of organisation. Owner keeps all the profits but assumes unlimited liability for the business’s debts. Life of the business is limited to the owner’s life span. Amount of equity raised is limited to owner’s personal wealth. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Partnership The business is formed by two or more owners.
All partners share in profits and losses of the business and have unlimited liability for debts. Easy and inexpensive form of organisation. Partnership dissolves if one partner sells out or dies. Amount of equity raised is limited to the combined personal wealth of the partners. Income is taxed as personal income to partners. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Company A business created as a distinct legal entity composed of one of more individuals or entities. Most complex and expensive form of organisation. Shareholders and management are usually separated. Ownership can be readily transferred. Both equity and debt finance are easier to raise. Life of a company is not limited. Owners (shareholders) have limited liability. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Possible Goals of Financial Management
Survival Avoid financial distress and bankruptcy Beat the competition Maximise sales or market share Minimise costs Maximise profits Maintain steady earnings growth Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Problems with these Goals
Each of these goals presents problems. These goals are either associated with increasing profitability or reducing risk. They are not consistent with the long-term interests of shareholders. It is necessary to find a goal that can encompass both profitability and risk. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Firm’s Objective The goal of financial management is to maximise shareholders’ wealth. Shareholders’ wealth can be measured as the current value per share of existing shares. This goal overcomes the problems encountered with the goals outlined above. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Agency Relationships The agency relationship is the relationship between the shareholders (owners) and the management of a firm. The agency problem is the possibility of conflict of interests between these two parties. Agency costs refer to the direct and indirect costs arising from this conflict of interest. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Do Managers Act in Shareholders’ Interests?
The answer to this will depend on two factors: how closely management goals are aligned with shareholder goals the ease with which management can be replaced if it does not act in shareholders’ best interests. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Alignment of Goals The conflict of interests is limited due to:
management compensation schemes monitoring of management the threat of takeover other stakeholders. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flows between the Firm and the Financial Markets
Total Value of the Firm to Investors in the Financial Markets Total Value of Firm’s Assets A. Firm issues securities B. Firm invests in assets Current Assets Fixed Assets Financial Markets Short-term debt Long-term debt Equity shares E. Retained cash flows F. Dividends and debt payments C. Cash flow from firm’s assets D. Government Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financial Markets Financial markets bring together the buyers and sellers of debt and equity securities. Money markets involve the trading of short-term debt securities. Capital markets involve the trading of long-term debt securities. Primary markets involve the original sale of securities. Secondary markets involve the continual buying and selling of issued securities. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Structure of Financial Markets

Two-period Perfect Certainty Model
Explains the behaviour of firms and individuals. Relies on three assumptions: perfect certainty perfect capital markets rational investors. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Two-period Perfect Certainty Model
The certainty model uses two periods—now (period 1) and the future (period 2). Individuals make consumption choices based on their tastes and preferences and the investment opportunities available to them. Utility curves represent indifference between period 1 (consume now) and period 2 (invest now, consume later) consumption. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Utility Curves Period 2 Utility curves q p Period 1

Representation of Opportunities
Opportunities facing firms in a two-period world include: investment/production payment of dividends. The production possibility frontier represents attainable combinations of period 1 (pay dividend now) and period 2 (invest now, pay dividend later) dollars from a given endowment of resources. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Production Possibility Frontier
Period 2 210 Production possibility frontier 160 100 150 Period 1 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Utility Maximisation Firms should invest funds until they reach a point on the production frontier that is just tangential to the market line. This then places the owner on the highest possible utility curve given the resources available. At this point, the owner’s utility is maximised. However, a problem exists if there is more than one owner. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution for Multiple Owners
Introduce a capital market—resources can be transferred between the present and the future. Add the market line. This produces an optimal investment policy where production possibility frontier is tangential to the market line. Consumption decisions can be made using the capital market. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Optimal Investment Policy
Period 2 Market line Optimal policy Period 1 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fisher’s Separation Theorem
In a perfect capital market, it is possible to separate the firm’s investment decisions from the owners’ consumption decisions. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Investment Decision
The point of wealth and utility maximisation for all shareholders can be reached through one of two rules: Net present value rule: invest so as to maximise the net present value of the investment. Internal rate of return rule: Invest up to the point at which the marginal return on the investment is equal to the expected rate of return on equivalent investments in the capital market. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Implications of Fisher’s Analysis
It is only the investment decision that affects firm value. Firm value is not affected by how investments are financed or how the distribution (dividends) are made to the owners. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Two Financial Statements, Taxes and Cash Flow

Chapter Organisation 2.1 The Statement of Financial Position
2.2 The Statement of Financial Performance 2.3 Taxes 2.4 Cash Flow 2.5 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the difference between book value (from the Statement of Financial Position) and market value. Understand the difference between net profit (from the Statement of Financial Performance) and cash flow. Explain the differences between the average tax rate, the marginal tax rate and the flat rate. Explain the calculation of cash flow from assets, and cash flow to debtholders and shareholders. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Statement of Financial Position
Shows a firm’s accounting value on a particular date. Equation: Assets = Liabilities + Shareholders’ Equity Assets are listed in order of liquidity. Net working capital = Current Assets – Current Liabilities Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Statement of Financial Position
Net Working Capital Current Liabilities Current Assets Non-current Liabilities Fixed Assets 1.Tangible fixed assets 2.Intangible fixed assets Shareholders’ Equity Total Value of Liabilities and Shareholders’ Equity Total Value of Assets Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Liquidity The speed and ease with which an asset can be converted to cash without significant loss of value. Current assets are liquid (e.g. debtors). The more liquid a business is, the less likely it is to experience financial distress, but liquid assets are less profitable to hold. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Debt versus Equity Creditors have first claim on a firm’s cash flow; equity holders have a residual claim. Financial leverage is the use of debt in a firm’s capital structure. Financial leverage increases the potential reward to shareholders, but also increases the potential for financial distress and business failure. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Market Value versus Book Value
Generally Accepted Accounting Principles (GAAP) require audited financial statements to show assets at historical cost or book value. Revaluations of assets to fair value are permitted. The value of a firm relates to market value, or the price that could be obtained in the current market place. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Market Value versus Book Value
ABC Company has fixed assets with a book value of $1700 but they have been revalued to have a market value of $ Net working capital has a book value of $1000, but if all current accounts were liquidated, the company would collect $ ABC Company has $1500 in long-term debt—both book value and market value. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Market Value versus Book Value
ABC Company Book Market Assets Liabilities Net working capital $1000 $1400 Long-term debt $1500 Fixed assets $1700 $2000 Equity $1200 $1900 Total $2700 $3400 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Statement of Financial Performance
Measures a firm’s performance over a period of time. Equation: Revenues – Expenses = Profit The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Statement of Financial Position. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Statement of Financial Performance
Sales $2000 Costs Depreciation EBIT Interest Taxable Income Tax Net Profit $200 Dividends Addition to R/E $120 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Statement of Financial Position
Beg End Beg End Cash $100 $150 A/P $100 $150 A/R N/P Inv C/L C/A $600 $700 NCL $400 $420 NFA Cap R/E $300 $430 Total $1000 $1200 Total $1000 $1200 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Recording of Financial Statement Entries
The realisation principle is to recognise revenue at the time of sale. Costs are recorded according to the matching principle, that is, revenues are identified and costs associated with these revenues are matched and recorded. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Differences The figures on the Statement of Financial Performance may differ from actual cash inflows and outflows during a period due to: Revenues and costs being recorded when they are realised, not when they are received or paid. The existence of non-cash items such as depreciation. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Corporate and Personal Tax Rates

Tax Rates The average tax rate is the total tax bill divided by taxable income, that is, the percentage of income that goes in taxes. The marginal tax rate is the extra tax paid if one more dollar is earned. A flat rate is where there is only one tax rate that is the same for all income levels. An example is the tax rate that applies to companies in Australia. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Tax Rates An individual has a taxable income of $28 500.
Total tax liability is $4930 (based on the current tax scales). The average tax rate is per cent. The marginal tax rate is 30 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow from Assets The total cash flow from assets consists of:
operating cash flow—the cash flow that results from day-to-day activities of producing and selling; less capital spending—the net spending on non-current assets; less additions to net working capital (NWC)—the amount spent on net working capital. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow from Assets Cash flow from assets = cash flow to debtholders + cash flow to shareholders The cash flow to debtholders includes any interest paid less the net new borrowing. The cash flow to shareholders includes dividends paid out by a firm less net new equity raised. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Summary Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes Net capital spending = Ending net fixed assets – Beginning net fixed assets + Depreciation Change in NWC = Ending NWC – Beginning NWC Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Statement of Financial Position ('000s)
Assets (‘000s) 2003 2004 Current assets Cash Accounts receivable Inventory Total Fixed assets Net plant and equipment TOTAL ASSETS $ 260 320 $ 625 985 $1 610 $ 310 385 $ 745 1 100 $1 845 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Liabilities and equity (‘000s) 2003 2004 Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings TOTAL LIABILITIES AND EQUITY $ 110 $ 320 $ 205 290 795 $1 085 $1 610 $ 175 $ 435 $ 225 895 $1 185 $1 845 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Statement of Financial Performance ('000s)
Net sales $710.00 Cost of goods sold Depreciation DEBIT $200.00 Interest Taxable income Tax Net profit $126.55 Dividends Addition to retained earnings $100.00 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow From Assets Operating cash flow: EBIT $ 200.00
+ Depreciation – Taxes – $176.55 Change in net working capital: Ending net working capital $ – Beginning net working capital $ Net capital spending: Ending net fixed assets $ 1,100.00 – Beginning net fixed assets – + Depreciation $145.00 Cash flow from assets: $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flows to Debtholders and Shareholders
Cash flow to debtholders: Interest paid $ – Net new borrowing – $ 0.00 Cash flow to shareholders: Dividends paid $ – Net new equity raised $26.55 Cash flow to debtholders and shareholders $26.55 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Working with Financial Statements
Chapter Three Working with Financial Statements Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Organisation 3.1 Cash Flow and Financial Statements: A Closer Look 3.2 Financial Statements of Publicly Listed Firms 3.3 The Du Pont Identity 3.4 Using Financial Statement Information 3.5 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Identify the ways that firms obtain and use cash as reported in the Statement of Cash Flows. Calculate and interpret key financial ratios. Discuss the Du Pont identity as a method of financial analysis. Understand the use of financial information for comparative purposes. Outline the problems associated with using financial ratios. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Cash is generated by selling a product or service, asset or security. Cash is spent by paying for materials and labour to produce a product or service and by purchasing assets. Recall: Cash flow from assets = Cash flow to debtholders + Cash flow to shareholders Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flow Sources of cash are those activities that bring in cash.
Uses of cash are those activities that involve spending cash. The firm’s statement of cash flows is the firm’s financial statement that summarises its sources and uses of cash over a specified period. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Assets (‘000s) 2003 2004 Current assets Cash Accounts receivable Inventory Total Fixed assets Net plant and equipment TOTAL ASSETS $ 260 320 $ 625 985 $1 610 $ 310 385 $ 745 1 100 $1 845 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Liabilities and equity (‘000s) 2003 2004 Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings TOTAL LIABILITIES AND EQUITY $ 110 $ 320 $ 205 290 795 $1 085 $1 610 $ 175 $ 435 $ 225 895 $1 185 $1 845 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Statement of Financial Performance ('000s)
Net sales $710.00 Cost of goods sold Depreciation EBIT $200.00 Interest Taxable income Tax Net profit $126.55 Dividends Addition to retained earnings $100.00 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Statement of Cash Flows
A statement that summarises the sources and uses of cash. Changes are divided into three main categories: Operating activities—includes net profit and changes in most current accounts Investment activities—includes changes in fixed assets Financing activities—includes changes in notes payable, long-term debt and equity accounts as well as dividends. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Operating activities + Net profit + Depreciation + Any decrease in current assets (except cash) + Increase in accounts payable – Any increase in current assets (except cash) – Decrease in accounts payable Investment activities + Ending fixed assets – Beginning fixed assets Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financing activities – Decrease in notes payable + Increase in notes payable – Decrease in long-term debt + Increase in long-term debt + Increase in ordinary shares – Dividends paid Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Operating activities + Net profit + $ + Depreciation + Increase in payables – Increase in receivables – – Increase in inventory – $ Investment activities + Ending fixed assets +$ – Beginning fixed assets – + Depreciation ( $ ) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financing activities + Increase in notes payable + $ 65.00 + Increase in long-term debt – Dividends – $ 58.45 Putting it all together, the net addition to cash for the period is: $ – = $5.00 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

‘Players’ in Accounting Standards
Accountants Government Regulators Other users Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Ratio Analysis Financial ratios are relationships determined from a firm’s financial information. Used to compare and investigate relationships between different pieces of financial information, either over time or between companies. Ratios eliminate the size problem. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Categories of Financial Ratios
Liquidity—measures the firm’s short-term solvency. Capital structure—measures the firm’s ability to meet long-run obligations (financial leverage). Asset management (turnover)—measures the efficiency of asset usage to generate sales. Profitability—measures the firm’s ability to control expenses. Market value—per-share ratios. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Liquidity Ratios Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Capital Structure Ratios

Turnover Ratios Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Turnover Ratios (continued)

Profitability Ratios Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Market Value Ratios Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Du Pont Identity Breaks ROE into three parts: operating efficiency
asset use efficiency financial leverage Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Uses for Financial Statement Information
Internal uses: performance evaluation planning for the future External uses: evaluation by outside parties evaluation of main competitors identifying potential takeover targets Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Benchmarks for Comparison
Ratios are most useful when compared to a benchmark. Time-trend analysis—examine how a particular ratio(s) has performed historically. Peer group analysis—using similar firms (competitors) for comparison of results. Global Industry Classification Standard (GICS) used by ASX is a useful way to find a peer company. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Problems with Ratio Analysis
No underlying theory to identify correct ratios to use or appropriate benchmarks. Benchmarking is difficult for diversified firms. Firms may use different accounting procedures. Firms may have different recording periods. One-off events can severely affect financial performance. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Long-term Financial Planning and Corporate Growth
Chapter Four Long-term Financial Planning and Corporate Growth Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Organisation 4.1 What is Financial Planning?
4.2 Financial Planning Models: A First Look 4.3 The Percentage of Sales Approach 4.4 External Financing and Growth 4.5 Some Caveats of Financial Planning Models 4.6 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand what financial planning is and what it can accomplish. Outline the elements of a financial plan. Discuss and be able to apply the percentage of sales approach. Understand how capital structure policy and dividend policy affect a firm’s ability to grow. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

What is Financial Planning?
Formulates the way financial goals are to be achieved. Requires that decisions be made about an uncertain future. Recall that the goal of the firm is to maximise the market value of the owner’s equity—growth will result from this goal being achieved. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dimensions of Financial Planning
The planning horizon is the long-range period that the process focuses on (usually two to five years). Aggregation is the process by which the smaller investment proposals of each of a firm’s operational units are added up and treated as one big project. Financial planning usually requires three alternative plans: a worst case, a normal case and a best case. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Accomplishments of Planning
Interactions—linkages between investment proposals and financing choices. Options—firm can develop, analyse and compare different scenarios. Avoiding surprises—development of contingency plans. Feasibility and internal consistency—develops a structure for reconciling different objectives. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Elements of a Financial Plan
An externally supplied sales forecast (either an explicit sales figure or growth rate in sales). Projected financial statements (pro-formas). Projected capital spending. Necessary financing arrangements. Amount of new financing required (‘plug’ figure). Assumptions about the economic environment. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—A Simple Financial Planning Model
Recent Financial Statements Financial performance Financial position Sales $100 Assets $50 Debt $20 Costs Equity 30 Net Income $ 10 Total $50 Total $50 Assume that: 1. Sales are projected to rise by 25 per cent 2. The debt/equity ratio stays at 2/3 3. Costs and assets grow at the same rate as sales Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—A Simple Financial Planning Model
Pro-Forma Financial Statements Financial performance Financial position Sales $ Assets $ Debt $25 Costs Equity Net $ Total $ Total $ 62.5 What is the plug? Notice that projected net income is $12.50, but equity only increases by $7.50. The difference, $5.00 paid out in cash dividends, is the plug. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Percentage of Sales Approach
A financial planning method in which accounts are varied depending on a firm’s predicted sales level. Dividend payout ratio is the amount of cash paid out to shareholders. Retention ratio is the amount of cash retained within the firm and not paid out as a dividend. Capital intensity ratio is the amount of assets needed to generate $1 in sales. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Financial Performance Statement
Sales $1000 Costs Taxable Income Tax (30%) Net profit $ 140 Retained earnings $112 Dividends $28 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Pro-Forma Financial Performance Statement
Sales (projected) $1 250 Costs (80% of sales) Taxable Income Tax (30%) Net profit $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Steps Use the original financial position statement to create a pro-forma; some items will vary directly with sales. Calculate the projected addition to retained earnings and the projected dividends paid to shareholders. Calculate the capital intensity ratio. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Financial Position Statement
Assets Current assets ($) (% of sales) Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment Total assets Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Financial Position Statement
Liabilities and owners’ equity Current liabilities ($) (% of sales) Accounts payable Notes payable n/a Total n/a Long-term debt n/a Shareholders’ equity Issued capital n/a Retained earnings n/a Total n/a Total liabilities & s’holders’ equity n/a Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Partial Pro-Forma Financial Position Statement
Assets Current assets ($) Change Cash $ 40 Accounts receivable Inventory Total $300 Non-current assets Net plant and equipment $450 Total assets $750 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Partial Pro-Forma Financial Position Statement
Liabilities and owners’ equity Current liabilities ($) Change Accounts payable $ 75 Notes payable Total $ 75 Long-term debt Shareholders’ equity Issued capital Retained earnings $140 Total $140 Total liabilities & s’holders’ equity $215 External financing needed $535 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Results of Model
The good news is that sales are projected to increase by 25 per cent. The bad news is that $535 of new financing is required. This can be achieved via short-term borrowing, long-term borrowing and new equity issues. The planning process points out problems and potential conflicts. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Results of Model (continued)
Assume that $225 is borrowed via notes payable and $310 is borrowed via long-term debt. ‘Plug’ figure now distributed and recorded within the financial position statement. A new (complete) pro-forma financial position statement can be derived. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Pro-Forma Financial Position Statement
Assets Current assets ($) Change Cash $ 40 Accounts receivable Inventory Total $300 Non-current assets Net plant and equipment $450 Total assets $750 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Pro-Forma Financial Position Statement
Liabilities and owners’ equity Current liabilities ($) Change Accounts payable $ 75 Notes payable $225 Total $300 Long-term debt $310 Shareholders’ equity Issued capital Retained earnings $140 Total $140 Total liabilities & s’holders’ equity $750 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

External Financing and Growth
The higher the rate of growth in sales/assets, the greater the external financing needed (EFN). Need to establish a relationship between EFN and growth (g). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Statement of Financial Performance
Sales $ 500 Costs Taxable Income $ 100 Tax (30%) Net profit $ Retained earnings $ 25 Dividends $ 45 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Statement of Financial Position

Ratios Calculated p (profit margin) = 14% R (retention ratio) = 36%
ROA (return on assets) = 7% ROE (return on equity) = % D/E (debt/equity ratio) = 0.818 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Growth Next year’s sales forecasted to be $600.
Percentage increase in sales: Percentage increase in assets also 20 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Increase in Assets What level of asset investment is needed to support a given level of sales growth? For simplicity, assume that the firm is at full capacity. The indicated increase in assets required equals: A × g where A = ending total assets from the previous period How will the increase in assets be financed? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Internal Financing Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected? This addition to retained earnings represents the level of internal financing the firm is expected to generate over the coming period. The expected addition to retained earnings is: where: S = previous period’s sales g = projected increase in sales p = profit margin R = retention ratio Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

External Financing Needed
If the required increase in assets exceeds the internal funding available (that is, the increase in retained earnings), then the difference is the external financing needed (EFN). EFN = Increase in Total Assets – Addition to Retained Earnings = A(g) – p(S)R × (1 + g) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—External Financing Needed
Increase in total assets = $1000 × 20% = $200 Addition to retained earnings = 0.14($500)(36%) × 1.20 = $30 The firm needs an additional $200 in new financing. $30 can be raised internally. The remainder must be raised externally (external financing needed). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—External Financing Needed (continued)

Relationship To highlight the relationship between EFN and g:
Setting EFN to zero, g can be calculated to be 2.56 per cent. This means that the firm can grow at 2.56 per cent with no external financing (debt or equity). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financial Policy and Growth
The example so far sees equity increase (via retained earnings), debt remain constant and D/E decline. If D/E declines, the firm has excess debt capacity. If the firm borrows up to its debt capacity, what growth can be achieved? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Sustainable Growth Rate (SGR)
The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Sustainable Growth Rate
Continuing from the previous example: The firm can increase sales and assets at a rate of 4.82 per cent per year without selling any additional equity and without changing its debt ratio or payout ratio. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Sustainable Growth Rate (SGR)
Growth rate depends on four factors: profitability (profit margin) dividend policy (dividend payout) financial policy (D/E ratio) asset utilisation (total asset turnover) Do you see any relationship between the SGR and the Du Pont identity? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Summary of Growth Rates
Internal growth rate This growth rate is the maximum growth rate that can be achieved with no external debt or equity financing. Sustainable growth rate The SGR is the maximum growth rate that can be achieved with no external equity financing while borrowing to maintain a constant D/E ratio. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Important Questions It is important to remember that we are working with accounting numbers and we should ask ourselves some important questions as we go through the planning process. How does our plan affect the timing and risk of our cash flows? Does the plan point out inconsistencies in our goals? If we follow this plan, will we maximise owners’ wealth? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Five First Principles of Valuation: The Time Value of Money

Chapter Organisation 5.1 Future Value and Compounding
5.2 Present Value and Discounting 5.3 More on Present and Future Values 5.4 Present and Future Values of Multiple Cash Flows 5.5 Valuing Equal Cash Flows: Annuities and Perpetuities 5.6 Comparing Rates: The Effect of Compounding Periods 5.7 Loan Types and Loan Amortisation 5.8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Distinguish between simple and compound interest.
Calculate the present value and future value of a single amount for both one period and multiple periods. Calculate the present value and future value of multiple cash flows. Calculate the present value and future value of annuities. Compare nominal interest rates (NIR) and effective annual interest rates (EAR). Distinguish between the different types of loans and calculate the present value of each type of loan. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Time Value Terminology
Future value (FV) is the amount an investment is worth after one or more periods. Present value (PV) is the current value of one or more future cash flows from an investment. 1 2 3 4 PV FV Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Time Value Terminology
The number of time periods between the present value and the future value is represented by ‘t’. The rate of interest for discounting or compounding is called ‘r’. All time value questions involve four values: PV, FV, r and t. Given three of them, it is always possible to calculate the fourth. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interest Rate Terminology
Simple interest refers to interest earned only on the original capital investment amount. Compound interest refers to interest earned on both the initial capital investment and on the interest reinvested from prior periods. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Future Value of a Lump Sum
You invest $100 in a savings account that earns 10 per cent interest per annum (compounded) for three years. After one year: $100  ( ) = $110 After two years: $110  ( ) = $121 After three years: $121  ( ) = $133.10 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The accumulated value of this investment at the end of three years can be split into two components: original principal $100 interest earned $33.10 Using simple interest, the total interest earned would only have been $30. The other $3.10 is from compounding. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

In general, the future value, FVt, of $1 invested today at r per cent for t periods is: The expression (1 + r)t is the future value interest factor (FVIF). Refer to Table A.1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Future Value of a Lump Sum
What will $1000 amount to in five years time if interest is 12 per cent per annum, compounded annually? From the example, now assume interest is 12 per cent per annum, compounded monthly. Always remember that t is the number of compounding periods, not the number of years. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interpretation The difference in values is due to the larger number of periods in which interest can compound. Future values also depend critically on the assumed interest rate—the higher the interest rate, the greater the future value. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Future Values at Different Interest Rates

Future Value of $1 for Different Periods and Rates

Present Value of a Lump Sum
You need $1000 in three years time. If you can earn 10 per cent per annum, how much do you need to invest now? Discount one year: $1000 ( ) –1 = $909.09 Discount two years: $ ( ) –1 = $826.45 Discount three years: $ ( ) –1 = $751.32 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interpretation In general, the present value of $1 received in t periods of time, earning r per cent interest is: The expression (1 + r)–t is the present value interest factor (PVIF). Refer to Table A.2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Present Value of a Lump Sum
Your rich grandmother promises to give you $ in 10 years time. If interest rates are 12 per cent per annum, how much is that gift worth today? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Present Values at Different Interest Rates

Present Value of $1 for Different Periods and Rates
1.00 .90 .80 .70 .60 .50 .40 .30 .20 .10 r = 0% r = 5% r = 10% r = 15% r = 20% Time (years) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solving for the Discount Rate
You currently have $100 available for investment for a 21-year period. At what interest rate must you invest this amount in order for it to be worth $500 at maturity? Given any three factors in the present value or future value equation, the fourth factor can be solved. r can be solved in one of three ways: Use a financial calculator Take the nth root of both sides of the equation Use the future value tables to find a corresponding value. In this example, you need to find the r for which the FVIF after 21 years is 5 (500/100). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Rule of 72 The ‘Rule of 72’ is a handy rule of thumb that states:
If you earn r per cent per year, your money will double in about 72/r per cent years. For example, if you invest at 6 per cent, your money will double in about 12 years. This rule is only an approximate rule. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Future Value of Multiple Cash Flows
You deposit $1000 now, $1500 in one year, $2000 in two years and $2500 in three years in an account paying 10 per cent interest per annum. How much do you have in the account at the end of the third year? You can solve by either: compounding the accumulated balance forward one year at a time calculating the future value of each cash flow first and then totalling them. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solutions Solution 1 Solution 2
End of year 1: ($1000  1.10) + $1500 = $2600 End of year 2: ($2600  1.10) + $2000 = $4860 End of year 3: ($4860  1.10) + $2500 = $ 846 Solution 2 $1000  (1.10)3 = $1331 $1500  (1.10)2 = $1815 $2000  (1.10)1 = $2200 $2500  1.00 = $2500 Total = $7846 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solutions Future value calculated by compounding forward one period at a time 1 2 3 4 5 Time (years) $0 0 $0 $ $2000 $ $4200 $ $6620 $ $9282 $ $ x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 Future value calculated by compounding each cash flow separately 1 2 3 4 5 Time (years) $2000 $2000 $2000 $2000 $ $ x 1.1 x 1.12 x 1.13 x 1.14 Total future value Figures 5.6/5.7 — Calculation of FV for Multiple Cash Flow Stream Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Present Value of Multiple Cash Flows
You will deposit $1500 in one year’s time, $2000 in two years time and $2500 in three years time in an account paying 10 per cent interest per annum. What is the present value of these cash flows? You can solve by either: discounting back one year at a time calculating the present value of each cash flow first and then totalling them. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solutions Solution 1 Solution 2 $2500  (1.10) –3 = $1878
End of year 2: ($2500  1.10–1) + $2000 = $4273 End of year 1: ($4273  1.10–1) + $1500 = $5385 Present value: ($5385  1.10–1) = $4895 Solution 2 $2500  (1.10) –3 = $1878 $2000  (1.10) –2 = $1653 $1500  (1.10) –1 = $1364 Total = $4895 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solutions Present value calculated by discounting each cash flow separately 1 2 3 4 5 $1000 $1000 $1000 $1000 $1000 Time (years) x 1/1.06 $ $ x 1/1.062 x 1/1.063 x 1/1.064 x 1/1.065 Total present value r = 6% Present value calculated by discounting back one period at a time 1 2 3 4 5 $ $ $ $ $ $ $ $ $ $ $ $ Time (years) Total present value = $ r = 6% Figures 5.8/5.9 — Calculation of PV for Multiple Cash Flow Stream Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Annuities An ordinary annuity is a series of equal cash flows that occur at the end of each period for some fixed number of periods. Examples include consumer loans and home mortgages. A perpetuity is an annuity in which the cash flows continue forever. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Present Value of an Annuity
C = equal cash flow The discounting term is called the present value interest factor for annuities (PVIFA). Refer to Table A.3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example 1 You will receive $500 at the end of each of the next five years. The current interest rate is 9 per cent per annum. What is the present value of this series of cash flows? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example 2 You borrow $7500 to buy a car and agree to repay the loan by way of equal monthly repayments over five years. The current interest rate is 12 per cent per annum, compounded monthly. What is the amount of each monthly repayment? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Future Value of an Annuity
The compounding term is called the future value interest factor for annuities (FVIFA). Refer to Table A.4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Future Value of an Annuity
What is the future value of $200 deposited at the end of every year for 10 years if the interest rate is 6 per cent per annum? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Perpetuities The future value of a perpetuity cannot be calculated as the cash flows are infinite. The present value of a perpetuity is calculated as follows: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Comparing Rates The nominal interest rate (NIR) is the interest rate expressed in terms of the interest payment made each period. The effective annual interest rate (EAR) is the interest rate expressed as if it was compounded once per year. When interest is compounded more frequently than annually, the EAR will be greater than the NIR. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Calculation of EAR m = number of times the interest is compounded

Comparing EARS Consider the following interest rates quoted by three banks: Bank A: 15%, compounded daily Bank B: 15.5%, compounded quarterly Bank C: 16%, compounded annually Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Comparing EARS Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Comparing EARS Which is the best rate? For a saver, Bank B offers the best (highest) interest rate. For a borrower, Bank C offers the best (lowest) interest rate. The highest NIR is not necessarily the best. Compounding during the year can lead to a significant difference between the NIR and the EAR. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Loans A pure discount loan is a loan where the borrower receives money today and repays a single lump sum in the future. An interest-only loan requires the borrower to only pay interest each period and to repay the entire principal at some point in the future. An amortised loan requires the borrower to repay parts of both the principal and interest over time. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Amortisation of a Loan Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Six Valuing Shares and Bonds

Chapter Organisation 6.1 Bonds and Bond Valuation
6.2 Ordinary Share Valuation 6.3 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Outline the features of bonds.
Calculate the value (price) of a bond assuming annual and semi-annual coupons. Understand the implications of interest rate risk for the value of a bond. Calculate the value of an ordinary share under different dividend growth scenarios. Explain the components of required return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Debt Securities Debt securities are issued when an organisation wishes to borrow money from the public on a long-term basis. Bonds are issued by the government. Debentures are secured and issued by a corporation. Notes are unsecured debt securities issued by a corporation. More recently, these are all known as bonds. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bond Features Coupon payments are the stated interest payments. Payment is constant and payable every year or half-year. Face value (par value) is the principal amount repayable at the end of the term. Coupon rate is the annual coupon divided by the face value. Maturity is the specified date at which the principal amount is payable. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bond Yields Yield to maturity is the market interest rate that equates a bond’s present value of interest payments and principal repayment with its price. There is an inverse relationship between market interest rates and bond price. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bond Price Sensitivity to Interest Rates (YTM)
$1 800 Coupon = $ years to maturity $1000 face value $1 600 Key Insight: Bond prices and YTMs are inversely related. $1 400 $1 200 $1 000 $ 800 $ 600 Yield to maturity, YTM 4% 6% 8% 10% 12% 14% 16% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bond Value Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example 1—Bond Value A bond with a face value of $1000 and a coupon rate of 6 per cent has 10 years to maturity. What is the market price of this bond if the market interest rate is 10 per cent? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example 2—Bond Value Assume now that the bond’s coupons are paid half-yearly. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interest Rate Risk Interest rate risk is the risk that arises for bond holders from changes in interest rates. All other things being equal, the longer the time to maturity, the greater the interest rate risk. All other things being equal, the lower the coupon rate, the greater the interest rate risk. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interest Rate Risk and Time to Maturity
Interest rate year years 5% $ $ Time to Maturity Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Computing Yield to Maturity
Yield to maturity (YTM) is the rate implied by the current bond price. Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity. If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

YTM with Annual Coupons
Consider a bond with a 10 per cent annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $ Will the yield be more or less than 10 per cent? N = 15; PV = 928.09; FV = 1000; PMT = 100 CPT I/Y = 11% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Ordinary Share Valuation
Share valuation is more difficult than debenture valuation for a number of reasons: uncertainty of promised cash flows shares have no maturity observing the market rate of return is not easy. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Ordinary Share Valuation
The market value of a share is the present value of all expected net cash flows to be received from the share, discounted at a rate of return that reflects the riskiness of those cash flows. The expected net cash flows to be received from a share are all future dividends. Dividend growth is an important aspect of share valuation. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Zero Growth Dividend Shares have a constant dividend into perpetuity, with no growth in dividends. The value of a share is then the same as the value of an ordinary perpetuity. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Constant Growth Dividend
Dividends grow at a constant rate each time period. Called the constant dividend growth model. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Constant Growth Dividend
Company XYZ has just paid a dividend of 15 cents per share, which is expected to grow at 5 per cent per annum. What price should you pay for the share if the required rate of return on the investment is 10 per cent? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Non-constant Growth Dividend
The growth rate cannot exceed the required rate of return indefinitely but can do so for a number of years. Allows for ‘super normal’ growth rates over some finite length of time. The dividends have to grow at a constant rate at some point in the future. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Non-constant Growth Dividend
A company has just paid a dividend of 15 cents per share and that dividend is expected to grow at a rate of 20 per cent per annum for the next three years, and at a rate of 5 per cent per annum forever after that. Assuming a required rate of return of 10 per cent, calculate the current market price of the share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Non-constant Growth Dividend

Solution—Non-constant Growth Dividend (continued)

Share Price Sensitivity to Dividend Growth, g
50 45 D1 = $1 Required return, R, = 12% 40 35 30 25 20 15 10 5 Dividend growth rate, g 2% 4% 6% 8% 10% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Share Price Sensitivity to Required Return, r
100 90 80 D1 = $1 Dividend growth rate, g, = 5% 70 60 50 40 30 20 10 Required return, R 6% 8% 10% 12% 14% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Components of Required Return

Chapter Seven Net Present Value and Other Investment Criteria

Chapter Organisation 7.1 Net Present Value 7.2 The Payback Rule
7.3 The Discounted Payback Rule 7.4 The Accounting Rate of Return 7.5 The Internal Rate of Return 7.6 The Present Value Index 7.7 The Practice of Capital Budgeting 7.8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Discuss the various investment evaluation techniques, including their advantages and disadvantages. Apply these techniques to the evaluation of projects. Interpret the results of the application of these techniques in accordance with their respective decision rules. Understand the importance of net present value. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Net Present Value (NPV)
Net present value is the difference between an investment’s market value (in today’s dollars) and its cost (also in today’s dollars). Net present value is a measure of how much value is created by undertaking an investment. Estimation of the future cash flows and the discount rate are important in the calculation of the NPV. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Net Present Value Steps in calculating NPV:
The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

NPV Illustrated 1 2 Initial outlay Revenues $1000 Revenues $2000
1 2 Initial outlay Revenues $1000 Revenues $2000 ($1100) Expenses 500 Expenses 1000 Cash flow $500 Cash flow $1000 – $ 1 $500 x 1.10 1 $1000 x 1.10 2 +$ 181.00 NPV Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

NPV An investment should be accepted if the NPV is positive and rejected if it is negative. NPV is a direct measure of how well the investment meets the goal of financial management—to increase owners’ wealth. A positive NPV means that the investment is expected to add value to the firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Payback Period The amount of time required for an investment to generate cash flows to recover its initial cost. Estimate the cash flows. Accumulate the future cash flows until they equal the initial investment. The length of time for this to happen is the payback period. An investment is acceptable if its calculated payback is less than some prescribed number of years. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Payback Period Illustrated
Initial investment = –$1000 Year Cash flow 1 $200 2 400 3 600 Accumulated Year Cash flow 1 $200 2 600 3 1200 Payback period = 2 2/3 years Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Advantages of Payback Period
Easy to understand. Adjusts for uncertainty of later cash flows. Biased towards liquidity. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Disadvantages of Payback Period
Time value of money and risk ignored. Arbitrary determination of acceptable payback period. Ignores cash flows beyond the cut-off date. Biased against long-term and new projects. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Discounted Payback Period
The length of time required for an investment’s discounted cash flows to equal its initial cost. Takes into account the time value of money. More difficult to calculate. An investment is acceptable if its discounted payback is less than some prescribed number of years. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Discounted Payback
Initial investment = —$1000 R = 10% PV of Year Cash flow Cash flow $ $182 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Discounted Payback (continued)
Accumulated Year discounted cash flow 1 $182 Discounted payback period is just under three years Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Ordinary and Discounted Payback
Initial investment = –$300 R = 12.5% Cash Flow Accumulated Cash Flow Year Undiscounted Discounted 1 2 3 4 5 $ 100 100 $ 89 79 70 62 55 200 300 400 500 $89 168 238 355 Ordinary payback? Discounted payback? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Advantages and Disadvantages of Discounted Payback
- Includes time value of money - Easy to understand - Does not accept negative estimated NPV investments - Biased towards liquidity Disadvantages May reject positive NPV investments Arbitrary determination of acceptable payback period Ignores cash flows beyond the cutoff date Biased against long-term and new products Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Accounting Rate of Return (ARR)
Measure of an investment’s profitability. A project is accepted if ARR > target average accounting return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—ARR Assume initial investment = $240 Year 1 2 3 Sales $440
Sales $440 $240 $160 Expenses 220 120 80 Gross profit 220 120 80 Depreciation 80 80 80 Taxable income 140 40 Taxes (25%) 35 10 Net profit $105 $30 $0 Assume initial investment = $240 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—ARR (continued)

Disadvantages of ARR The measure is not a ‘true’ reflection of return.
Time value is ignored. Arbitrary determination of target average return. Uses profit and book value instead of cash flow and market value. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Advantages of ARR Easy to calculate and understand.
Accounting information almost always available. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Internal Rate of Return (IRR)
The discount rate that equates the present value of the future cash flows with the initial cost. Generally found by trial and error. A project is accepted if its IRR is > the required rate of return. The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—IRR Initial investment = –$200 Year Cash flow 1 $ 50 2 100 3
$ 50 2 100 3 150 n Find the IRR such that NPV = 0 50 0 = – (1+IRR) 1 (1+IRR) 2 (1+IRR) 3 50 200 = (1+IRR) 1 (1+IRR) 2 (1+IRR) 3 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—IRR (continued)
Trial and Error Discount rates NPV 0% $100 5% 68 10% 41 15% 18 20% –2 IRR is just under 20%—about 19.44% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

NPV Profile Net present value 120 Year Cash flow – $275 100 1 100 2 100 80 3 100 4 100 60 40 20 – 20 – 40 Discount rate 2% 6% 10% 14% 18% 22% IRR Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Problems with IRR Advantages of IRR
More than one negative cash flow  multiple rates of return. Project is not independent  mutually exclusive investments. Highest IRR does not indicate the best project. Advantages of IRR Popular in practice Does not require a discount rate Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Multiple Rates of Return
Assume you are considering a project for which the cash flows are as follows: Year Cash flows –$252 1 1431 2 –3035 3 2850 4 –1000 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

What’s the IRR? Find the rate at which the computed NPV = 0: at 25.00%: NPV = at 33.33%: NPV = at 42.86%: NPV = at 66.67%: NPV = n Two questions: u 1. What’s going on here? u 2. How many IRRs can there be? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

NPV $0.06 $0.04 IRR = 25% $0.02 $0.00 ($0.02) IRR = 33.33% IRR = 66.67% IRR = 42.86% ($0.04) ($0.06) ($0.08) 0.2 0.28 0.36 0.44 0.52 0.6 0.68 Discount rate Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

IRR and Non-conventional Cash Flows
When the cash flows change sign more than once, there is more than one IRR. When you solve for IRR you are solving for the root of an equation and when you cross the x axis more than once, there will be more than one return that solves the equation. If you have more than one IRR, you cannot use any of them to make your decision. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

IRR, NPV and Mutually-exclusive Projects
Net present value Year 160 3 4 140 Project A: – $350 50 100 150 200 120 100 Project B: – $250 125 100 75 50 80 60 40 Crossover Point 20 – 20 – 40 – 60 – 80 – 100 Discount rate 2% 6% 10% 14% 18% 22% 26% IRR IRR A B Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Present Value Index (PVI)
Expresses a project’s benefits relative to its initial cost. Accept a project with a PVI > 1.0. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—PVI Assume you have the following information on Project X:
Initial investment = –$1100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1000 $500 2 2000 1000 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—PVI (continued)
Net Present Value Index = 181 1100 = Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—PVI (continued)
Is this a good project? If so, why? This is a good project because the present value of the inflows exceeds the outlay. Each dollar invested generates $ in value or $ in NPV. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Advantages and Disadvantages of PVI (and NPVI)
- Closely related to NPV, generally leading to identical decisions. - Easy to understand. - May be useful when available investment funds are limited. Disadvantages - May lead to incorrect decisions in comparisons of mutually exclusive investments. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Capital Budgeting in Practice
We should consider several investment criteria when making decisions. NPV and IRR are the most commonly used primary investment criteria. Payback is a commonly used secondary investment criteria. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Eight Making Capital Investment Decisions

Chapter Organisation 8.1 Project Cash Flows: A First Look
8.2 Incremental Cash Flows 8.3 Project Cash Flows 8.4 More on Project Cash Flows 8.5 Some Special Cases of Discounted Cash Flow Analysis 8.6 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Identify incremental cash flows relevant to investment evaluation. Calculate depreciation expense for tax purposes. Apply incremental analysis to project evaluation. Determine how to set the bid price and how to value options. Compare mutually-exclusive projects using annual equivalent costs. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Incremental Cash Flows
Any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project. The only relevant cash flows in capital project evaluation. Stand-alone principle: we can evaluate the project on its own. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Cash Flows Sunk costs  a cost that has already been incurred and cannot be removed  incremental cash flow Opportunity costs  the most valuable alternative that is given up by the investment = incremental cash flow Side effects  erosion = incremental cash flow Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Cash Flows (continued)
Financing costs  incorporated in discount rate  incremental cash flow Always use after-tax incremental cash flow Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Investment Evaluation
Step 1 Calculate the taxable income. Step 2 Calculate the cash flows. Step 3 Discount the cash flows. Step 4 Decision. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Investment Evaluation
Purchase price $42 000 Salvage value $1000 at end of Year 3 Net cash flows Year 1 $31 000 Year 2 $25 000 Year 3 $20 000 Tax rate is 30% Depreciation 20% reducing balance Required rate of return 12% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Depreciation Schedule

Solution—Taxable Income

Solution—Cash Flows Year 0 Year 1 Year 2 Year 3 Tax paid (6 780)
(5 484) 1 764 Net cash flow 31 000 25 000 20 000 Salvage value 1 000 Outlay (42 000) Cash flow 24 220 19 516 22 764 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—NPV and Decision
Decision: NPV > 0, therefore ACCEPT. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interest As the project’s NPV is positive, the cash flows from the investment will cover interest costs (as long as the interest cost is less than the required rate of return). Interest costs should not therefore be included as an explicit cash flow. Interest costs are included in the required rate of return (discount rate) used to evaluate the project. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes. Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes. Prime cost vs diminishing value methods Depreciation tax shield = DT -D = depreciation expense -T = marginal tax rate Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Disposal of Assets If the salvage value > book value, a profit/gain is made on disposal. This profit/gain is subject to tax (excess depreciation in previous periods). If the salvage value < book value, the ensuing loss on disposal is a tax deduction (insufficient depreciation in previous periods). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Capital Gains Capital gains made on the sale of assets such as rental property are subject to taxation. Capital losses are not a tax deduction but can be offset against future capital gains. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Incremental Cash Flows
A firm is currently considering replacing a machine purchased two years ago with an original estimated useful life of five years. The replacement machine has an economic life of three years. Other relevant data is summarised below: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Taxable Income

Solution—Cash Flows Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—NPV and Decision
Decision: NPV < 0, therefore REJECT. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Setting the Bid Price How to set the lowest price that can be profitably charged. Cash outflows are given. Determine cash inflows that result in zero NPV at the required rate of return. From cash inflows, calculate sales revenue and price per unit. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Setting the Option Value
Asset value × Probability of the Value – Present value of the exercise price × Probability the exercise price will be paid. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Annual Equivalent Cost (AEC)
When comparing two mutually-exclusive projects with different lives, it is necessary to make comparisons over the same time period. AEC is the present value of each project’s costs to infinity calculated on an annual basis. Select the project with the lowest AEC. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—AEC Project A costs $3000 and then $1000 per annum for the next four years. Project B costs $6000 and then $1200 for the next eight years. Required rate of return for both projects is 10 per cent. Which is the better project? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Project A Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Project B Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Interpretation
Project A is better because it costs $1946 per year compared to Project B’s $2325 per year. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Nine Project Analysis and Evaluation

Chapter Organisation 9.1 Evaluating NPV Estimates
9.2 Scenario and Other ‘What If’ Analysis 9.3 Break-even Analysis 9.4 Operating Cash Flow, Sales Volume and Break-even 9.5 Operating Leverage 9.6 Additional Considerations in Capital Budgeting 9.7 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand and apply scenario analysis, sensitivity analysis and simulation analysis to capital project evaluation. Apply break-even analysis, distinguishing between accounting break-even, cash break-even and financial break-even. Measure the degree of operating leverage of a firm. Discuss the various managerial options in capital budgeting. Outline capital rationing and the difference between soft and hard rationing. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Evaluating NPV Estimates
The basic problem: How reliable is our NPV estimate? Projected cash flows are based on a distribution of possible outcomes each period: resulting in an ‘average’ cash flow. Forecasting risk: the possibility of an incorrect decision due to errors in cash flow projections (GIGO system). Ask: What sources of value create the estimated NPV? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Scenario and Other ‘What If’ Analysis
Base case estimation Estimated NPV based on initial cash flow projections. Scenario analysis Examine effect on NPV of best-case and worst-case scenarios. Sensitivity analysis Examine effect on NPV by changing only one input variable. Simulation analysis Vary several input variables simultaneously to construct a distribution of possible NPV estimates. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Driving Range Example
Fairways Driving Range expects annual rentals to be buckets at $3 per bucket. Equipment costs $ and is depreciated using the straight-line method over five years to a zero salvage value. Variable costs are 10 per cent of rentals income and fixed costs are $ per year. Assume no increase in working capital and no additional capital outlays. The required rate of return is 15 per cent and the tax rate is 30 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Example—Net Profit

Fairways Example—Base Case NPV
Estimated annual cash flow: $ $4000 – $3000 = $11 000 At 15%, the 5-year annuity factor is The base case NPV is then: NPV = – $ ($ × ) = $16 874 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Example—Scenario Analysis
Inputs for scenario analysis: Base case: Rentals are buckets p.a., variable costs are 10 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Best case: Rentals are buckets p.a., variable costs are 8 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Worst case: Rentals are buckets p.a., variable costs are 12 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Example—Scenario Analysis

Fairways Example—Sensitivity Analysis
Inputs for sensitivity analysis: Base case: Rentals are buckets p.a., variable costs are 10 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Best case: Rentals are buckets p.a. All other variables are unchanged. Worst case: Rentals are buckets p.a. All other variables are unchanged. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

NPV Best case NPV = $48 552 $60 000 x Base case NPV = $16 874 x Worst case NPV = $4 202 x –$60 000 15 000 20 000 25 000 Rentals per Year Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Break-even Analysis Useful for analysing the relationship between sales volume and profitability. Break-even point is the sales volume at which the present value of the project’s cash inflows and outflows are equal  NPV = 0. Important distinction between variable costs and fixed costs. Accounting break-even is the sales volume that results in a zero net profit. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fixed and Variable Costs
There are two types of costs that are important in break-even analysis: variable and fixed. -Variable costs change when the quantity of output changes -Total variable costs= quantity × cost per unit -Fixed costs are constant, regardless of output, over some time period -Total Costs = fixed + variable = FC + vQ Example: Your firm pays $3000 per month in fixed costs. You also pay $15 per unit to produce your product. (Total cost if you produce 1000 units = (1000) = ) (Total cost if you produce 5000 units = (5000) = ) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Average versus Marginal Cost
Average Cost - TC/number of units - Will decrease as number of units increases Marginal Cost - The cost to produce one more unit - Same as variable cost per unit Example: What is the average cost and marginal cost under each situation in the previous example? - Produce 1000 units: Average = /1000 = $18 - Produce 5000 units: Average = /5000 = $15.60 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Example—Accounting Break-even Analysis

Total revenues $80 000 Accounting break-even point buckets Total accounting costs $50 000 Fixed costs + Dep’n = $44 000 Net Income < 0 Net Income > 0 $20 000 15 000 20 000 25 000 Rentals per Year Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solve algebraically for break-even quantity (Q): If sales do not reach buckets, Fairways will incur losses in both the accounting sense and the financial sense. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Accounting of Break-even Point
General expression Q = (FC + D)/(P – v) where: Q = total units sold FC = total fixed costs D = depreciation P = price per unit v = variable cost per unit Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Using Accounting Break-even
Accounting break-even is often used as an early- stage screening number. If a project cannot break even on an accounting basis, then it is not going to be a worthwhile project. Accounting break-even gives managers an indication of how a project will impact accounting profit. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Summary of Break-even Measures
Accounting break-even Q = (FC + D)/(P – v) At accounting break-even, net income = 0, NPV is negative and IRR =0. Cash break-even Q = FC/(p – v) At cash break-even, OCF = 0, NPV is negative and IRR = –100%. Financial break-even Q = (FC + OCF)/(P – v) At financial break-even, NPV = 0 and IRR = required return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Example—Break-even Measures

Operating Leverage The degree to which a firm is committed to its fixed costs. The higher the degree of operating leverage, the greater the danger from forecasting risk. The lower the degree of operating leverage, the lower the break-even point. DOL depends on the current sales level. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Fairways Example—DOL Let Q = buckets and, ignoring taxes, OCF = $ and FC = $ A 10 per cent increase (decrease) in quantity sold will result in a per cent increase (decrease) in OCF. Note: Higher DOL equals greater volatility (risk) in OCF and leverage is a two-edged sword—sales decreases will be magnified as much as increases. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Managerial Options and Capital Budgeting
A static DCF analysis ignores management’s ability to modify the project as events occur. Contingency planning The option to expand. The option to abandon. The option to wait. Strategic options ‘Toe hold’ investments. Research and development. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Capital Rationing A condition which prevents management from undertaking all acceptable projects because of a shortage of funds. Soft rationing occurs when management limits the amount that can be invested in new projects during some specified time period. Hard rationing occurs when the firm is unable to raise the financing for a project. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Ten Some Lessons from Capital Market History

Chapter Organisation 10.1 Returns 10.2 Inflation and Returns
10.3 The Historical Record 10.4 Average Returns: The First Lesson 10.5 The Variability of Returns: The Second Lesson 10.6 Capital Market Efficiency 10.7 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Distinguish between dollar returns and percentage returns. Examine the effect of inflation on returns. Gain an appreciation of historical returns and their variability for different assets. Calculate average return and standard deviation. Discuss market efficiency and its three forms. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dollar Returns The gain (or loss) from an investment.
Made up of two components: income (e.g. dividends, interest payments) capital gain (or loss). Not necessary to sell investment to include capital gain or loss in return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Percentage Returns Dividends paid at Change in market end of period value over period Percentage return = Beginning market value Dividends paid at Market value end of period at end of period 1 + Percentage return = Beginning market value + + Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Percentage Return Example
Pt = $ Pt+1 = $ Dt+1 = $1.85 Per dollar invested we get 5 cents in dividends and 9 cents in capital gains—a total of 14 cents or a return of 14 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Percentage Returns Total $42.18 Inflows Dividends $1.85
Ending market value $40.33 Time t t = 1 Outflows – $37 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Inflation and Returns R ≈ r + h
Real return is the return after taking out the effects of inflation. Real return shows the percentage change in buying power. Nominal return is the return before taking out the effects of inflation. The Fisher effect explores the relationship between real returns (r), nominal returns (R) and inflation (h). R ≈ r + h Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Average Equivalent Returns & Risk Premiums 1978–2002

Average Returns: The First Lesson
Risky assets on average earn a risk premium (i.e. there is a reward for bearing risk). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Frequency of Returns on Ordinary Shares 1978–2002

Variance Measure of variability.
The mean of the squared deviations from the average return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Variance ABC Co. have experienced the following returns in the last five years: Year Returns 1998 -10% 1999 5% 2000 30% 2001 18% 2002 10% Calculate the average return and the standard deviation. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Variance Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Historical Record Conclusion: Historically, the riskier the asset, the greater the return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Normal Distribution

Variability: The Second Lesson
The greater the risk, the greater the potential reward. This lesson holds over the long term but may not be valid for the short term. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Capital Market Efficiency
The efficient market hypothesis (EMH) asserts that the price of a security accurately reflects all available information. Implies that all investments have a zero NPV. Implies also that all securities are fairly priced. If this is true then investors cannot earn ‘abnormal’ or ‘excess’ returns. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Price Behaviour in Efficient and Inefficient Markets
Overreaction and correction 220 180 140 100 Delayed reaction Efficient market reaction Days relative to announcement day –8 –6 –4 –2 +2 +4 +6 +7 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

What Makes Markets Efficient?
There are many investors out there doing research: - As new information comes into the market, this information is analysed and trades are made based on this information. - Therefore, prices should reflect all available public information. If investors stop researching stocks, then the market will not be efficient. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Common misconceptions about EMH
Efficient markets do not mean that you can’t make money. They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and that there is not a bias in prices that can be exploited to earn excess returns. Market efficiency will not protect you from making the wrong choices if you do not diversify—you still don’t want to put all your eggs in one basket Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Price Behaviour in Efficient and Inefficient Markets
Efficient market reaction: The price instantaneously adjusts to and fully reflects new information. There is no tendency for subsequent increases and decreases. Delayed reaction: The price partially adjusts to the new information. Several days elapse before the price completely reflects the new information. Overreaction: The price over-adjusts to the new information. It ‘overshoots’ the new price and subsequently corrects itself. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Forms of Market Efficiency
Weak form efficiency: Current prices reflect information contained in the past series of prices. Semi-strong form efficiency: Current prices reflect all publicly available information. Strong form efficiency: Current prices reflect all information of every kind. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Eleven Return, Risk and the Security Market Line

Chapter Organisation 11.1 Expected Returns and Variances
11.2 Portfolios 11.3 Announcements, Surprises and Expected Returns 11.4 Risk: Systematic and Non-systematic 11.5 Diversification and Portfolio Risk 11.6 Systematic Risk and Beta 11.7 The Security Market Line 11.8 The Capital Market Line 11.9 Portfolio Characteristics The SML and the Cost of Capital: A Preview Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Organisation (continued)
11.11 Problems with the CAPM Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Calculate the expected return and risk (standard deviation) of both a single asset and a portfolio. Distinguish between systematic and non-systematic risk. Explain the principle of diversification. Explain the capital asset pricing model (CAPM). Distinguish between the security market line (SML) and the capital market line (CML). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Expected Return and Variance
Expected return—the weighted average of the distribution of possible returns in the future. Variance of returns—a measure of the dispersion of the distribution of possible returns. Rational investors like return and dislike risk. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Calculating Expected Return

Example—Calculating Variance

Example—Expected Return and Variance
Expected Returns: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Expected Return and Variance
Variances: Standard deviations: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Portfolios A portfolio is a collection of assets.
An asset’s risk and return is important in how it affects the risk and return of the portfolio. The risk–return trade-off for a portfolio is measured by the portfolio’s expected return and standard deviation, just as with individual assets. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Portfolio Expected Returns
The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio. m E(Rp) = ∑ wjE (Rj) j =1 You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Portfolio Return and Variance
Assume 50 per cent of portfolio in asset A and 50 per cent in asset B. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Portfolio Return and Variance
Var(Rp)  (0.50 x Var(RA)) + (0.50 x Var(RB)). By combining assets in a portfolio, the risks faced by the investor can significantly change. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Effect of Diversification on Portfolio Variance
Portfolio returns: 50% A and 50% B Asset A returns Asset B returns 0.05 0.04 0.03 0.02 0.01 -0.01 -0.02 -0.03 -0.04 -0.05 0.05 0.04 0.03 0.02 0.01 -0.01 -0.02 -0.03 0.04 0.03 0.02 0.01 -0.01 -0.02 -0.03 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Announcements, Surprises and Expected Returns
Key Issues What are the components of the total return? What are the different types of risk? Expected and Unexpected Returns Total return (R) = expected return (E(R))+ unexpected return (U) Announcements and News Announcement = expected part + surprise It is the surprise component that affects a stock’s price and, therefore, its return. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Risk Systematic risk: that component of total risk which is due to economy-wide factors. Non-systematic risk: that component of total risk which is unique to an asset or firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Standard Deviations of Monthly Portfolio Returns

Diversification The process of spreading investments across different assets, industries and countries to reduce risk. Total risk = systematic risk + non-systematic risk Non-systematic risk can be eliminated by diversification; systematic risk affects all assets and cannot be diversified away. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Principle of Diversification
Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another. However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Portfolio Diversification

Systematic Risk The systematic risk principle states that the expected return on a risky asset depends only on the asset’s systematic risk. The amount of systematic risk in an asset relative to an average risky asset is measured by the beta coefficient. Std Deviation Beta Security A 30% 0.60 Security B 10% 1.20 Security A has greater total risk but less systematic risk (more non-systematic risk) than Security B. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Measuring Systemic Risk
What does beta tell us? - A beta of 1 implies the asset has the same systematic risk as the overall market. - A beta < 1 implies the asset has less systematic risk than the overall market. - A beta > 1 implies the asset has more systematic risk than the overall market. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Beta Coefficients for Selected Companies

Example—Portfolio Beta Calculations
Amount Portfolio Share Invested Weights Beta (1) (2) (3) (4) (3) (4) ABC Company $6 000 50% 0.90 0.450 LMN Company 4 000 33% 1.10 0.367 XYZ Company 2 000 17% 1.30 0.217 Portfolio $12 000 100% 1.034 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Portfolio Expected Returns and Betas
Assume you wish to hold a portfolio consisting of asset A and a riskless asset. Given the following information, calculate portfolio expected returns and portfolio betas, letting the proportion of funds invested in asset A range from 0 to 125 per cent. Asset A has a beta of 1.2 and an expected return of 18 per cent. The risk-free rate is 7 per cent. Asset A weights: 0 per cent, 25 per cent, 50 per cent, 75 per cent, 100 per cent and 125 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Portfolio Expected Returns and Betas
Proportion Proportion Portfolio Invested in Invested in Expected Portfolio Asset A (%) Risk-free Asset (%) Return (%) Beta 100 7.00 0.00 25 75 9.75 0.30 50 50 12.50 0.60 75 25 15.25 0.90 100 18.00 1.20 125 –25 20.75 1.50 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Return, Risk and Equilibrium
Key issues: What is the relationship between risk and return? What does security market equilibrium look like? The ratio of the risk premium to beta is the same for every asset. In other words, the reward-to-risk ratio for the market is constant and equal to: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Asset Pricing
Asset A has an expected return of 12 per cent and a beta of Asset B has an expected return of 8 per cent and a beta of Are these two assets valued correctly relative to each other if the risk-free rate is 5 per cent? Asset B offers insufficient return for its level of risk, relative to A. B’s price is too high; therefore, it is overvalued (or A is undervalued). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Security Market Line The security market line (SML) is the representation of market equilibrium. The slope of the SML is the reward-to-risk ratio: (E(RM) – Rf)/ßM But since the beta for the market is ALWAYS equal to one, the slope can be rewritten. Slope = E(RM) – Rf = market risk premium Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Security Market Line (SML)
Asset expected return (E (Ri)) = E (RM) – Rf E (RM) Rf Asset beta (i) M = 1.0 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Capital Asset Pricing Model (CAPM)
An equilibrium model of the relationship between risk and return. What determines an asset’s expected return? The risk-free rate—the pure time value of money. The market risk premium—the reward for bearing systematic risk. The beta coefficient—a measure of the amount of systematic risk present in a particular asset. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Calculation of Systematic Risk
Where: Cov = covariance i = random distribution of return for asset i M = random distribution of return for the market M = standard deviation of market return Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Covariance and Correlation
The covariance term measures how returns change together—measured in absolute terms. The correlation coefficient measures how returns change together—measured in relative terms. Correlation coefficient ranges between –1.0 and +1.0. Where i = standard deviation of the return on asset i. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Security Market Line versus Capital Market Line
* SML explains the expected return for all assets. * CML explains the expected return for efficient portfolios. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Risk of a Portfolio Variance of a two-asset portfolio is calculated as: weighted variance of the expected return for each asset in the portfolio + twice the weighted covariance of the expected return on the first asset with the expected return on the second Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Risk of a Portfolio
Weighting Std Deviation Asset A Asset B The covariance of the expected returns between A and B is Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Problems with CAPM Difficulties in estimating beta - thin trading
- non-constant beta Using CAPM - adding explanatory variables - measure of market return Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Twelve Current Investment Decisions

Chapter Organisation 12.1 The Investments Involved
12.2 The Operating Cycle and the Cash Cycle 12.3 Some Aspects of Short-term Financial Policy 12.4 The Cash Budget 12.5 A Short-term Financial Plan 12.6 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the components of the operating cycle and the cash cycle. Explain the key issues in a firm’s short-term financial policy. Understand and apply the inventory model. Prepare a cash budget. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Current Investment Decisions
Involve the administration of the company’s current assets (cash and marketable securities, receivables and inventory), and the financing needed to support these assets. Problems in using discounted cash flow techniques to evaluate these decisions: identification of all relevant cash inflows and outflows determining the size and timing of these cash flows determining the correct discount rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Operating Cycle versus Cash Cycle
Operating cycle—the time period between the acquisition of inventory and the collection of cash from receivables. Operating cycle = Inventory period + A/cs receivable period Cash cycle—the time period between the outlay of cash for purchases and the collection of cash from receivables. Cash cycle = Operating cycle – A/cs payable period Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Accounts receivable period Accounts payable period
Cash Flow Time Line Inventory sold Cash received Inventory purchased Inventory period Accounts receivable period Time Accounts payable period Cash paid for inventory Operating cycle Cash cycle Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Operating Cycle
The following information has been provided for Overcredit Co.: Sales for the year were $ (assume all credit) and the cost of goods sold was $ Calculate the operating cycle and cash cycle. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Operating Cycle (continued)
a) Find the inventory period: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

b) Find the accounts receivable period: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cash Cycle a) Find the payables period:

Example—Cash Cycle (continued)

Short-term Financial Policy
Size of investments in current assets -Flexible policy—maintain a high ratio of current assets to sales -Restrictive policy—maintain a low ratio of current assets to sales Financing of current assets - Flexible policy—less short-term debt and more long-term debt - Restrictive policy—more short-term debt and less long-term debt Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Short-term Financial Policy
The size of the firm’s investment in current assets is determined by its short-term financial policies. Flexible policy actions include: keeping large cash and securities balances keeping large amounts of inventory granting liberal credit terms. Restrictive policy actions include: keeping low cash and securities balances keeping small amounts of inventory allowing few or no credit sales. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Costs of Investments Need to manage the trade-off between carrying costs and shortage costs. Carrying costs increase with the level of investment in current assets, and include the costs of maintaining economic value and opportunity costs. Shortage costs decrease with increases in the level of investment in current assets, and include trading costs and the costs related to being short of the current asset. For example, sales lost as a result of a shortage of finished goods inventory. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Carrying Costs and Shortage Costs

The Inventory Model The economic quantity (EOQ) is the optimal quantity of inventory ordered that minimises the costs of purchasing and holding the inventory. Where TC = total cost X = order size EOQ = economic order qty A = acquisition costs Y = total demand C = carrying costs P = price per unit Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—EOQ Smile Camera Shop sells rolls of film per year, each with a wholesale price of $ The cost of processing each order placed is $10.00 and carrying costs are 20 cents per roll per year. Calculate the EOQ. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

EOQ Example With Quantity Discounts
Smile Camera Shop is offered a 2-cent-per-roll discount if 2000–3500 rolls of film are ordered, and a 3-cent-per-roll discount if more than 3500 rolls are ordered at a time. Determine the optimal order quantity. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

EOQ Example With Quantity Discounts (continued)
Calculate the total cost for each quantity: Smile Camera Shop would be better off purchasing in lots of 2000 to reduce the total cost. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Inventory Management Under Uncertainty
Inventory management requires two decisions: quantity to be ordered reorder point Safety stock is the additional inventory held when demand is uncertain so as to reduce the probability of a stock out. Reorder point takes into account the lead time from placement of an order to receipt of the goods. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

EOQ Example Under Uncertainty
Smile Camera Shop’s EOQ (with quantity discounts) is 2000 rolls of film and five orders are placed each year. Determine the reorder point if it takes 30 days to fill an order, a safety stock of 100 is desired and daily usage is 30 rolls. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

EOQ Example Under Uncertainty
Reorder point Qty 2 100 Reorder points 1 000 100 Safety stock Time Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Budget Forecast of cash receipts and disbursements over the next short-term planning period. Primary tool in short-term financial planning. Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs. Allows a company to plan ahead and begin the search for financing before the money is actually needed. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cash Budget Projected sales for the first six months of 2004:
Jan. $ Apr. $ Feb. $ May $ Mar. $ Jun. $ Analysis of collection of accounts receivable: collected in month of sale 20% collected in month following sale 60% collected in second month following sale 20% Actual sales for November and December were $ and $ respectively. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cash Budget (continued)
Wages and other expenses are 30 per cent of total monthly sales. Purchases are 50 per cent of the month’s estimated sales, all paid for in the month of purchase. Monthly interest payments are $ (interest rate is 1.5 per cent per month). An annual dividend of $ is payable in March. The beginning cash balance is $ The minimum cash balance is $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Collections Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Disbursements Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Budget Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Short-term Financial Planning

Chapter Thirteen Cash and Liquidity Management

Chapter Organisation 13.1 Reasons for Holding Cash
13.2 Determining the Target Cash Balance 13.3 Managing the Collection and Disbursement of Cash 13.4 Investing Idle Cash 13.5 Regulation of Financial Intermediaries 13.6 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the various reasons for holding cash.
Explain and apply both the BAT model and the Miller–Orr model. Explain what float is and the different types of float. Discuss various ways of managing float. Outline ways that firms overcome temporary surpluses/deficits of cash. Discuss the role of the various regulators of financial markets. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Reasons for Holding Cash
Speculative motive—the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases. Precautionary motive—the need to hold cash as a safety margin to act as a financial reserve. Transaction motive—the need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations. Compensating balance requirements—cash balances kept at commercial banks to compensate for banking services the firm receives. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Target Cash Balance Key issues:
What is the trade-off between carrying a large cash balance versus a small cash balance? That is, carrying costs versus shortage costs. What is the proper management of the cash balance? BAT model versus Miller–Orr model. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The BAT Model Starting cash C=$2 000 000 Average cash $500 000=C/4 4 8
4 8 Weeks Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The BAT Model Assumptions -Cash is spent at the same rate every day
-Cash expenditures are known with certainty Optimal cash balance is where opportunity cost of holding cash ([C/2]*R) = trading cost ([T/C]*F): F = fixed cost of making a securities trade to replenish cash T = total amount of new cash needed for transactions purposes over the relevant planning period R = the opportunity cost of holding cash (the interest rate on marketable securities) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Miller–Orr Model Assumes that, if left unmanaged, a company’s cash balance would follow a random walk with zero drift. Cash balance is allowed to wander freely between an upper limit (U*) and a lower limit (L). If cash holdings reach U*, management intervenes by withdrawing U* – C* dollars to return the cash balance to the target level C*. If cash balance reaches L, management intervenes by injecting C* – L dollars to return the cash balance to the target level C*. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Miller–Orr Model Cash U* C* L Time X Y U* is the upper control limit. L is the lower control limit. The target cash balance is C*. As long as cash is between L and U*, no transaction is made. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Miller–Orr Model Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Miller–Orr Model
Assume L = $0, F = $10, i = 0.5 per cent per month and the standard deviation of monthly cash flows is $2000. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Miller–Orr Model Implications
Considers the effect of uncertainty (through 2 in net cash flows). The higher the 2, the greater the difference between C* and L. The higher the 2, the higher is the upper limit and the average cash balance. All things being equal: the greater the interest rate, the lower is the C* the greater the order costs, the higher is the C*. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Miller–Orr Model With Overdraft
Yield on short-term investments < cost of bank overdraft < yield on long-term investments. A dollar invested in short-term assets earns less than the costs saved by applying that dollar to reduce overdraft usage. The company invests nothing in short-term assets and as much as possible in long-term assets, while meeting its liquidity needs through using the overdraft facility. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Miller–Orr Model With Overdraft
Where: d = cost of bank overdraft Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Understanding Float What is float? Types of float:
The difference between book cash and bank cash, representing the net effect of cheques in the process of being cleared. Types of float: Disbursement float—the result of cheques written; decreases book balance but does not immediately change available balance. Collection float—the result of cheques received; increases book balance but does not immediately change available balance. Net float—the overall difference between the firm’s available balance and its book balance. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Float Management Objectives: Components of float:
In cash collection—speed up cheque collections (reduce float components). In cash disbursement—control payments and minimise costs (increase float components). Components of float: Mail float—cheques trapped in postal system. Processing float—until receiver of cheque deposits cheque. Availability float—until cheque clears in the banking system. Mail float + processing float + availability float = total time delay. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Measuring and Costing the Float
The cost of collection float to the firm is the opportunity cost from not being able to use that cash. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Managing the Float Factoring—the selling of receivables to a financial institution (the factor), usually ‘without recourse’. Credit insurance—protection against the risk of bad debt losses. Delaying disbursements—increases the disbursement float. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Investing Idle Cash Temporary cash surpluses can be invested in marketable securities. Temporary cash deficits—sell marketable securities or use short-term bank financing. The temporary surpluses/deficits are a result of: seasonal or cyclical activities planned or possible expenditures. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Securities Markets
Temporary cash surplus Futures market Long-term debt market Financial intermediaries Options market Short-term money market Sharemarket Foreign exchange market Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Short-term Securities
Characteristics of short-term securities include: Maturity  maturities usually less than 90 days. Investments then avoid interest rate risk but have low returns. Default risk  idle cash generally invested in less risky securities (e.g. government issues). Marketability  idle funds usually invested in highly liquid securities. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Investing Cash Temporary Cash Surpluses
-Seasonal or cyclical activities—buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occur. -Planned or possible expenditures—accumulate marketable securities in anticipation of upcoming expenses. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financing Seasonal or Cyclical Activities

Regulation of Financial Intermediaries
Australian Prudential Regulation Authority (APRA) Prudential supervision of all deposit-taking entities, insurance and superannuation funds. Council of Financial Regulators Australian Securities and Investments Commission (ASIC) Corporate regulation, consumer protection, market integrity. Reserve Bank of Australia (RBA) Payments system, monetary policy, stability of the financial system. Source: Australian Financial Review, 18 March 1998, p.4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Regulation of Financial Intermediaries
Terminology to know: CGS Commonwealth Government Securities ESAs  exchange settlement accounts RTGS  real-time gross settlement ADIs  authorised deposit-taking institutions CAR  capital adequacy ratio PAR  prime assets ratio Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Fourteen Credit Management

Chapter Organisation 14.1 Credit and Receivables
14.2 Terms of the Sale 14.3 Analysing Credit Policy 14.4 More on Credit Policy Analysis 14.5 Optimal Credit Policy 14.6 Credit Analysis 14.7 Collection Policy 14.8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the components of credit policy and the cash flows associated with granting credit. Identify the factors that influence the length of the credit period. Calculate the cost of forgoing discounts in credit periods. Outline the various credit policy effects. Calculate the cost and NPV of switching policies. Determine the optimal credit policy. Discuss the five Cs of credit. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Components of Credit Policy
Terms of sale The conditions on which a firm sells its goods and services for cash or credit. Credit analysis The process of determining the probability that customers will not pay. Collection policy Procedures that are followed by a firm in collecting accounts receivable. Accounts receivable = Average daily sales × average collection period Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Flows from Granting Credit
Customer Firm deposits Bank credits sale is mails cheque in firm’s made cheque bank account Time Cash collection Accounts receivable Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Terms of the Sale Credit period
The length of time that credit is granted, usually between 30 and 120 days. Cash discount A discount that is given for a cash purchase to speed up the collection of receivables. Credit instrument Evidence of indebtedness such as an invoice or promissory note. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Length of the Credit Period
Factors that influence the length of the credit period include: buyer’s inventory period and operating cycle perishability and collateral value of goods consumer demand for the product cost, profitability and standardisation credit risk of the buyer the size of the account competition in the product market customer type. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cost of the Credit 2/10, net 30 = buyer pays in 10 days to get a 2 per cent discount, or within 30 days for no discount. Buyer has an order for $1500 and ignores the credit period  gives up $30 discount. The benefit obviously lies in paying early. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Credit Policy Effects Revenue effects—Payment is received later, but price and quantity sold may increase. Cost effects—Cost of sale is still incurred even though the cash from the sale has not been received. The cost of debt—The firm must finance receivables and, therefore, incur financing costs. The probability of non-payment—The firm always gets paid if it sells for cash, but risks losses due to customer default if it sells on credit. The cash discount—Discounts induce buyers to pay early; the size of the discount affects payment patterns and amounts. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Evaluating a Proposed Credit Policy
P = price per unit Q’ = new quantity expected to be sold v = variable cost per unit Q = current quantity sold per period R = periodic required return The benefit of switching is the change in cash flow: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Evaluating a Proposed Credit Policy
The present value of switching is: PV = [(P – v) × (Q’ – Q)]/R The cost of switching is the amount uncollected for the period plus the additional variable costs of production: Cost = PQ + v(Q’ – Q) And the NPV of the switch is: NPV = –[PQ + v(Q’ – Q)] + [(P – v)(Q’ – Q)]/R Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Evaluating a Proposed Credit Policy
ABC Co. is thinking of changing from a cash-only policy to a ‘net 30 days on sales’ policy. The company has estimated the following: P = $55 v = $32 Q = 160 Q’ = 175 R = 2% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Evaluating a Proposed Credit Policy

Solution—Evaluating a Proposed Credit Policy
Therefore, the switch is very profitable. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Break-even Point The switch is a good idea as long as the company can sell an additional 7.87 units. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Discounts and Default Risk
ABC Co. currently has a cash price of $55 per unit. If the company extends the 30 day credit policy, the price will increase to $56 per unit on credit sales. ABC Co. expects 0.5 per cent of credit to go uncollected (). All other information remains unchanged. Should the company switch to the credit policy? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Discounts and Default Risk
NPV of changing credit terms: As the NPV of the change is negative, ABC Co. should not switch. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Costs of Granting Credit
Opportunity costs are lost sales from refusing credit. These costs go down when credit is granted. Carrying costs are the cash flows that must be incurred when credit is granted. They are positively related to the amount of credit extended. The required return on receivables. The losses from bad debts. The costs of managing credit and credit collections. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Optimal Credit Policy Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Credit Analysis Process of deciding which customers receive credit.
One-time sale—risk is variable cost only. Repeat customers—benefit is gained from one- time sale in perpetuity. Grant credit to almost all customers once as long as variable cost is low relative to price (high markup). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Five Cs of Credit Character Customer’s willingness to pay.
Capacity Customer’s ability to pay. Capital Financial reserves/borrowing capacity. Collateral Pledged assets. Conditions Relevant economic conditions. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Collection Policy Monitoring receivables:
- Keep an eye on average collection period relative to your credit terms. Ageing schedule—compilation of accounts receivable by the age of each account; used to determine the percentage of payments that are being made late. Collection procedures include: delinquency letters telephone calls employment of collection agency legal action. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Fifteen Australian Financial Markets: Short-term Financing

Chapter Organisation 15.1 The Financial System 15.2 Financial Markets
15.3 Financial Intermediaries 15.4 Short-term Financing 15.5 Short-term Financing Sources 15.6 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the operations of the Australian financial system. Outline the assets traded in the listed and unlisted markets. Discuss the role of individual financial intermediaries. Understand the different current asset financing policies. Discuss the various short-term financing sources. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Financial System Saving Lenders Financial markets Borrowing
Productive investment Financial intermediaries Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financial Markets Financial Markets Primary Market Secondary Market
Foreign exchange market Futures & options markets Long-term debt market Short-term debt market Share markets Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Listed Market Ordinary shares Contributing shares
Preference shares Rights Company options Property and equity trusts Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financial Intermediaries
Source: Council of Financial Supervisors Annual Report 2001, RBA. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Banks Trading banks  includes activities such as deposits, loans, insurance, superannuation and stockbroking, usually through subsidiaries and affiliated companies. Retail banking  involves transactions with the general public. Wholesale banking  involves transactions with companies or businesses. Hold approximately 44 per cent of market share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Merchant Banks Primarily concerned with wholesale finance.
Responsible for the development of CMTs, rebatable preference shares, the commercial bills market, the promissory note market, the currency hedge market and the unofficial deposit market. Activities now include ‘investment banking’. Market share has decreased dramatically since the 1980s, now approximately 5 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Superannuation and Life Insurance Companies
Crucial for the saving and provision of funds for retirement (superannuation) or ‘one-off’ events such as death, disability or trauma (insurance). Diversified operations to include general insurance, short-term money market dealing and merchant banking. Hold approximately 30 per cent of market share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Finance Companies Initially responsible for the provision of hire purchase and instalment credit, financing of vehicles and home loans, lease financing and factoring. Funds obtained mainly through the issue of debentures. Deregulation in 1980s led to many finance companies’ activities being absorbed by their large parent banks. Market share now only approximately 6 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Building Societies and Credit Unions
Traditionally provide housing finance to small savers. Diversified activities to include lending for other purposes. Credit unions Pool the funds of people with common interests to provide consumer-type financing and lending to ‘members’. Both have very small market share, totalling approximately 2 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Unit Trusts Pool funds of small investors with the aim of earning a greater return collectively than that achieved individually. Cash management trusts, equity trusts, property trusts, mortgage trusts. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Other Intermediaries Authorised foreign exchange dealers  perform a full range of foreign exchange transactions. Australian Stock Exchange (ASX) and share brokers  provide the medium for buying and selling shares and other listed securities. Friendly societies  non-profit, state-controlled intermediaries for small groups to pool funds to be used for funerals, sickness or, simply, savings. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financing Policy for an ‘Ideal’ Economy
Long-term debt plus ordinary shares Time In an ideal world, net working capital is always zero because short-term assets are financed by short-term debt. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Optimal Amount of Short-term Borrowing
Factors to consider: Cash reserves—reducing the probability of financial distress vs investments in zero NPV securities. Maturity hedging—match maturity of asset with maturity of liability. Relative interest rates—cheaper to have short-term borrowing than long-term borrowing. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Alternative Asset Financing Policies

A Compromise Financing Policy
With a compromise policy, the firm keeps a reserve of liquidity which it uses to initially finance seasonal variations in current asset needs. Short-term borrowing is used when the reserve is exhausted. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Short-term Financing Used for:
Working capital requirements in the day-to-day operations of the business. Transactions that are self-financing over short periods. Main providers are trading banks, merchant banks and finance companies. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Short-term Financing Sources
Overdrafts A credit arrangement where the bank permits the customer to draw more money from the bank account than has been put in it, up to an agreed limit. Repayable on demand although this is rarely required. Interest rate is variable and account balance fluctuates between positive (deposit) and negative (loan) over the business cycle. Short-term loans An advance of funds made by a financial institution for a specific purpose, repayable over a fixed period. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bills of exchange A negotiable instrument requiring the payment of a specific sum of money, either on demand or at a specified time. Trade bills versus accommodation bills. Three parties to a bill: drawer (borrower), acceptor (endorser) and payee (owner). Discounted value (price) of a bill: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Promissory notes A negotiable instrument whereby the borrower promises to repay the face value to the holder at maturity. Different to bills of exchange because they are unsecured (no acceptor). Most borrowers are well-known large organisations. There is an active secondary market. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Inventory loans A short-term loan used specifically to purchase inventory, including a blanket inventory lien, a trust receipt and field warehouse financing. Letters of credit Irrevocable and unconditional undertaking by a bank to repay a loan if the borrower defaults. Short-term eurocurrency funding Financing in a currency outside the country of issue. Factoring Selling of accounts receivables to a factor. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Sixteen Long-term Financing: An Introduction

Chapter Organisation 16.1 Corporate Long-term Debt 16.2 Debt Ratings
16.3 Some Different Types of Debenture 16.4 Callable Debentures and Debenture Refunding 16.5 Preference Shares 16.6 Ordinary Shares 16.7 Size of the Capital Market 16.8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Explain the characteristics of debt.
Identify the various sources of long-term debt. Outline the provisions of a debenture trust deed. Understand debt ratings. Identify the different types of debentures. Calculate the cost, value and NPV of callable debentures. Discuss the different features of both preference shares and ordinary shares. Understand the various definitions of financial distress. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

What is Debt? An obligation to pay a specific amount of money to another party. Characteristics of debt: short-term vs long-term fixed vs floating interest rate loans secured vs unsecured domestic vs foreign Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Long-term Debt
Leasing Project finance Transferable loan certificates Derivative debt products Debentures Secured and unsecured notes Convertible notes Fixed deposit loans Mortgages Eurobonds Eurocurrency term loans Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Sources of Long-term Financing
Debentures—secure, fixed-term loan instruments issued by companies. Secured notes—same as debentures with lower security. Unsecured notes—shorter-term loans to a company offering no assets as security. Convertible notes—debt that provides an option to convert to equity at maturity. Fixed deposits—unsecured loans at fixed rates for definite terms. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Mortgages—the conveyance of property for the security of debt. Eurobonds—unsecured fixed-interest borrowings denominated in a currency of a country other than its country of issue. Eurocurrency FRNs—a foreign currency borrowing whose rates adjust to reflect market interest rates. Leasing—purchaser of equipment leases the asset to another party. Project financing—syndicate financing of very large (and expensive) projects. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Transferable loan certificates—marketable evidence of the existence of a debt. Derivative debt products—instruments used to manage interest rate risk: interest rate swaps forward rate agreements (FRAs) interest rate futures options on futures contracts. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Debt versus Equity Corporations try to create debt securities that are really equity to get the tax benefits of debt and the bankruptcy benefits of equity. Interest on debt is fully tax deductible, so the distinction is important for tax purposes. Hybrid securities have characteristics of both debt and equity: convertible notes subordinated debt preference shares. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Debenture Trust Deed
Legal document binding the corporation and its creditors. Provisions in a trust deed include: the basic terms of the issue the amount of the debentures issued property used as security repayment arrangements call provisions any protective covenants. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Debt Ratings Letter grades that designate investment quality.
Assigned to a debt issue by independent rating agencies such as Moody’s and Standard & Poor’s. Long-term ratings range from Aaa to C; short-term ratings range from Prime-1 to Prime-3. Ratings relieve individual investors of the task of evaluating the investment quality of an issue. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Different Types of Debentures
Zero coupon debentures—initially priced at a deep discount as they make no coupon payments. Floating-rate debentures—coupon payments are tied to an interest rate index and are therefore adjustable. Usually contain a put provision, together with coupon ceilings and floors. Income debentures—coupons dependent on company income. Put debentures—holder can force the buy back of debt at a stated price. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Securitisation The process of transforming financial institutions’ assets such as mortgages, into marketable securities, by pooling and selling the rights to the income streams. Advantages: Investor—negotiable security provides both regular income and final payout. Mortgage agency—conversion of an illiquid asset into a marketable security. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Debenture Refunding Process of replacing all or part of an issue of outstanding debentures. Used to refinance a higher-interest loan with a lower-interest one. Call provision allows a company to repurchase or ‘call’ part or all of the debt issue at stated prices over a specified period. Debtholders demand a coupon that exactly compensates them for the possibility of a call. Cost of call provision = Value of call position Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Debentures Assume:
Current interest rate on debentures is 10 per cent Probability of interest rate changes by the end of the year: — fall to 5 per cent (50 per cent probability) — rise to 15 per cent (50 per cent probability) Call premium = $20 Call period = by the end of the year Face value of debenture = $100 Debentures are perpetual Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Debentures Market price of debenture (if not callable):

Solution—Debentures If issue is callable, what coupon (C) must be offered? This is higher than the non-callable coupon. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Debentures What is the cost of the call provision?
The call provision effectively costs $50. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Debentures What is the NPV per debenture of the refunding if interest rates fall to 5 per cent? As NPV is positive, refunding should commence. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Reasons for Issuing Callable Debentures
Superior interest rate forecasting—company insiders may think they know more about interest rate decreases than debtholders. Taxes—call provisions provide tax advantages to both debtholders and the company. Future investment opportunities—allows the company to buy back debentures to take advantage of superior investment opportunities. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Preference Shares Shares with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes without voting rights. Cumulative vs non-cumulative dividends. Irredeemable vs redeemable shares. Non-participating vs participating shares. Most preference shares issued are cumulative, irredeemable and non-participating. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Reasons for Issuing Preference Shares
Redeemable preference shares can be used to enhance the balance sheet by increasing the equity base. As subordinate debt, they can be included in a bank’s capital base. They can be used to avoid the threat of bankruptcy that exists for debt. Companies unable to take advantage of the tax deductibility of debt favour preference shares. A means of raising equity without surrendering control. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Ordinary Shares Equity without priority for dividends or in bankruptcy. Types of companies: companies limited by shares companies limited by guarantee companies limited by both shares and guarantee unlimited companies no liability companies. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Shareholders’ Rights The right to share proportionally in dividends paid. The right to share proportionally in assets remaining after liabilities have been paid in liquidation. The right to elect the directors and to vote on important shareholder matters (one share = one vote). The right to share proportionally in any new shares sold (pre-emptive right). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dividends Payment by a corporation to shareholders; made in either cash or shares. The return on capital to shareholders. They are not a liability of the company unless declared by the board of directors. They are not a business expense and are therefore not tax deductible. They are fully taxable in the hands of the shareholder. However, an imputation credit may be allowed. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Classes of Ordinary Shares
Different classes of ordinary shares may be distinguished by: voting rights dividend entitlement priority to dividend payment priority to capital repayment and surplus asset distribution in the event of liquidation. Reasons for different classes: debt characteristics for some shares retain control in small/newly listed firms taxation issues nature of company (e.g. home units). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Size of the Capital Market

Financial Distress The disadvantage of using debt is the possibility of financial distress, which can be defined as: business failure legal bankruptcy technical insolvency accounting insolvency. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Seventeen Issuing Securities to the Public

Chapter Organisation 17.1 The Public Issue 17.2 The Cash Offer
17.3 New Equity Sales and the Value of the Firm 17.4 The Costs of Issuing Securities 17.5 Rights 17.6 Dilution 17.7 Issuing Long-term Debt 17.8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Outline the advantages and disadvantages of public company listing. Discuss the process of underwriting and the associated costs. Identify the costs associated with issuing securities. Explain the process of a rights issue and calculate the value of a right. Discuss the dilution effect of new issues. Understand the reasons for recent growth in the corporate debt market. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Issuing Securities to the Public
Analyse funding needs and how they can be met. Approval from board of directors for a public issue. Outside expert opinions sought for support of issue. Pricing, time-tabling, prospectus prepared, marketing. Prospectus filed with ASIC and ASX. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Issuing Securities to the Public
Underwriting agreement executed. Prospectus registered. Public announcement of offering. Funds received. Shares allotted, holdings registered. Shares listed for trading on ASX. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

New Issues Flotation is the initial offering of securities to the public. Primary issues used to: convert from a private company to a public company spin-off a portion of the business of a listed company form a new public company privatise a public organisation, or demutualise a mutual society. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Advantages of Public Company Listing
Access to additional capital. Increased negotiability of capital. Growth not limited by cash resources. Enhancement of corporate image. Can attract and retain key personnel. Gain independence from a spin-off. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Disadvantages of Public Company Listing
Dilution of control of existing owners. Additional responsibilities of directors. Greater disclosure of information. Explicit costs. Insider trading implications. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Secondary Issues Private placements—securities are offered and sold to a limited number of investors who are often the current major investors in the business. Rights issues—issue of shares made to all existing shareholders, who are entitled to take up the new shares in proportion to their present holdings. Terms are determined by: amount of funds required by the company the market price of the company’s securities general economic conditions desire to benefit shareholders nature of the company’s shareholders. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Underwriting Firm underwriting Standby underwriting
A guarantee that funds will be made available to a company at a specific time on agreed terms and conditions. Standby underwriting Where the bidding company has insufficient cash in a successful bid or if cash is offered as an alternative to a share bid. Best efforts underwriting Underwriter must use ‘best efforts’ to sell the securities at the agreed offering rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Underwriting Role of underwriter Sub-underwriter pricing the issue
marketing the issue engaging sub-underwriters placing the shortfall Sub-underwriter A group of underwriters formed to reduce the risk and to help to sell an issue. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Underwriting Fees The underwriter’s fee is a reflection of the:
size of the issue issue price general market conditions market attitude towards shares time period required for underwriting. Fees also include brokerage and management fees. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Average Initial Returns
Source: Ibbotson, Sindelar and Ritter (1988) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

New Equity Sales—Research Findings
Shares prices tend to decline after a new equity issue announcement, but rise following a debt announcement. Why? Management has superior information about firm value and knows when the firm is overvalued → sell equity. Excessive debt usage. Substantial issue costs. Management needs to understand the signals that an equity issue sends. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of Issuing Securities

Rights Offerings—Basic Concepts
Issue of ordinary shares to existing shareholders. Allows current shareholders to avoid the dilution that can occur with a new share issue. ‘Rights’ are given to the shareholders specifying: number of shares that can be purchased purchase price time frame. Shareholders can either exercise their rights or sell them. They neither win nor lose either way. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Rights Offerings—Basic Concepts
Subscription price The dollar cost of one of the shares to be issued, generally less than the current market price. Ex-rights date Beginning of the period when shares are sold without a recently declared right, normally four trading days before the holder-of-record date. The share price will drop by the value of the right. Holder-of-record date Date on which existing shareholders are designated as the recipients of share rights. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Ex-rights Share Prices
Rights-on Ex rights Announcement Ex-rights Record date date date 30 September 13 October 15 October Rights-on price $20.00 $3.33 =Value of a right Ex-rights price $16.67 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Theoretical Rights Price
Where: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Rights Issue Lemon Co. currently has 5 million shares on issue with a market price of $8 each. To finance new projects, the company needs to raise an additional $6 million. To raise the finance, the company makes a rights issue at a subscription price of $6 per share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Rights Issue (continued)
The number of new shares to be sold: The holder of one right is entitled to subscribe to one new share at $6 per share. To issue 1 million shares, the company would have to issue 1 million rights. The company has 5 million shares on issue, which means that for every 5 shares held, a shareholder is entitled to receive one right (1-for-5 rights issue). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Rights Issue (continued)
Calculate the theoretical rights price: If an outsider buys a right, it will cost $1.67. The right can be exercised at a subscription price of $6. Total cost of a new share = $ $6 = $7.67. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Value of Rights *$8.00 – 7.67 = 0.33 **$0.33 × 5 = $1.65

New Issues and Dilution
Loss in existing shareholders’ value in terms of either ownership, market value, book value or EPS. Types of dilution Dilution of proportionate ownership—a shareholder’s reduction in proportionate ownership due to less-than-proportionate purchase of new shares. Dilution of market value—loss in share value due to use of proceeds to invest in negative NPV projects. Dilution of book value and earnings per share (EPS) —reduction in EPS due to sale of additional shares. This has no economic consequences. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Corporate Debt The late 1980s saw a major growth in the Australian corporate debt market due to: the substantial cutback in the level of government borrowing the fall in interest rates from extremely high levels the flight to quality the shortage of government bonds the attractiveness of raising funds in the domestic market relative to that of the euromarket. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Long-term Debt Differences between direct, private long-term financing and public issues of debt include: direct loans avoid ASIC registration costs direct loans have more restrictive covenants term loans and private placements are easier to renegotiate than public issues private placements are dominated by life insurance companies and pension funds, whereas commercial banks dominate the term-loan market. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Eighteen Cost of Capital

Chapter Organisation 18.1 The Cost of Capital: Some Preliminaries
18.2 The Cost of Equity 18.3 The Costs of Debt and Preference Shares 18.4 The Weighted Average Cost of Capital 18.5 Divisional and Project Costs of Capital 18.6 Flotation Costs and the Weighted Average Cost of Capital 18.7 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Apply the dividend growth model approach and the SML approach to determine the cost of equity. Estimate values for the costs of debt and preference shares. Calculate the WACC. Discuss alternative approaches to estimating a discount rate. Understand the effects of flotation costs on WACC and the NPV of a project. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of Capital: Preliminaries
Vocabulary—the following all mean the same thing: required return appropriate discount rate cost of capital. The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. The assumption is made that a firm’s capital structure is fixed—a firm’s cost of capital then reflects both the cost of debt and the cost of equity. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. There are two major methods for determining the cost of equity: Dividend growth model SML or CAPM. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Dividend Growth Model Approach
According to the constant growth model: Rearranging: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cost of Equity Capital: Dividend Approach
Reno Co. recently paid a dividend of 15 cents per share. This dividend is expected to grow at a rate of 3 per cent per year into perpetuity. The current market price of Reno’s shares is $3.20 per share. Determine the cost of equity capital for Reno Co. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Estimating g One method for estimating the growth rate is to use the historical average. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Dividend Growth Model Approach
Advantages Easy to use and understand. Disadvantages Only applicable to companies paying dividends. Assumes dividend growth is constant. Cost of equity is very sensitive to growth estimate. Ignores risk. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The SML Approach Required return on a risky investment is dependent on three factors: the risk-free rate, Rf the market risk premium, E(RM) – Rf the systematic risk of the asset relative to the average,  Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cost of Equity Capital: SML Approach
Obtain the risk-free rate (Rf) from financial press— many use the 1-year Treasury note rate, say, 6 per cent. Obtain estimates of market risk premium and security beta: historical risk premium = 7.94 per cent (Officer, 1989) beta—historical investment information services estimate from historical data Assume the beta is 1.40. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cost of Equity Capital: SML Approach (continued)

The SML Approach Advantages Disadvantages Adjusts for risk.
Accounts for companies that don’t have a constant dividend. Disadvantages Requires two factors to be estimated: the market risk premium and the beta co-efficient. Uses the past to predict the future, which may not be appropriate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of Debt The cost of debt, RD, is the interest rate on new borrowing. RD is observable: yields on currently outstanding debt yields on newly-issued similarly-rated bonds. The historic cost of debt is irrelevant—why? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cost of Debt Ishta Co. sold a 20-year, 12 per cent bond 10 years ago at par. The bond is currently priced at $86. What is our cost of debt? The yield to maturity is 14.4 per cent, so this is used as the cost of debt, not 12 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of Preference Shares
Preference shares pay a constant dividend every period. Preference shares are a perpetuity, so the cost is: Notice that the cost is simply the dividend yield. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cost of Preference Shares
An $8 preference share issue was sold 10 years ago. It sells for $120 per share today. The dividend yield today is $8.00/$120 = 6.67 per cent, so this is the cost of the preference share issue. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Weighted Average Cost of Capital
Let: E = the market value of equity = no of outstanding shares × share price D = the market value of debt = no. of outstanding bonds × price Then: V = E + D So: E/V + D/V = 100% That is: The firm’s capital structure weights are E/V and D/V. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Weighted Average Cost of Capital
Interest payments on debt are tax deductible, so the after-tax cost of debt is: Dividends on preference shares and ordinary shares are not tax-deductible so tax does not affect their costs. The weighted average cost of capital is therefore: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Weighted Average Cost of Capital
Zeus Ltd has million ordinary shares on issue with a book value of $22.40 per share and a current market price of $58 per share. The market value of equity is therefore $4.54 billion. Zeus has an estimated beta of Treasury bills currently yield 4.5 per cent and the market risk premium is assumed to be 7.94 per cent. Company tax is 30 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Weighted Average Cost of Capital (continued)
The firm has four debt issues outstanding: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cost of Equity (SML Approach)

Example—Cost of Debt The weighted average cost of debt is 7.15 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Capital Structure Weights
Market value of equity = million × $58 = $4.539 billion. Market value of debt = $1.474 billion. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

WACC The WACC for a firm reflects the risk and the target capital structure to finance the firm’s existing assets as a whole. WACC is the return that the firm must earn on its existing assets to maintain the value of its shares. WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Divisional and Project Costs of Capital
When is the WACC the appropriate discount rate? When the project’s risk is about the same as the firm’s risk. Other approaches to estimating a discount rate: divisional cost of capital—used if a company has more than one division with different levels of risk pure play approach—a WACC that is unique to a particular project is used subjective approach—projects are allocated to specific risk classes which, in turn, have specified WACCs. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The SML and the WACC Expected return (%) SML = 8% Incorrect acceptance
16 15 14 B WACC = 15% A Incorrect rejection Rf =7 Beta A = .60 firm = 1.0 B = 1.2 If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Using WACC for all Projects
What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15 per cent Project Required Return IRR Decision A 15% 14% Reject B 15% 16% Accept Project A should be accepted because its risk is low (Beta = 0.60), whereas Project B should be rejected because its risk is high (Beta = 1.2). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The SML and the Subjective Approach
Expected return (%) SML = 8% 20 High risk (+6%) A WACC = 14 10 Rf = 7 Moderate risk (+0%) Low risk (–4%) Beta With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Flotation Costs The issue of debt or equity may incur flotation costs such as underwriting fees, commissions, listing fees. Flotation costs are relevant expenses and need to be reflected in any analysis. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Project Cost including Flotation Costs
Saddle Co. Ltd has a target capital structure of 70 per cent equity and 30 per cent debt. The flotation costs for equity issues are 15 per cent of the amount raised and the flotation costs for debt issues are 7 per cent. If Saddle Co. Ltd needs $30 million for a new project, what is the ‘true cost’ of this project? The weighted average flotation cost is 12.6 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Project Cost including Flotation Costs (continued)

Example—Flotation Costs and NPV
Apollo Co. Ltd needs $1.5 million to finance a new project expected to generate annual after-tax cash flows of $ forever. The company has a target capital structure of 60 per cent equity and 40 per cent debt. The financing options available are: An issue of new ordinary shares. Flotation costs of equity are 12 per cent of capital raised. The return on new equity is 15 per cent. An issue of long-term debentures. Flotation costs of debt are 5 per cent of the capital raised. The return on new debt is 10 per cent. Assume a corporate tax rate of 30 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—NPV (No Flotation Costs)

Example—NPV (With Flotation Costs)
Flotation costs decrease a project’s NPV and could alter an investment decision. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Nineteen Dividends and Dividend Policy

Chapter Organisation 19.1 Cash Dividends and Dividend Payment
Does Dividend Policy Matter? Real-world Factors Favouring a Low Payout Real-world Factors Favouring a High Payout A Resolution of Real-world Factors? Establishing a Dividend Policy Share Repurchase: An Alternative to Cash Dividends Share Dividends and Share Splits Employee Share Ownership Plans 19.10 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Know the different forms of dividends and the appropriate dividend payment terminology. Outline the arguments supporting the case for dividend irrelevance. Discuss factors favouring a low or a high payout. Explain the residual dividend policy. Illustrate the situation of share repurchases vs paying a cash dividend. Understand both bonus issues and share splits. Outline the various employee share ownership plans. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Dividends A dividend is a payment made out of a firm’s earnings to its owners (shareholders). Dividends are usually paid in the form of cash. Types of cash dividends include: regular cash dividends extra dividends special dividends liquidating dividends. Share dividends are also paid, and share repurchases are a dividend alternative. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Procedure for Dividend Payment

Procedure for Dividend Payment
Declaration date: the board of directors declares a payment of dividends. Ex-dividend date: if you buy the share on or after this date the seller is entitled to keep the dividend. Under ASX rules, shares are traded ex-dividend on and after the seventh business day before the record date. Record date: declared dividends are distributable to shareholders of record on a specific date. Payment date: the dividend cheques are mailed to shareholders of record. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Ex-date Price Drop Ex date -t . . . –2 –1 0 +1 +2 . . . t
The share price will fall by the amount of the dividend on the ex date (Time 0). If the dividend is $1 per share, the price will be equal to $10 – 1 = $9 on the ex date. Before ex date (Time –1) Dividend = $0 Price = $10 On ex date (Time 0) Dividend = $1 Price = $9 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Do Dividends Matter? Yes: the value of a share is based on the present value of expected future dividends. No: the value of a share is not affected by a switch in dividend policy. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Does Dividend Policy Matter?
Dividend policy versus cash dividends n An illustration of dividend irrelevance u Original dividends 1 2 $1000 $1000 If RE = 20%: P0 = $1000/1.2 + $1000/1.22 = $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Does Dividend Policy Matter?
Assume an additional $200 of dividends is offered, financed by an issue of debt or shares. New dividend plan: 1 2 $1000 $1000 +200 –240 $1200 $760 P0 = $1200/1.2 + $760/1.22 = $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dividend Policy Irrelevance
Any increase in dividends at one point is offset exactly by a decrease somewhere else. An alternative explanation is home-made dividends. Individual investors can undo corporate dividend policy by reinvesting dividends or selling shares. Companies may help with creating home-made dividends by offering shareholders automatic dividend reinvestment plans (DRIPs). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dividends and the Real World
A low payout is better if one considers: Taxes: Optimal dividend policy is determined by various shareholder situations. Some shareholders prefer high franked dividends, others prefer the company to pay no dividend and retain the funds for reinvestment (tax on dividend income vs capital gains tax). Flotation costs: Higher dividend payouts may require a new share issue, which could be expensive and decrease the value of the firm. Dividend restrictions: Debt contracts might limit the percentage of income that can be paid out as dividends. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dividends and the Real World
A high payout is better if one considers: Desire for current income instead of capital gain. Uncertainty resolution: ‘bird-in-hand’ story. Tax benefits: There are some investors who do receive favourable tax treatment from holding high dividends (e.g. corporate investors). Legal benefits. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Examples of Imputed Tax Credits

To Date … Based on the home-made dividend argument, dividend policy is irrelevant. Because of high taxation of some individual investors, a high-dividend policy may be best. Because of new issue costs, a low-dividend policy is best. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dividends and Signals Changes in dividends convey information
Dividend increases: Management believes it can be sustained. Expectation of higher future dividends, increasing present value. Signal of a healthy, growing firm. Dividend decreases: Management believes it can no longer sustain the current level of dividends. Expectation of lower dividends indefinitely; decreasing present value. Signal of a firm that is having financial difficulties. The information content makes it difficult to interpret the effect of the dividend policy of the firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Clientele Effect Shares attract particular groups based on dividend yield and the resulting tax effects. Some investors prefer low dividend payouts and will buy shares in those companies that offer low dividend payouts. Some investors prefer high dividend payouts and will buy shares in those companies that offer high dividend payouts. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Residual Dividend Policy
Issue costs eliminate any indifference between financing by internal capital and new shares. Dividends are paid only if profits are not completely used for investment purposes. Desired debt-to-equity ratio is maintained. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Residual Dividend Policy

Relationship Between Dividends and Investment
New investment Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Key Concepts in Dividend Policy
Dividend stability—dividends are only increased if the increase is sustainable. Dividend streaming—shareholders can choose different dividend schemes to suit their tax position (franked vs unfranked dividends) Special dividends—‘one-off’’ extra dividends. Dividend reinvestment schemes—company reinvests individuals’ dividends into fully paid shares of the company. Avoids transactions costs and need for prospectus, and shares are usually offered at a discount. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Australian Equity Raisings 2001
Source: Australian Stock Exchange Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Share Repurchases Company buys back its own shares.
Similar to a cash dividend in that it returns cash from the firm to the shareholders. This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Share Repurchases Equal access purchase
Offer made by company to all shareholders to purchase shares in the same proportion as their holdings. On-market purchase Purchase by a company of its own shares on the open market. Employee share purchase Repurchase shares from employees that were issued under employee incentive scheme. Selective purchase Repurchase of shares from specific shareholders. Odd-lot purchase Repurchase of small parcels of shares. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Dividend versus Share Repurchase
Assume no taxes, commissions or other market imperfections. Consider a firm with shares outstanding, net profit of $ and the following balance sheet. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Dividend versus Share Repurchase (continued)
Price per share is $20 ($ /50 000). EPS = $2.00 ($ /50 000). PE ratio = 10. The firm is considering either: Paying a $1 per share cash dividend. OR Repurchasing 2500 shares at $20 a share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cash Dividend Option Cash $ $ 0 Debt Other Assets Equity Total $ Price per share is $19.00 ($ /50 000). EPS = $2.00 ($ /50 000). PE ratio = 10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Share Repurchase Option Cash $ $ 0 Debt Other Assets Equity Total $ Price per share is $20.00 ($ /47 500). EPS = $2.10 ($ /47 500). PE ratio = 9.5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Share Dividends and Share Splits
Bonus shares and share splits: involve issuing new shares on a pro-rata basis to the current shareholders do not change the firm’s assets, earnings, risk assumed and investors’ percentage of ownership in the company increase the number of shares outstanding reduce the value per share A common explanation is to adjust the share price to a ‘more desirable trading range’. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Reverse Splits The firm reduces the number of shares outstanding.
Reasoning: reduction in transaction costs increase in share marketability (trading range) regain respectability. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Share Ownership Plans Encourage the financial participation of employees in the company, including: fully paid shares partly paid shares special classes of shares options phantom or shadow shares employee share trusts. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Twenty Financial Leverage and Capital Structure Policy

Chapter Organisation 20.1 The Capital Structure Question
The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I & II With Corporate Taxes Bankruptcy Costs Optimal Capital Structure The Pie Again Corporate versus Personal Borrowing Observed Capital Structures 20.10 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the impact of financial leverage on a firm’s capital structure. Illustrate the concept of home-made leverage. Outline both M&M Proposition I and M&M Proposition II. Discuss the impact of corporate taxes on M&M Propositions I and II. Understand the impact of bankruptcy costs on the value of a firm. Identify a firm’s optimal capital structure. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Capital Structure Question
Key issues What is the relationship between capital structure and firm value? What is the optimal capital structure? Cost of capital A firm’s capital structure is chosen if WACC is minimised. This is known as the optimal capital structure or target capital structure. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Computing Break-even EBIT
ABC Company currently has no debt in its capital structure. The company has decided to restructure, raising $2.5 million debt at 10 per cent. ABC currently has shares on issue at a price of $10 per share. As a result of the restructure, what is the minimum level of EBIT the company needs to maintain EPS (the break-even EBIT)? Ignore taxes. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Computing Break-even EBIT (continued)
With no debt: EPS = EBIT/ With $2.5 million in 10%: EPS = (EBIT – $ )/ 1 Interest expense = $2.5 million × 10% = $ 2 Debt raised will refund ($2.5 million/$10)shares, leaving shares outstanding Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Computing Break-even EBIT (continued)
These are then equal: EPS = EBIT/ = (EBIT – $ )/ With a little algebra: EBIT = $  EPSBE = $1.00 per share Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financial Leverage, EPS and EBIT
3 2.5 2 1.5 1 0.5 – 0.5 – 1 D/E = 1 D/E = 0 EBIT ($ millions, no taxes) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Home-made Leverage and ROE
Home-made leverage is the use of personal borrowing to alter the degree of financial leverage. Investors can replicate the financing decisions of the firm in a costless manner. Example Original capital structure and home-made leverage  investor uses $500 of their own and borrows $500 to purchase 100 shares. Proposed capital structure  investor uses $500 of their own, together with $250 in shares and $250 in bonds. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Original Capital Structure and Home-made Leverage

Proposed Capital Structure

Capital Structure Theory
Modigliani and Miller Theory of Capital Structure Proposition I—firm value Proposition II—WACC The value of the firm is determined by the cash flows to the firm and the risk of the assets Changing firm value: Change the risk of the cash flows Change the cash flows Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

M&M Proposition I Value of firm Value of firm
(The size of the pie does not depend on how it is sliced.) The value of the firm is independent of its capital structure. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

M&M Proposition II Because of Proposition I, the WACC must be constant, with no taxes: WACC = RA = (E/V) × RE + (D/V) × RD where RA is the required return on the firm’s assets Solve for RE to get M&M Proposition II: RE = RA + (RA – RD) × (D/E) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of Equity and the WACC
Cost of capital RE = RA + (RA – RD ) x (D/E) WACC = RA RD Debt-equity ratio, D/E The firm’s overall cost of capital is unaffected by its capital structure. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Business and Financial Risk
By M&M Proposition II, the required rate of return on equity arises from sources of firm risk. Proposition II is: RE = RA + [RA – RD] × [D/E] Business risk—equity risk arising from the nature of the firm’s operating activities (measured by RA). Financial risk—equity risk that comes from the financial policy (i.e. capital structure) of the firm (measured by [RA – RD] × [D/E]). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The SML and M&M Proposition II
How do financing decisions affect firm risk in both M&M’s Proposition II and the CAPM? Consider Proposition II: All else equal, a higher debt/equity ratio will increase the required return on equity, RE. RE = RA + (RA – RD) × (D/E) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The SML and M&M Proposition II
Substitute RA = Rf + (RM  Rf)βA and by replacement RE = Rf + (RM  Rf)βE The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity. βE = βA(1 + D/E) Debt increases systematic risk (and moves the firm along the SML). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Corporate Taxes The interest tax shield is the tax saving attained by a firm from interest expense. Assumptions: perpetual cash flows no depreciation no fixed asset or NWC spending. For example, a firm is considering going from $0 debt to $400 debt at 10 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Corporate Taxes Tax saving = $16 = 0.40 x $40 = TC × RD × D

Corporate Taxes What is the link between debt and firm value?
Since interest creates a tax deduction, borrowing creates a tax shield. The value added to the firm is the present value of the annual interest tax shield in perpetuity. M&M Proposition I (with taxes): Key result VL = VU + TCD Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

M&M Proposition I with Taxes
Value of the firm (VL) VL = VU + TC x D = TC TC x D VL= VU + $160 VU VU VU Total debt (D) $400 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Taxes, the WACC and Proposition II
Taxes and firm value: an example EBIT = $100 TC = 30% RU = 12.5% Suppose debt goes from $0 to $100 at 10 per cent. What happens to equity value, E? VU = $100 × (1 – 0.30)/0.125 = $560 VL = $560 + (0.30 × $100) = $590  E = $490 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

WACC and the cost of equity (M&M Proposition II with taxes): RE = RU + (RU – RD) × (D/E) × (1 – TC) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Taxes, the WACC and Propositions I and II—Conclusions
The WACC decreases as more debt financing is used. Optimal capital structure is all debt. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cost of capital (%) RE RE RU RU WACC WACC RD  (1 – TC) RD  (1 – TC) Debt-equity ratio, D/E Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bankruptcy Costs Borrowing money is a good news/bad news proposition.
The good news: interest payments are deductible and create a debt tax shield (TCD). The bad news: all else equal, borrowing more money increases the probability (and therefore the expected value) of direct and indirect bankruptcy costs. Key issue: The impact of financial distress on firm value. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Direct versus Indirect Bankruptcy Costs
Direct costs Those costs directly associated with bankruptcy, (e.g. legal and administrative expenses). Indirect costs Those costs associated with spending resources to avoid bankruptcy. Financial distress: significant problems in meeting debt obligations most firms that experience financial distress do recover. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Direct versus Indirect Bankruptcy Costs
The static theory of capital structure: A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. This is the point at which WACC is minimised and the value of the firm is maximised. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Optimal Capital Structure and the Value of the Firm
Value of the firm (VL ) VL = VU + TC  D Present value of tax shield on debt Financial distress costs Maximum firm value VL* Actual firm value VU VU = Value of firm with no debt Debt-equity ratio, D/E D/E Optimal amount of debt Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Optimal Capital Structure and the Cost of Capital
WACC Minimum cost of capital RD  (1 – TC) WACC* Debt/equity ratio (D/E) D*/E* The optimal debt/equity ratio Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Capital Structure Question
Value of the firm ( VL ) Case II M&M (with taxes) VL* PV of bankruptcy costs Case III Static Theory Net gain from leverage VU Case I M&M (no taxes) Total debt (D) D* Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Managerial Recommendations
The tax benefit is only important if the firm has a large tax liability. Risk of financial distress: The greater the risk of financial distress, the less debt will be optimal for the firm. The cost of financial distress varies across firms and industries. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Lower financial leverage Higher financial leverage
The Extended Pie Model Lower financial leverage Higher financial leverage Bondholder claim Bondholder claim Shareholder claim Bankruptcy claim Shareholder claim Bankruptcy claim Tax claim Tax claim Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Value of the Firm Value of the firm = marketed claims + non-marketed claims: Marketed claims are the claims of shareholders and bondholders. Non-marketed claims are the claims of the government and other potential stakeholders. The overall value of the firm is unaffected by changes in the capital structure. The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Corporate Borrowing and Personal Borrowing
Without tax, corporate and personal borrowing are interchangeable. With corporate and personal tax, there is an advantage to corporate borrowing because of the interest tax shield. With corporate and personal tax, and dividend imputation, shareholders are again indifferent between corporate and personal borrowing. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Dynamic Capital Structure Theories
Pecking order theory Investment is financed first with internal funds, then debt, and finally with equity. Information asymmetry cost Management has superior information on the prospects of the firm. Agency costs of debt These occur when equity holders act in their own best interests rather than the interests of the firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Twenty-one Options, Corporate Securities and Futures

Chapter Organisation 21.1 Options: The Basics
21.2 Fundamentals of Options Valuation 21.3 Valuing a Call Option 21.4 Black–Scholes Option Pricing Model 21.5 Equity as a Call Option on the Firm’s Assets 21.6 Types of Equity Option Contracts 21.7 Futures Contracts 21.8 Term Structure of Interest Rates 21.9 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the key terminology associated with options. Outline the five factors that determine option values. Price call options using the Black–Scholes option pricing model. Discuss the types of equity option contracts offered. Outline the types of warrants available to investors. Discuss the characteristics of future contracts. Understand the term structure of interest rates. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Option Terminology Call option Put option European option
Right to buy a specified asset at a specified price on or before a specified date. Put option Right to sell a specified asset at a specified price on or before a specified date. European option An option that can only be exercised on a particular date (on expiry). American option An option that can be exercised at any time up to its expiry date. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Option Terminology Striking price Expiration date Option premium
The contracted price at which the underlying asset can be bought (call) or sold (put). Expiration date The date at which an option expires. Option premium The price paid by the buyer for the right to buy or sell an asset. Exercising the option The act of buying or selling the underlying asset via the option contract. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Option Contract Characteristics
Expiration month Option type Contract size Expiry Exercise price Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Option Valuation S1 = share price at expiration S0 = share price today
C1 = value of call option on expiration C0 = value of call option today E = exercise price on the option Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Value of Call Option at Expiration
Call option value at expiration (C1) S1  E S1 > E Share price at expiration (S1) 45 Exercise price (E) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Value of Call Option at Expiration
Option is out of the money. Option is in the money. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Value of a Call Option Before Expiration
Call price (C0) Upper bound C0  S0 Lower bound C0  S0 – E C0  0 45 Share price (S0) Exercise price (E) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Call Option Boundaries
Upper bound—a call option will never be worth more than the share itself: C0  S0 Lower bound—share price cannot fall below 0 and to prevent arbitrage, the call value must be (S0 – E): The larger of 0 or (S0 – E) Intrinsic value—option’s value if it was about to expire = lower bound. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Factors Determining Option Values
The value of a call option depends on four factors: share price exercise price time to expiration risk-free rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Another Factor to Consider?
The above four factors are relevant if the option is to finish in the money. If the option can finish out of the money, another factor to consider is volatility. The greater the volatility in the underlying share price, the greater the chance the option has of expiring in the money. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Factors that Determine Option Value

Black–Scholes Option Pricing Model

Black–Scholes Option Pricing Model
Note: The risk-free rate, the standard deviation and the time to maturity must all be quoted using the same time units. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Black–Scholes Option Pricing Model
Rf = 8%  = 30% t = 0.5 years Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Black–Scholes Option Pricing Model (continued)

Example—Black–Scholes Option Pricing Model (continued)
From the cumulative normal distribution table: N(d1) = N(1.34) = N(d2) = N(1.13) = Therefore, the value of the call option is: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Equity: A Call Option Equity can be viewed as a call option on the company’s assets when the firm is leveraged. The exercise price is the value of the debt. If the assets are worth more than the debt when it becomes due, the option will be exercised and the shareholders retain ownership. If the assets are worth less than the debt, the shareholders will let the option expire and the assets will belong to the bondholders. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Equity Option Contracts
Types of equity option contracts offered in Australia: Exchange traded put and call options on company shares Exchange traded long dated contracts issued by a financial institution that can then trade them (warrants) Over-the-counter options on company shares Convertible notes issued by companies, comprising both a debt and an equity component. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Warrants A long-lived option that gives the holder the right to buy shares in a company at a specified price. Types of warrants available: equity warrants low exercise price warrants fractional warrants endowment warrants basket warrants currency warrants fully covered warrants index warrants instalment warrants Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Company Options A holder is given the right to purchase shares in a company at a specified price over a given period of time. Usually offered as a ‘sweetener’ to a debt issue. These options are often detached and sold separately. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Company Options versus Exchange-traded Options
Company options have longer maturity periods and are often European-type options. Company options are issued as part of a capital- raising program and are therefore limited in number. The clearing house has no role in the trading of company options. Company options are issued by firms. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Earnings Dilution Put and call options have no effect on the value of the firm. Company options do affect the value of the firm. Company options cause the number of shares on issue to increase when: the options are exercised the debts are converted. This increase does not lower the price per share but EPS will fall. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Forward Contracts A contract where two parties agree on the price of an asset today to be delivered and paid for at some future date. Forward contracts are legally binding on both parties. They can be tailored to meet the needs of both parties and can be quite large in size. Positions Long—agrees to buy the asset at the future date Short—agrees to sell the asset at the future date Because they are negotiated contracts and there is no exchange of cash initially, they are usually limited to large, creditworthy corporations. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Forward Contracts A. Buyer’s perspective B. Seller’s perspective ∆V ∆V
Payoff profile ∆Poil ∆Poil Payoff profile A. Buyer’s perspective B. Seller’s perspective Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Futures Contracts An agreement between two parties to exchange a specified asset at a specified price at a specified time in the future. Do not need to own an asset to sell a future contract. Either buy before delivery or close out position with an opposite market position. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Futures Markets Enable buyers and sellers to avoid risk in commodities (and other) markets with high price variability → hedging. Involves standardised contracts. Deposit required by all traders to guarantee performance. Adverse price movements must be covered daily by further deposits called margins (‘marked to market’). Futures also available for short-term interest rates, to protect against interest rate movements. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Futures Quotes Commodity, exchange, size, quote units
The contract size is important when determining the daily gains and losses for marking-to-market. Delivery month Open price, daily high, daily low, settlement price, change from previous settlement price, contract lifetime high and low prices, open interest The change in settlement price multiplied by the contract size determines the gain or loss for the day: Long—an increase in the settlement price leads to a gain Short—an increase in the settlement price leads to a loss Open interest is how many contracts are currently outstanding. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Term Structure of Interest Rates

Term Structure of Interest Rates
Yield curve shows the different interest rates available for investments of different maturities, at a point in time. The relationship between interest rates of different maturities is called the term structure. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Factors Determining the Term Structure
Risk preferences—borrowers prefer long-term credit whereas lenders prefer short-term loans (explains upward-sloping yield curve only). Supplydemand conditions—segmented capital markets can cause supplydemand imbalances (explains all yield curve shapes). Expectations about future interest rates (most favoured explanation) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Twenty-two Mergers, Acquisitions and Takeovers

Chapter Organisation 22.1 The Legal Forms of Acquisitions
22.2 Regulation of Business Combination 22.3 Taxes and Acquisitions 22.4 Gains from Acquisition 22.5 Some Financial Side-effects of Acquisitions 22.6 The Cost of an Acquisition 22.7 Defensive Tactics 22.8 Some Evidence on Acquisitions 22.9 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Discuss the legal forms of acquisitions.
Understand the legal framework for mergers, acquisitions and takeovers. Discuss the gains from acquisition. Explain the financial side-effects of acquisitions. Calculate the costs and NPV of an acquisition. Identify and discuss possible defensive tactics to a takeover attempt. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Legal Forms of Acquisitions
Merger  complete absorption of one company by another. Consolidation  creation of a new firm by combining two existing firms. Advantages of mergers and consolidations: simplicity (buyer assumes all assets and liabilities) inexpensive. Disadvantages of mergers and consolidations: shareholders of both firms must approve difficulty in obtaining cooperation of target company’s management. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Legal Forms of Acquisitions
Acquisition of assets  transfer of assets and liabilities of the target company to the acquiring company. Acquisition of shares (tender offer)  acquire sufficient voting shares to gain management control via a direct public offer for the shares. Majority control versus effective control. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Acquisition Classifications
Horizontal acquisition  between two firms in the same industry. Vertical acquisition  the buyer expands backwards by acquiring a firm with the source of raw materials or forwards by acquiring a firm that is closer in the direction of the ultimate consumer. Conglomerate acquisition  involves companies in unrelated industries. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

A Note on Takeovers Merger or consolidation Acquisition
Acquisition of stock Takeovers Proxy contest Acquisition of assets Going private (leveraged buyouts) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Takeover Situations Creeping takeover Off market bid Market bid
Holdings in a target company can be increased by no more than 3 per cent every six months. Off market bid A formal written offer is made to acquire the shares of a target company. Market bid An announcement by a stockbroker that a broking firm will stand in the market to purchase the target company’s shares for a specified price for a specified period. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Australian Securities
The Legal Framework Common law Enacted law (legislation) Stock Exchange Rules Contract law Law of tort Trade Practices Act 1974 Corporations Act 2001 Australian Securities Commission Act 1989 Corporations Regulations Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Taxes and Acquisitions
Generally, assets purchased after 19 September 1985 are subject to capital gains tax (CGT) when sold. CGT can be deferred under rollover provisions. CGT still applies when the consideration is shares, and when more than 50 per cent of pre-19 September 1985 shareholders have changed (regardless of purchase date). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Gains from Acquisition
Synergy  the value of the combined companies is higher than the sum of the value of the individual companies. Need to determine incremental cash flows. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

= Revenue – Cost – Tax – Capital requirements A. Increased revenues 1. Gains from better marketing efforts. 2. Strategic benefits—‘beachhead’ into new markets. 3. Increased market power—monopoly. B. Decreased costs 1. Economies of scale. 2. Economies of vertical integration. 3. Complementary resources. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

C. Tax gains 1. Use of net operating losses. 2. Use of excess or unused franking credits. 3. Use of unused debt capacity. 4. Asset revaluations. D. Changing capital requirements 1. Reduced investment needs. 2. More efficient asset management. 3. Sell redundant assets. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Mistakes to Avoid Do not ignore market values.
Estimate only incremental cash flows. Use the correct discount rate. Be aware of transactions costs. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Acquisitions and EPS Growth
Pizza Shack and Checkers Pizza are merging to form Stop ’n’ Go Pizza. The merger is not expected to create any additional value. Stop ‘n’ Go, valued at $ , is to have shares outstanding at $15 per share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Before and after merger financial positions Stop ’n’ Go shares to Pizza Shack holders Stop ’n’ Go shares to Checkers holders Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

EPS has increased (and the P/E ratio has decreased) because the total number of shares is less. The merger has not ‘created’ value. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Diversification Does not create value in a merger.
Is not, in itself, a good reason for a merger. Reduces unsystematic risk. BUT Shareholders can do this for themselves more easily and less expensively. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of an Acquisition
The net incremental gain from a merger of Firms A and B is: V = VAB – (VA + VB) The total value of Firm B to Firm A is: VB* = VB + V The NPV of the merger is: NPV = VB* – Cost to Firm A of the acquisition The cost of the acquisition to Firm A depends on the medium of exchange used to acquire Firm B—cash or shares. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

The Cost of an Acquisition
Whether cash or shares are used to finance the acquisition depends on the following factors: Sharing gains: If cash is used, the selling firm’s shareholders will not participate in the potential gains (or losses) from the merger. Control: Control of the acquiring firm is unaffected in a cash acquisition. Acquisition with voting shares may have implications for control of the merged firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cash or Shares?
Pre-merger information for Firm A and Firm B: Both firms are 100 per cent equity financed. The estimated incremental value of the acquisition is $500. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cash or Shares? (Continued)
Firm B has agreed to a sale price of $675, payable in cash or shares. The value of Firm B to Firm A is: How much does Firm A have to give up? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cash Acquisition
Cost of acquiring Firm B is $675. NPV of the cash acquisition is: The value of Firm A after the merger is: Price per share after the merger is $18.20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Share Acquisition
The value of the merged firm: Firm A must give up $675/$15 = 45 shares. After the merger there will be 165 shares outstanding, valued at $17.33 per share. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Share Acquisition
True cost of the acquisition: 45 shares × $17.33 = $779.85 NPV of the merger to Firm A: Cash acquisition preferred (higher NPV). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Defensive Tactics Managers who believe their firms are likely to become takeover targets and who wish to fend off unwanted acquirers often implement one or more takeover defences. These defensive tactics take several forms: Friendly shareholders offer the best defence. Poison pills—designed to ‘repel’ takeover attempts. Share rights plans—allow existing shareholders to purchase shares at some fixed price in the event of a takeover bid. Going private and leveraged buyouts—the publicly owned shares in a firm are replaced with complete equity ownership by a private group (often financed by debt). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Terminology of Defensive Tactics
Golden parachutes—compensation to top-level management. Poison puts—purchase securities back at a set price. Crown jewels—selling off of major assets. White knights—acquisition by a ‘friendly’ firm. Lockups—option for a ‘friendly’ firm to purchase shares or assets at a fixed price. Shark repellant—designed to discourage unwanted mergers. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Evidence on Acquisitions
Shareholders of target companies involved in successful takeovers gain substantially. Abnormal gains of around 25 per cent reflect merger premium. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Evidence on Acquisitions
Shareholders of bidding firms involved in successful takeovers only experience gains of 5 per cent. There are a variety of explanations for this: Overestimated anticipated gains Scale effect (bidders usually larger than targets) Agency problem Competitive market for takeovers Gains already reflected in bidder’s price (no new information) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Twenty-three International Corporate Finance

Chapter Organisation 23.1 Terminology
23.2 Foreign Exchange Markets and Exchange Rates 23.3 Purchasing Power Parity 23.4 Interest Rate Parity, Unbiased Forward Rates and the International Fisher Effect 23.5 International Capital Budgeting 23.6 Exchange Rate Risk 23.7 Political Risk 23.8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Be familiar with international finance terminology.
Apply exchange rates and cross rates. Understand triangle arbitrage and covered interest arbitrage. Distinguish between purchasing power parity, interest rate parity, unbiased forward rates, uncovered interest parity and the international Fisher effect. Calculate the NPV of a foreign operation in home currency terms. Explain exchange rate risk and political risk. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Domestic versus International Financial Management
Whenever transactions involve more than one currency, the levels of, and possible changes in, exchange rates need to be considered. The risk of loss associated with actions taken by foreign governments also needs to be considered. This political risk can be difficult to assess and difficult to hedge against. Financing opportunities encompass international capital markets and instruments, which can reduce the firm’s cost of capital. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

International Finance Terminology
Cross rate The implicit exchange rate between two currencies quoted in some third currency. Euro The monetary unit for the European Monetary System (EMS). Eurobonds International bonds issued in multiple countries but denominated in the issuer’s currency. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Eurocurrency Money deposited in a financial centre outside the country whose currency is involved. Foreign bonds International bonds issued in a single country usually denominated in that country’s currency. Foreign exchange market The market in which one country’s currency is traded for another. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Gilts British and Irish government securities. London Interbank Offer Rate (LIBOR) The rate most international banks charge one another for overnight Eurodollar loans. Swaps Agreements to exchange two securities or currencies. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Global Capital Markets
Asia/Pacific Region Americas Australian Stock Exchange New York Stock Exchange Sydney Futures Exchange American Stock Exchange New Zealand Stock Exchange Boston Stock Exchange Cincinnati Stock Exchange Hong Kong Stock Exchange Chicago Stock Exchange Hong Kong Futures Exchange Pacific Stock Exchange Philadelphia Stock Exchange Shanghai Securities Exchange Chicago Board of Trade Shenzen Stock Exchange Kansas City Board of Trade Toronto Stock Exchange Osaka Stock Exchange Europe and the UK Tokyo Stock Exchange Tokyo Int’l Financial Futures Exchange Frankfurt Stock Exchange London Stock Exchange Singapore Stock Exchange Paris Bourse Swiss Stock Exchange Kuala Lumpur Stock Exchange Nasdaq Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Participants in Foreign Exchange Market
Importers Exporters Portfolio managers Foreign exchange brokers Traders Speculators Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Exchange Rates Q: If you wish to exchange $100 for British pounds at an exchange rate of $A1/£0.337, how many pounds will you receive? A: $A100 × (0.337) = £33.7 Q: You paid 20 French francs for a croissant in France. If the exchange rate is $A1/FF4.1184, how much did it cost in dollars? A: FF20  = $A4.8563 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Exchange Rate Quotations
$US – Rate at which dealer BUYS $US or SELLS $A Rate at which dealer SELLS $US or BUYS $A Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Exchange Rates
If you wish to convert $A1000 to $US at the above exchange rates: you SELL $A; therefore, the dealer BUYS $A $A1000 × = $US519 If you now convert $US519 back to $A: you BUY $A; therefore, the dealer SELLS $A $US519  = $A995.21 The difference is the dealer fee ($A1000  = $A4.79). Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Triangle Arbitrage You have observed the following exchange rates:
$A1/FF10 $A1/DM2.00 DM/FF4.00 Step 1 Buy 1000 francs for $100 Step 3 Exchange DM250 for $A125 Step 2 Buy DM250 for FF1000 You have just made $A25! Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Cross Rates To prevent triangle arbitrage: Cross rate must be:
the $A can be exchanged for FF10 or DM2.00 Cross rate must be: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Cross Rates The exchange rates for the British pound and the Japanese yen are: $A1 = £0.3538 $A1 = ¥63.74 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Transactions Spot deal  an agreement to trade currencies based on the exchange rate today for settlement within two business days. Spot exchange rate  the exchange rate on a spot deal. Forward deal  an agreement to exchange currency at some time in the future. Forward exchange rate  the agreed-upon exchange rate to be used in a forward deal. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Purchasing Power Parity
The idea that the exchange rate adjusts to keep purchasing power constant among currencies. Absolute purchasing power parity (PPP)—a commodity costs the same regardless of what currency is used to purchase it or where it is selling. For absolute PPP to hold: transaction costs must be zero there must be no barriers to trade the items purchased must be identical in all locations. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Relative Purchasing Power Parity
The idea that the change in the exchange rate between two currencies is determined by the difference in inflation rates between the two countries. Relative PPP, therefore, explains the changes in exchange rates over time rather than the absolute levels of exchange rates. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Relative PPP Equation Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Relative PPP The German exchange rate is currently 1.3 DM per dollar. The inflation rate in Germany over the next five years is estimated to be 5 per cent per year, while the Australian inflation rate is estimated to be 3 per cent per year. What will be the estimated exchange rate in five years? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Relative PPP
The DM will become less valuable; $A will become more valuable. The exchange rate change will be 5% – 3% = 2% per year. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Covered Interest Arbitrage (CIA)
Assume: S0 = $A1/¥66.42 F1 = $A1/¥64.80 RA = 7% RJ = 5% $A @ 7% $A $A Profit @ ¥ year @ ¥64.80 ¥ @ 5% ¥ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Interest Rate Parity (IRP)
The interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Unbiased Forward Rates (UFR)
The current forward rate is an unbiased predictor of the future spot exchange rate. On average, the forward exchange rate is equal to the future spot exchange rate. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Uncovered Interest Parity (UIP)
The expected percentage change in the exchange rate is equal to the difference in interest rates. Combines IRP and UFR. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

International Fisher Effect (IFE)
Real interest rates are equal across countries. Combines PPP and UFR. Ignores risk and barriers to capital movements. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—International Capital Budgeting
Pizza Shack is considering opening a store in Mexico. The store would cost $A or 3 million pesos (at an exchange rate of $A1/6.000 pesos). They hope to operate the store for two years and then sell it to a local franchisee. Assume that the expected cash flows are pesos in the first year and 5 million pesos in year 2 (including the selling price of the store and fixtures). The Australian risk-free rate is 7 per cent and the Mexican risk-free rate is 10 per cent. The required return in Australia is 12 per cent. Ignore taxes. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Method 1: Home Currency Approach
Using the interest rate parity relationship: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Method 2: Foreign Currency Approach
Using a 3 per cent inflation premium: (1.12 × 1.03) – 1 = 15.36% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Exchange Rate Risk The risk related to having international operations in a world where currency values vary. Short-run exposure—uncertainty arising from day-to-day fluctuations in exchange rates. Long-run exposure—potential losses due to long-run, unanticipated changes in the relative economic conditions in two or more countries. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Translation Exposure Uncertainty arising from the need to translate the results from foreign operations (in foreign currency) to home currency for accounting purposes. What is the appropriate exchange rate to use for transferring each balance sheet account? How should balance sheet accounting gains and losses from foreign currency translation be handled? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Political Risk Changes in value due to political actions in the foreign country. Investment in countries that have unstable governments should require higher returns. The extent of political risk depends on the nature of the business: The more dependent the business is on other operations within the firm, the less valuable it is to others. Natural resource development can be very valuable to others, especially if much of the ground work in developing the resource has already been done. Local financing can often reduce political risk. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Political Risk

Chapter Twenty-four Leasing

Chapter Organisation 24.1 The Nature of Leases 24.2 Types of Leases
24.3 A Brief Look at Accounting for Leases 24.4 Taxation and Leases 24.5 An Evaluation of Leasing 24.6 The Role of the Residual Value 24.7 Setting Lease Premiums 24.8 Alleged Advantages and Disadvantages of Leasing 24.9 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter Objectives Understand the characteristics of the different types of leases. Explain how leases are recorded in a firm’s accounting records. Identify the tax implications of leases. Evaluate a lease by calculating the net advantage of leasing (NAL). Explain the calculation of lease premiums. Discuss the advantages and disadvantages of leases. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Leasing versus Buying Buy Lease
Sass buys asset and uses asset; financing raised by debt Sass leases asset from lessor; the lessor owns the asset Manufacturer of asset Manufacturer of asset Sass arranges financing and buys asset from manufacturer Sass leases asset from lessor Lessee (Sass) Uses asset Does not own asset Sass 1. Uses asset Owns asset Lessor Owns asset Does not use asset Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Leasing What is a lease? A lessee (user) enters an agreement in which they make lease payments to the lessor (owner) in return for the use of the leased property/asset. Who are the major providers of lease finance in Australia? Finance companies and banks. What assets are leased? Any asset including photocopiers, cars, construction equipment, computers, shop/office fittings and equipment. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Leases Operating lease Financial lease
Sale and leaseback agreement Leveraged lease Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Operating Leases Short-term lease.
Cancellable prior to the expiry date at little or no cost. Lessor is responsible for maintenance and upkeep of asset. The sum of the lease payments does not provide for full recovery of the asset’s costs. Includes telephones, televisions, computers, photocopiers, cars. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Financial Leases Long-term lease.
Non-cancellable (without penalty) prior to expiry date. Lessee is responsible for the maintenance and upkeep of the asset. Lease period approximates asset’s economic life. The sum of the lease payments exceeds the asset’s purchase price. Includes specialist equipment, heavy industrial equipment. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Residual Value Clause Lease continues for its full term
Lessee can purchase the asset for its residual value, return the asset to the lessor (paying any shortfall from residual value) or renew the lease. Lease is cancelled during its initial term Lessee must pay outstanding premiums (less interest component) plus residual value of asset. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Types of Financial Leases
Sale and leaseback agreements Companies sell an asset to another firm and immediately lease it back. Enables the company to receive cash and yet maintain use of the asset. Leveraged leases The lessor arranges for funds to be contributed by one or more parties—form of risk-sharing and transferring tax benefits. Often used to finance large-scale projects. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Leasing and the Statement of Financial Position
A. Statement of Financial Position with Purchase (company finances $ truck with debt) Truck $ Debt $ Other assets Equity Total assets $ Debt plus equity $ B. Statement of Financial Position with Operating Lease (co. finances truck with an operating lease) Truck $ Debt $ Other assets Equity Total assets $ Debt plus equity $ C. Statement of Financial Position with Financial Lease (co. finances truck with a financial lease) Assets under financial Obligations under lease $ financial lease $ Other assets Equity Total assets $ Debt plus equity $ Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Criteria for a Financial Lease
AAS17 ‘Accounting for Leases’ states that a financial lease occurs where substantially all risks and benefits pass to the lessee. A financial lease must be disclosed on the Statement of Financial Position if at least one of the following criteria is met: the lease term is 75 per cent or more of the estimated economic life of the asset the present value of the lease payments is at least 90 per cent of the fair market value of the asset at the start of the lease. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Leasing and Taxation Lease premiums paid under a lease contract are tax deductible. Any payment relating to the ultimate purchase of the asset is not deductible. The residual payment does not qualify as a tax deduction. Any profit made on the asset previously leased is subject to capital gains tax. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Lease versus Buy
Macca Co. has to decide whether to borrow the $ needed to purchase a new gadget machine (with a borrowing cost of 10 per cent) or to lease the machine for $4000 per annum. If purchased, the asset could be depreciated using the straight-line method over the three-year life. The company tax rate is 30 per cent. Under the lease agreement, Macca Co. would be responsible for maintaining the machine. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Lease versus Buy: Repayment Schedule

Example—Lease versus Buy: Tax Subsidises Borrowing

Example—Lease versus Buy: Tax Subsidises Leasing

Example—Lease versus Buy: Net Advantage of Leasing
The advantage is greater than zero so Macca Co. should lease. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Residual Value The residual value is the amount for which the asset may be purchased by the lessee from the lessor at the end of the lease term. The salvage value is the amount the asset can be sold for in the market place by the lessee (once they have acquired the asset). In the previous example, assume a residual value of $2000 and a salvage value of $1500. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Lease the Asset with Residual Value

Example—Borrow to Purchase the Asset with Residual Value

Net Advantage of Leasing

Setting Lease Premiums
Lease premiums are paid in advance in Australia. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Example—Lease Premiums
KAZ Co. has started a four-year lease of a photocopier which has a $ purchase price. Had the company purchased the copier, the interest rate quoted on borrowings was 1.5 per cent per month. KAZ has agreed with the lessor to a residual value of $ at the end of four years. What will be the amount of the lease premiums? Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Solution—Lease Premiums

Advantages of Financial Leases
No restrictions on future borrowing. Can be tailored to suit firm’s needs. Eliminates the need to raise extra capital. No unnecessary financial outlay. May be excluded from the Statement of Financial Position. Facilitates financing capital additions on a piecemeal basis. Is an allowable cost under government contracting. Offers tax advantages. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Advantages of Operating Leases
Frees up capital for alternative uses. Increases the company’s working capital. Provides greater control due to greater certainty in future outlays. Assures more competent upkeep of asset. Avoids the risk of obsolescence. Avoids the equipment disposal problem. Future outlays cost less in real terms due to inflation. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Disadvantages of Leasing
Interest cost often higher. May not offer the right to the residual value of the asset. Allows the acquisition of assets without submitting formal capital expenditure procedures. May cause distortions in the evaluation of interfirm and interdivision performance. Lacks the prestige associated with ownership. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Good Reasons for Leasing
Taxes may be reduced by leasing. The lease contract may reduce certain types of uncertainty that might otherwise decrease the value of the firm. Leasing reduces the impact of obsolescence of an asset on a firm. Transaction costs may be lower for a lease contract than for buying the asset. Leasing may require fewer (if any) restrictive covenants than secured borrowing. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Bad Reasons for Leasing
The perception of 100 per cent financing. The apparent low cost. Using leasing to artificially enhance accounting income. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

Chapter One Introduction to Corporate Finance

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