Examples in class most important

 Quiz (best 6 out of 8)

 Midterm 1
 Midterm 2
 Final exam

Capital Budgeting

 The capital budgeting decision is the process in which long term investments are generated,
analyzed and undertaken
o Another word for investment decision in corporate finance
 Ex. companies have projects where they need to decide how to allocate the
money
 Do we do the project or not?
 If we do, which projects do we allocate resources to?
o LT projects: life >= 1 yr
 The goal of the firm is to maximize firm value
o Good investment decisions increase firm value
 Maximizing value does not equate maximizing profits
o Profits is based on accounting  Profits = revenue - expenses
 Profit is accrual based, meaning that you record the revenue when earned and
expenses when incurred, not when cash goes in or out
 Ex. revenue has credit sales, if you sell something on credit, you don’t
get the cash but it is included in revenue though you don’t have any
increase in cash flow
 Includes depreciation which is a non-cash expense
 If you use a different depreciation rule, you can manipulation
depreciation to change profit
o Value is more cash flow based
 How does a firm decide which projects to undertake?
o Accepting positive NPV projects benefits the shareholders
o This is the rule used to evaluate which decision should be undertaken ex. NPV, IRR,
payback rule
o NPV is considered the best since its consistent with the goal of maximizing value

Capital Budgeting Principles

 Decisions based on incremental A-T CFs, not accounting income

o Cash flows should be incremental after tax (given to government) cash flow
 o Incremental CF = CF if you undertake the project – cash flow if you do not undertake the
project
o Sunk costs: not incremental
 Ex. you hired a consultant to analyze project A, the consulting fee is $2m.
 The consulting fee is a sunk costs. If we go ahead with the project, we
pay $2m to consulting, if you don’t go ahead with the project, we still
pay $2m.
 Incremental CF = (-2) – (-2) = 0
 Therefore, sunk costs are not included in incremental cash flows
o Externalities: incremental
 Your behaviour affects other people
 Externalities are difficult to quantify but in theory, they should be included in
incremental cash flows
 If they can be quantified, then you should include them
 Ex. if there’s pollution and you must need clean up, the clean up costs
should be included
 Cash flow timing is important (TVM)
o Apply proper discounting to all cash flows
 CFs based on opportunity costs
o Value of the asset‘s next best use
o Ex. you purchase a machine 1 yr ago at $1m. Now you can use the project for Project A
to generate CF of $0.2 mm from yr 1 to n. the machine can be sold now for $0.8 mm. No
salvage value.
 NPV (project A) = ?


 NPV = -0.8 + (0.2/(1+r)) + (0.2/(1+r)^n)….
 Must also consider the value it can be sold for
 Incremental CF = CF if you undertake the project – cash flow if you do not
undertake the project
 Incremental cash flow = (0.2 for yr 1 to n) – (0 for yr 1 to n + $0.8m) =
 Do not include the -$1m since it already happened, cash flow if project
is undertaken should be based on the present
o Ex. you have office space. You may use it in project A to generate CFs of $10,000 per
year OR you may rent the space out at a rental income of $9,000 per year
 Incremental cash flow = $10,000 from yr 1 to n - $9,000 yr 1 to n = $1000 for yr
1 to n
 NPV = CF0 + (1000/(1+r)) + (1000/(1+r)^n)…
 Important point: financing costs reflected in required return
o Financing costs  ex. interest expense
 Raise money through 1. Debt or 2. Equity
o Ex. company borrows $10m at 10% interest. Pays interest = $1m per year
o NPV (project A) = CF0 + (CF1 /(1+r)) + (CF2 /(1+r)^n)…
 o We don’t put the $1m interest in incremental cash flows since the interest rate has
already been accounted through the discount rate (r)
o Financing costs always in the denominator
 WACC = average of cost of debt and equity from company’s perspective = required rate of
return from investor’s perspective (debtholders and shareholders)
o This is the cost for the company but also what the investor’s expect as a return for
their investment given to the company
o Ex. required rate of return is 13%, therefore discount rate in NPV formula = 13%

Incremental Project Cash Flows

 Cash flows are evaluated in 3 stages

o Initial investment outlay
 Spending money ex. purchasing materials, land etc.
o After tax operating cash flow over project’s life OCF
 Production occurs
o Terminal year cash flow TNOCF
 When production is done, we sell everything related to the project ex. finished,
unfinished goods, machinery
 Sell inventory  inventory decreases  current assets decrease  NWC
decreases  change in NWC less than 0  cash inflow, + pos. sign in CF

Initial Investment Outlay

 Outlay = FCInv + NWCInv

o NWC = current assets – current liabilities
o Change in NWC = Change in non cash current assets – change in non debt current
liabilities
 Current assets (related to daily operations)
 Accounts receivable
 Inventory
o Raw materials, work in process products, finished goods
o Typically in yr 0, you buy raw material  inventory
increases current assets increase  NWC increases 
change in NWC greater than > 0  increase in change in NWC
 cash outflow therefore, - neg sign in cash flow
 Cash outflow if change in NWC > 0
 Cash inflow if change in NWC < 0
 Current liabilities (related to daily operations)
 Accounts payable
o NWCInvestment = change in net working capital
 NWCt – NWC (t-1)
After Tax OCF

 CF = (sales – cash opex – depreciation exp) (1 – tax rate) + depreciation

 OR CF = (sales – cash opex)(1- tax rate) + (tax rate x depreciation)

Terminal Year After Tax Non Operating Cash Flows (TNOCF)


 SalT = salvage value
 Ex. salvage value = market price of machine at T
o Book value = on BS
o Buy machine for a price of $2500 at yr 0
o On BS: beginning yr 1: $2500, end of yr 1 $1500, beginning yr 2: $1500, end of yr 2: $500
 No uncertainty in book value as it is dependent on accounting method
 When book value and salvage are different, you must pay a tax
 If SalT > BT  this means that you recorded too much depreciation, book value is too low
o Too much depreciation tax shield (dep x tax rate), need to pay more tax
o If the difference is too high, you will have to pay more tax
 If SalT < BT  this means that you had too little depreciation
o Few depreciation tax savings, paid too much tax before
o You will then get a tax rebate or credit, everything in the bracket is negative, making the
last portion of the formula an inflow (+)

Problem: Expansion Project

 New equipment
o Cost $450m
o Straight line dep to $0 over 3 years
o WC increase $25m
o Can be sol in 3 yrs for $50m
o Paid outside consultant $2m for detailed market share and cost analysis
o Incremental rev $400m/yr
 o Annual cash opex of $200m
o Cost of capital 20%
o Marginal tax rate 40%
o Calculate NPV and IRR and determine investment decision
 Step 1: outlay = -$450 - $25 = -$475
o NWC increased, meaning cash outflow
 Step 2: ATOCF = (400 – 200) (1- 0.4) + 0.4 x 150 = 180
o Depreciation
 Initial cost is $450, final BV = 0
 Straight line over three years, every year depreciation is $150
 Step 3: TNOCF = 50 – (0.4) x (50 – 0) + 25
o If question states that $25m of inventory will be sold at end of project or $25m NWC will
be recovered then we add $25m to the TNOCF
 NPV = -475 + (180/1.2) +(180/1.2^2) + (180/1.2^3) + (55/1.2^3)
 IRR is the discount rate that makes NPV = 0
o -475 + (180/1+x) +(180/1+x^2) + (180/1+x ^3) + (55/1+x ^3) = 0
o -475 +180 x (1-(1+x)^-3)/x + 55/(1+x)^3 = 0
o Solve for x
 If they only give year three cash flow (no yr1 or yr 2 cash flow), can solve
 =-475 + 880/(1+x)^3 = 0
 X = (880/475)^(1/3)-1

Annuity Formulas

 Numerator is always first year CF

 Annuity: PV = A (1- (1+i)^-n)/i
 Flat perpetuity: PV = A / i
 Growing perpetuity: PV = A/(i-g)
 Gordan growth perpetuity: PV = A(1+g)/(i-g)

Expansion Project
Answer

 Outlay = - (350,000 + 110,000) - 73,000 = 533,000

o Cash outflow (cost of equipment and installation fees)
o Subtract inventory investment since it’s a cash outflow that is required
 CF = (265,000 – 83,000) (1- 40%) + (40% x 92,000) = 146,000
o Annual revenue – annual costs
o Annual straight-line Depreciation = shipping costs, installation costs, and sales taxes
should all be included in capital outlay
 To be capitalized and therefore subject to depreciation
 Purchase price + installation costs = total initial value – ending value
 ((350,000 + 110,000) – 0) / 5 years = 92,000
 TNOCF = 85,000 – 0.40 (85,000 – 0) + 73,000 = 124
o Reverse the NWC
 NPV = - 533 + 146 x ((1-1.1^(-5)) / 0.1) + 124/1.1^5 = 197.449 thousand
o Annuity factor
Answer

 Beginning value using accelerated depreciation does NOT change

 The book value should = 0 if the depreciation percentages add up to 100%  meaning it is
fully depreciated

If straight line, does NPV become higher or lower?

 The NPV would decrease

 If you use straight line, depreciation expense would be $10,000 every year
 o Present value of depreciation decreases, and NPV decreases
 If accelerated, you get the money sooner than rather deferring
 You always prefer getting the money earlier because of time value of money
 You save tax on depreciation
 Straight line
o NPV = -45 + 7 x (1-(1.12)^6 /0.12 – 9/1.12^6 = -20.8
 Using accelerated depreciation, a company can accelerate the depreciation on their assets to
depreciate earlier rather than later, this increase cash flows as depreciation acts as a tax shield
and would be greater in earlier years if
o 1. Depreciation expense in earlier years is greater
o 2. Greater depreciation expense also gets discounted less as it gets depreciated earlier

What discount rate should you use?

 The hurdle rate: the minimum rate of return on a project or investment required by a
manager or investor
 The reason we want to discount the cash flows is because there is uncertainty and TVM
 Higher risk = higher discount
 Discount rate must match the risk of the project
 Firm WACC matches firm wide risk
o If project risk doesn’t equal average firm risk, use firms WACC
 Then adjust firm WACC by incorporating project risk

CFs for a replacement project

 Differences:
o Sale of old: reduce the initial outlay by the after-tax proceeds from the sale (t=0)
o Depreciation: use only the difference between old and new depreciation
o Operating CFs: consider only incremental cash flows form new project
  Outlay = cash flow with – cash flow without = - 1000 – 80 + 600 (market value of old at 0) –
(0.3 x 600 – 400) = -540
o WHY IS THE MARKET VALUE ADDED NOT SUBTRACTED AS IN FORMULA?
 ATOCF = new – old = [(450 – 150)(1-0.3) + 100 X 0.3) – (300-120)*(1-0.3) +0.3 x 40)] = 102
o Take the difference between the two
 TNOCF = sell the new – sell the old = [200 -0.3(200-0)] – [100-0.3(100-0)] + 80 = 150
 NPV = -540 +102x 1-(1.08)-10 / 0.08 + 150/1.08^10 = 213.91 > 0 therefore, replace that shit

Replacement Project – Another Example

Step 1: Outlay = -90 + 30 – 0.4(30-13) + 5 = -61.8

 NWC = CA – CL = +20 – (+25) = -5, decrease in change in NWC  cash inflow

o Treat NWC as an asset, if it increases, you spent more cash on it, therefore it’s a cash
outflow. If NWC goes down, it’s a cash inflow

Step 2: ATOCF = 16.8

Step 3: TNOCF = selling new (15 – 0.4(15 – 19.8)) - selling old (0) – 5

 Depreciation rates = 14% + 20% + 17% + 13% + 9% = 78%

o Remaining = 1- 78% = 22%
o BV of new at end year 5 = 90 x 0.22 = 19.8
o BV and SV of old at end year 5 = 0
 No information provided for end of year 5 therefore, assume 0.

NPV = -61.8 + (16.8 x ((1-1.13^-5 )/ 0.13)) + (11.92/(1.13^5)) = 3.7592

Effects of Inflation on Analysis

 Nominal vs. real CFs

o Must match cash flows with correct discount rate
o Discount real CFs with real rate and nominal CFs with nominal rate
 (1+ nominal rate) = (1+ real rate)(1 + inflation rate)
o Nominal rate is the real rate (which is adjusted lower to account for inflation)
multiplied by inflation to get the nominal rate which is much greater than the real rate
o Real rate will always be lower than nominal rate unless inflation is 0%
 Higher than expected inflation:
o Ex. When we forecast future cash flows, we expected inflation = 4%, now inflation is 6%.
This means that the inflation is higher than expected.
o How would it affect NPV?
 Reduces value of depreciation tax shield
 Decreases value of fixed payments to bondholders
 Different impact on revenues vs costs
 Ex. nominal $ = $100, inflation rate = 4%, what is real $ = 100/1.04 = …
  Ex. nominal $ = $100 now, inflation rate in 2022 = 4%, inflation rate in 2021 = 3%, real $ in 2021
= 100/(1.04 x 1.03)
 Ex. inflation rate = 4%, nominal rate = 10%
o (1+ nominal rate) = (1+ real rate) (1 + inflation rate)
o 1+10% = (1+4%)(1+x)
o 1.1 + (1.04)(1+x)
o 1.05769 = 1+x
o X = 0.05769
 Real rate: interest rate that has been adjusted to remove the effects of inflation
o Accounting for inflation, removing inflation
 Nominal rate: interest rate before taking into account inflation.
o Not accounting for inflation

Inflation Example

 Answer = A  both WACC and CFs up

I learned that a WACC calculation has to use nominal rates of return (calculated by real rates and
expected inflation - compare Fisher equation). Reason is that expected free cash flows (unlevered) are
expressed in nominal terms. In consequence, the higher expected inflation the higher nominal rates in
the WACC model.
  Answer A  1 only
 Inflation does not cause the WACC to decrease, but increase
 Inflation in CFs tends to exert upward pressure on the NPV
 IRR depends on cash flows, which will be affected by inflation

Projects with Unequal Lives

Two approaches

 1. Equivalent annual NPV: Shorten both projects to one year and compare
o 3245 = A x (1-1.12^-6/ 0.12)  NPV of 1 yr A = 789
o 2577 = B x (1-1.12^-3/0.12)  NPV of 1 yr B = 1073
o Project B is higher and better
 2. Least common multiple: make project times longer, make both projects 6 years and compare
 o NPV6 of project A = 3,245
o NPV6 of project B = 2577 + (2577/1.12^3) = 4412
o Project B is higher and better
 Answers using both methods is always the same

 EAN method:
o Printer A NPV3 = $20,000
 20 = A x (1-12^-3/0.12)  A = 8.327
o Printer B NPV5 = $25,000
 25 = B x (1-1.12^-5/0.12)  B = 6.935
 LCM method:
o LCM of (3,5) = 15
o NPV15 of printer A = 20 +(20/1.12^3) +(20/1.12^6) + (20/1.12^9) + (20/1.12^12) = 56.7
 Replicate 5 times
o NVP15 of printer B = 25 + (25/1.12^5) + (25/1.12^10) = 47.2
 Replaced 3 times
o Always add the multiples except the last multiple, as that has been accented for in the
first and original figure
o Project A is higher and better

Capital Rationing

 Point: allocate fixed capital to maximize shareholder wealth

 How? Choose the combination of project that has the highest total NPV
  Go through combinations one by one
 A + C: outlay = 2700, NPV = 1100
 A + D + E: outlay = 2550, NPV = 960
 B + C + E: outlay = 2800, NPV = 1130
o Highest NPV while still remaining in budget
 B + D+ E: outlay = 2300, NPV = 930

Profitability Index

 PI = total inflow / outlay = (1650 + 700) / 1650 = 1.42

 NPV = total inflow – outlay
o Total inflow = NPV + outlay
 Final answer should be based on NPV not PI

Chapter 2 – Valuation

The Essence of Valuation

 The basic valuation model is based on three basic postulates of human nature
o 1. Cash flows: want more, rather than less
 Theory of wealth preference
o 2. Risk: want less, rather than more
 Theory of risk preference
o 3. Timing: want now, rather than later
 Theory of time preference
 Impatient
What may we need to value?

 Valuation
o Value a company
 Value a company stock (our focus in this topic)
 Value company debt
 Beyond the scope of this course
 Value of debt often does not vary much

Valuation Models – A big picture

 Absolute valuation models (estimate an asset’s intrinsic value)

o DCF model
 Dividend discount
 FCF model
 Residual income model EVA, MVA, etc
 APV: adjusted present value approach
o Asset based valuation model
 Value a company on the basis of the market value of the assets or resources the
company controls
o Relative valuation models (estimate an asset’s value relative to that of another asset)
 Multiples
 Premiums paid (comp transactions)
V0 = Div 1 / ( r – g) = 15.65, market price is 17.21

 Since 15.65 < 17.21, therefore the market price is overvalued.

 Dividend 0 = 0.38 x 4 = 1.52 (annual)
 r = not wacc, cost of equity
o The cash flow is equity related, only to equity holders, not including debtholders.
o r = rf + B (rm-rf)
o (rm-rf) = market risk premium
o r = 5% + 1.4(6.5%) = 14.1%
 g=
o earning’s growth rate = 4%
o dividend growth rate = 4% (if we assume payout ratio is constant)
o payout ratio = dividend / earnings = 0.4
o earning retention ratio = 1 – payout ratio = 0.6

Valuation Using the Multistage Dividend Discount Model

  Div0 = 0.38 x 4 = 1.52
 Rs = 14.1%
 Gr1=6% yr 1 – 10
 Gr2= 3% yr 11 and so on
Stage 1: v1 = (1.52x1.06)/1.141 +(1.52x1.06^2)/ 1.141^2 +….+ (1.52x1.06^10)/(1.141^10) =
10.366
o Using excel
o On test you’d be asked one or two years, not 10 years
 Stage 2: terminal value (value as of beginning of stage 2, at start of yr 11) = div 11/(1+r +
div12/(1+r)+…. = Div11/(r-g2) = (1.52x1.06^10x1.03)/(0.141-0.03) = 25.259
o Red = dividend at year 10
o v0 = v1 + (TV/1.141^10) = 10.366 +25.259/(1.141^10) = ~$17.12

The Free Cash Flow Valuation Model

 FCF are defined as all cash flows in excess f what is required to fund the firm’s investments
(capex + WC)
 FCF are taken from the firm’s BS and IS
 Beginning with the income statement, FCF are defined as:
 o

Net Working Capital

 Liquid assets available to the firm (i.e. cash)

 A company may have many assets (i.e. buildings) which cannot be easily converted to liquid
assets are important for short term operations, interest payments, etc.
 NWC = current assets – current liabilities
 Current assets: cash, AR, inventories
 Current liabilities: AP
 An increase in NWC Is an outflow and a decrease in NWC in inflow
Example:

 FCF2020 = 175.3
 V (value as of yr2020) = FCF2021/(r-g) = (175.3 x1.04)/(0.1-0.04) = 3038.48

Terminal Values – Example

 1. WACC = ws x rs + wd x rs (1- tax rate)
o = (80% x 9.99%) +(20% x 7.1%)(1- 34%) = 8.93%
o Rs = rf + B(rm-rf) = 9.99%
o Rs = 5.04% + 0.9(5.5%) = 9.99%
 2. Value of firm = PV of all future FCFs to the firm
o Stage 1 (year 1 to 4)
 V1 = (745*1.088) /1.0893 + (745*1.088)^2 /1.0893^2 + (745*1.088)^3
/1.0893^3 + (745*1.088)^4 /1.0893^4 = 2971.12
 First calculate the value of the firm in initial years using (FCF x (1+ growth
rate)^n/(1 + WACC)^n
 Add all years up
o You use the WACC for the value of the firm (including both equity and debt)
o In dividend model, you only use the cost of equity
o Stage 2 (year 5 to 7)
 V2 = (745*1.088^4*1.074)/1.0893^5 + (745*1.088^4*1.074*1.06)/1.0893^6 +
(745*1.088^4*1.074*1.06*1.046) /1.0893^7 = 2125.50
 Then individually calculate each year with a different growth rate but include
the prior years
 Ex. FCF x (1+gr from initial years)^4*(1+ new g)/(1+WACC)^5
o Stage 3 (year 8 to T)
 Terminal value = FCF8 / (r-g) = (FCFt x 1.032) /(0.0893 - 0.032) = 22389.21
 Find the terminal value using with FCFt that includes growth rates of all cash
flows from previous years*(1+ terminal value growth rate) / (WACC – g)
o Total value of the firm = 2971.12 + 2125.50 + (22389.21/1.0893^7) = 17399.49
 Add values from all stages to get value of firm
 Must discount terminal value back to present using WACC
 Formula: Future value TV / (1+WACC)^(n-1)
 3. Value of equity
o 17399.49 – 1518 = 15881.49
 o Subtract the debt
 4. Equity value per share
o 15881.49 / 309.39 shares = $51.33

FCF To Equity

 FCFF; cash flow to firm, available to the company’s capital supplies after all opex (including
taxes) have been paid and investments in WC and fixed capital have been made
 FCFF: EBIT(1-tax rate) + depreciation – changes in NWC – Capex
o = net income + interest (1 – tax rate) + depreciation – changes in NWC – Capex
 FCF to equity is the cash flow available to the company’s equity holders
 FCFE = FCFF – interest (1 – tax rate) + net borrowing
o Net borrowing = debt issued – debt repaid over the period for which one is calculating
FCF
 Ex. Issued 400mm – repaid 200 mm = 200 in net borrowings, meaning you that
issued 200 more than you repaid, you’re adding the debt issued
 Ex. Issued 200mm – repaid 400mm = - 200 in net borrowings, meaning you that
repaid more than you issued, and that’s being deducted from cash flows
 Basically, you add to FCFE if you’ve issued /borrowed more since you’re getting
more cash, subtract if you’ve repaid since that cash can no longer be used as
cash flow
o FCFE is more likely to be negative because you must subtract the interest and what
you’ve repaid from what you issued/borrowed
o If you have a net borrowing, it is +, but if you repay
 For all equity firms: FCFF = FCFE

FCF Valuation

 If using FCFF

o Firm value
o Equity value = firm value – market value of debt
o Using WACC (including debt and equity)
 If using FCFE
o Equity value = PV of all future FCFE discounted at the cost of equity capital

FCFF vs. FCFE

 FCFF is also called unlevered FCF

 o Cash flows available to all provides of capital, including debt and equity (roughly cash
flows before interest payments)
 FCFE is also called levered FCF
o Cash flows available to stockholders after interest payments on debt and debt
repayments are made
 If a company has a stable capital structure, use FCFE gives the value of stock directly
 FCFF is often used:
o A company has changing capital structure
 FCFF is less affected by the change in debt levels than FCFE  FCFF reflects
fundamentals better than FCFE when debt levels change substantially
 FCFE is mostly negative

Calculate FCFF and FCFE for 2020

FCFF = net income + interest(1-t) + dep – capex – change in NWC

FCFF = EBIT(1-t) – (capex x dep) – change in NWC

 Where capex – dep = net capex

 Where 400 – 300 = capex – depreciation = net capex = change in net fixed assets or net PPE =
1400 – 1300 = 100
 We can use the change in net fixed assets to get (capex x dep)

FCFF = EBIT(1-t) – capex – dep – change in NWC

 FCFF = 500(1-0.4) + 300 – 400 – 45 = 155

  Capex = money invested in LT assets, in BS
o Gross fixed assets is $2200 in 2019, $2600 in 2020
o Capex = (2600 – 2200) = change in gross fixed assets / change in PPE = 400
o Gross means that we have not considered depreciation since depreciation is also
included in the equation already
 NWC = do not include cash
o For the purpose of calculating FCFs, when finding the change in NWC, we exclude cash
and ST debt (notes payable)
 We exclude cash because change in cash is what we’re calculating
 If we subtract cash, we are underestimating FCF
 We exclude ST debt because debt is part of the capital provided to the company
(such debt has explicit interest costs and is thus a financing item) and not an
operating item
o NWC in 2020 = current assets – current liabilities = (600 + 440) – (300 + 150) = 590
o NWC in 2019 = (560 +410) – (285 + 140) = 545
o Change in NWC = NWC in 2020 – NWC In 2019 = 590 – 545 = 45

Difference between gross fixed assets/PPE and net fixed assets/PPE is depreciation

FCF to Equity

 FCFF = EBIT(1-t) – capex – dep – change in NWC

 = net income + interest (1-t) + debt – capex – change in NWC
 EBT (earnings before tax) = EBIT – interest
 NI = EBT – taxes = EBT(1-t) = (EBIT – interest) (1-T) = EBIT (1-t) – Interest(1-t) = NI
 EBIT(1-t) = NI + interest(1-t)

FCFE = FCFF – interest(1-t) + net borrowing = 155 – 100(1-0.4) + 75

 NB = $ you borrowed - $ you repaid

 Long term debt increased from $865 to $890
o Therefore, the difference is $890 - $865 = $25, therefore borrowing increased by $25
 Short term debt (note payable and current portion of short term debt) increased from $200 to
$250
o Therefore $250 - $200 = $50
 Total net borrowing = $25 + $50 = $75
  Cost of equity = Rs = 6% + 1.1*4% = 10.4%
o Risk free rate + beta x market risk premium
 FCFE = FCFF + interest(1+t) + NB
 FCFF = EBIT(1-t) + deb – capex – change in NWC = net income + interest(1-t) + deb – capex –
change in NWC
 FCFE = net income + interest(1-t) + deb – capex – change in NWC + interest(1-t) + NB
o Interest cancels out
o FCFE = NI – (capex x dep) – change in NWC + NB = NI – net capex - change in NWC+NB
o FCFE = NI – x – 0.5x + 0.45x = NI -1.05x
 They give EPS, no EBIT, therefore use net income
 Let net capex = x, Change in NWC = 0.5*net capex = 0.5x
 NB = 0.3(x (net capex)+ 0.5x (change in NWC)) = 0.45x

FCFE for each year:

 Yr 2020 (yr 1 – now is first day of 2020) FCFE1 = 1 2.4*1.3 – 1.05(3) = -0.03
 Yr 2021 FCFE (yr 2021) FCFE2 = 2.4*1.3*1.18 – 1.05*2.5 = 1.057
 FCFE3 (yr 2022) = 2.023
 FCFE4 (yr2023) = 2.919
 Stage 1 = V1 = -0.03/(1.104) + (1.057/1.104^2) + … + 2.919/1.104^4 = 4.309
 Stage 2 (from 2024-t): FCFE = 1st year of stage 2 is yr 2024, FCFE = 3.759
 o Since capex varies from year to year, you must recalculate the FCFE (can’t just add
growth rate to FCFE 2023)
 2.4*1.3*1.18*1.12*1.09*1.07 -1.05*(1) = 3.579
o Terminal value = 3.759 /(0.104 – 0.07) = 110.562
 This would be the price on the first day of 2024
 V0 = 4.309 +110.562 / (1.104^4) = 4.309 + 74.427 = 78.74 = current share price
o N-1 = 4, 2024 is yr 5
o V0 is on a per share basis, therefore is the current share price as well

What is the trailing PE on the first day of 2020 and the first day of 2024 (beginning of stage 2)?

 Trailing P/E = current P/E = current price / current yr (most recent) earnings
 Leading P/E = forward P/E = prospective P/E = current price / next year expected earnings
 Yr 0: trailing P/E = P0 / E0 = 78.74 /2.40 = 32,807
 1st day of 2024: trailing P/E = price at beginning of stage 2 / 2023 earnings (most recent
earnings at beginning of 2024) = 110.562 (future value of terminal value at year 2024) / 4.494
(2023 EPS)= 24.599
o 4.494 = 2.4 x 1.3 x 1.18 x 1.12 x 1.09  2023 EPS
Liquidation value = salvage value – tax x (salvage value – PPE of end of year 5) + NWC at end of year 5

Use book value of debt if market value of debt not given

 NA = net assets = total assets – current liabilities

o We use current liabilities in this class
o = LT assets + ST assets – current liabilities
o = LT assets + NWC
 o = net PPE + NWC
 Total assets = shareholders equity + total liabilities
o NA = (shareholder equity + total liabilities) - current liabilities
o = shareholders equity + (total liabilities – current liabilities)
o = shareholder equity + long term debt = long term capital (financing) = capital charge
 Profit margin = alpha = EBIT / sales
 change in net assets = change in net PPE + change in NWC = (capex – dep) + change in NWC
o change in NET PPE = capex – dep (must subtract depreciation) = net capex

 If you compare year 2 and 3, more growth gives a higher firm value
 If you compare year 3 and 4, less growth yields a higher firm value
 A higher alpha (profit margin) matters
 That’s why when the profit margin (a) decreases, the firm value decreases
even when the growth rate increases

When is growth valuable?

 Growth is good because earnings increase

 However, to keep up increases in earnings and sales, assets (and capital investments) must
grow too, this is expensive
 If investment needed to maintain earnings is bigger than earnings, this is not worth it
 The following math derive the condition under which growth is valuable
  Because r is small (close to 0), r/(1+r) =(approx.) r
o Ex. 0.001/(1+0.001) =
 RONA = EBIT(1-t)/NA
o Return on net assets (RONA) = EBIT (1- t) / NA > r  growth will add value, WACC =
cost of capital
o The return on net assets must be greater than r, the cost of capital
 RONA > WACC
 EBIT(1-t) > r x NA
o EBIT(1-t) = return in dollar amount = capital charge
o r x NA = cost of capital in dollar amount
 EVA > 0
 EBIT(1-t) > r x NA
 If RONA < WACC, EVA < 0, EBIT(1-t) < r x NA  then company should NOT grow unless they
IMPROVE OPERATIONS AND INCREASE PROFIT MARGINS (alpha)  raise prices without
reducing sales too much
 Sales  (remove costs)  EBIT  (remove interest)  EBT  (remove tax)  net income
 Interest goes to debt holders, taxes go to government, net income goes to shareholders
(residual claimers)
o Sales – costs (COGS and opex) = EBIT
o EBIT – interest = EBT
o EBT (1-t) = net income
 Net income goes to:
o 1. Retained earnings (kept in the company)
 On the balance sheet in shareholders equity
o 2. Payout (ex. share repurchases, dividends)
 FOR CURRENT LIABILITIES, INCLUDE ALL SHORT TERM LIABILITES – EVEN ST NOTE PAYABLES 
NOT SAME AS NWC CALCULATION

Residual income = shareholders equity + LTD (aka long term debt)

 = net income – charge (deduction) for common SE’s cost in generating net income
 Equity charge = cost of equity x BV of equity
 Q1: Net income = (EBIT – interest)(1- tax) = (200,000 – (0.07% x ($2m x 50% debt))(1- 30%) =
$91,000
 Q2:
o RI = NI – equity charge
 = $91,000 – (12%x ($2m x 50% equity) = -$29,000
 Losing value for shareholders, equity charge > net income
o RI = EBIT(1-t) – equity charge – debt charge
 Equity charge = (12%x ($2m x 50% equity)
 Debt charge = (7%x ($2m x 50% debt)(1-30%)
 200,000 (1-30%) - (12%x ($2m x 50% equity) - (7%x ($2m x 50% debt)(1-30%) = -
$29,000
  Residual income is the money that goes to shareholders, therefore the r is the cost of equity
 RI = earnings – cost of equity x book value of equity t-1
o = (equity / book value of equity t-1 – cost of equity) x book value t-1
o ROE = earnings / book value of equity
 = net income / beginning book value of equity
 = Et / BVt-1
 Make sure timing is correct

Yr Et (earnings) Dt (dividends) BVbeginning BVend

2021 30 10 100 120 (100+30-10)
2022 50 40 120 130 (120+50 -40)
Book value of end of t-1 is the same as beginning of t

 Use 120 for 2022, not 130, as 130 is the year end
  1. Vddm = 1/1.1 +1/1.1^2 + …. = 1/0.1 = $10
 2. RIt = Et – (r*BVt-1) = 1 – (10%*6) = 0.4
o Subtract equity charge (r x BV) from earning (Et)
o BVt = BVt-1 + Et (earnings) - Dt (dividend)
o 6 + (1-1) = $6 (book value will remain constant if payout is 100%)
o Clean surplus retention  Retained earnings = Et (earnings) - Dt (dividend)
 3. VRI = 6 + 0.4 / 1.1 + 0.4 / 1.1^2 … = 6+ (0.4/0.1) = $10
o Not 0.4^2 / 1.1^2 because 0.4 remains constant
 Value of ddm and VRI should give the same answer, theoretically

Yr Et Dt BVbeginnig BVend RI
0 6
1 2 1 6 6+2-1 = 7 2 – 0.1 x 6 = 1.4
2 2.5 1.25 7 7+2.5-1.25 = 8.25 2.5 – 0.1 x 7 = 1.8
3 4 12.25 8.25 8.25+4 -12.25 = 0 4 – 0.1 x 8.25 = 3.175

 2. VRI = 6 + 1.4/1.1 + 1.8/1.1^2 + 3.15/1.1^3 = 11.146

 3. VDDM = 1/1.1 +1.25 / 1.1^2 + 12.25 / 1.1^3 = 11.146
 V0 = 19/59 +1.3215/1.15 + … + 3.266 /1.15^10
=$32.135 < market price of $42.9 therefore, stock is
overvalued

RI

 DDM and FCF models

o Forecast future cash flows and find the value by discounting them back to the present
using the required return
 RI models
o Start with value (BV of equity) based on the BS
o Then adjust value by adding present values of expected future residual income
 RI models recognize value earlier than DDM and FCF models
o RI models are less sensitive to distant cash flows, which often have greater uncertainty

Alternative Valuation Models

 Common practice for financial analysts and IB to use alternative valuation methods for valuing
companies in addition to DCF:
o Multiple approach
o Premium paid (or comp transaction) approach

Absolute Valuation – value A

Relative valuation – compare A to B (public competitors / comparables)

 EPSa = 1.5
 (P/E)b = 22
 Cannot compare stock prices directly to say one company is overvalued compared to another
 1. Price of A = 37.50
o P/Ea = 37.5 / 1.5 = 25, P/E b = 22
o Therefore, A is overvalued relative to B since their PE is higher
 2. Assume P/Ea = 22, estimate the price of A = 22 x 1.5 = 33

 ADI’s 5 yr sales growth and ROE are less than average

 To come up with appropriate multiples for ADI, shave down the mean multiples by say…. 15%?
 

Multiples Approach

 Valuing a company based on comparable companies multiples

 Comparing the average multiples of peers and adjusting your company multiples based on
comparison
 Can use multiples estimates to get a value estimate (find what EV, equity value and stock price
should be)
 Ex. Equity value = estimate PE x actual NI
o `Stock price = equity value / # of shares
 Ex. Firm value = estimate M/BV of firm x (actual BV of D + actual BV of E)
o BV of firm = (actual BV of D + actual BV of E)
 To get the firm value, multiply the multiple by the denominator estimate

We use the Mean for comparables if there are no outliers

Premiums Paid Approach

 Premium = price paid to purchase target – pre announcement market price of the target
company

 P of UGS for 1 day = 21.31

 o 21.31 x (1 + 0.422)
o = 30.30
o 0.422 = mean premium paid over one day 42.2%
 P fo UGS for 90 days
o 19.07 x 1.408 = 26.85
 The investment bank would find a range of equity values per share of $26.85 to $30.30 for
UGS

For final example

 Ignore NWC in middle years – just look at NWC for year 0 and t

Midterm Review – Quiz Takeup

 TNOCF = SalT – T(SalT – BV) + NWC

o Salvage value at end of T is the long term
o NWC is short term
 Always use ending book value

WACC Method

 Determine FCF of the investment

 Compute WACC
 Compute value of investment including tax benefit of leverage, by discount the GCG of the
investment using WACC

Limitation of WACC method

 WACC is the company wide cost of capital, and is used for new investments
o That are of comparable risk to the company wide risk
o And that will not alter the firm’s debt equity ratio
 What about the project has different risk?
o Pure play approach
 What about the firm has changing leverage?
o Adjusting present value approach

Firm vs. Project Risks

  Security market line SML = CAPM formula
 Rf = 7%
 Rm – Rf = 8% (market risk premium)
o Also the slope of the SML
 Firm
o B of firm = 1, assume its an all equity firm
o WACC = 15% (based on B of firm = 1)
 Project A
o B of A = 0.6
o IRR of A = 14%
o Discount rate for A = 0.07 + 0.6(0.08) = 11.8%
o IRR of A = 14% > discount rate = 11.8%  accept project A
o INCORRECT: IRR of A = 14% < WACC = 15%  reject project A
 Project B
o Beta of B = 1.2
o IRR of B = 16%
o Discount rate for B = 0.07 + 1.2(0.08) = 16.6%
o IRR of B = 16% < discount rate = 16.6%  reject project B
o INCORRECT: IRR of B = 16% > WACC = 15%  accept project B
 IRR of project > discount rate of project  accept
 IRR of project < discount rate of project  reject
o Discount rate must match the risk of the project NOT the general firm WACC
 The common assumption is that you are supposed to reject any project with an IRR below
WACC (less than 15%) BUT, this leads to an incorrect rejection/acceptance because the IRR
may already be below/above the current firm WACC, it could be above the risk of the project
itself (project discount rate)  which means the project should have been rejected/accepted

Calculating Project WACC – pure play approach

 1. Calculate after tax cost of debt (ri) for the firm, assume it applies across all divisions
 o This will be used to calculate the WACC of the project in the last step
o Ri = cost of debt x (1- tax rate)
o Use all pure play’s info (D/E, beta)
 2. Find a publicly traded firm whose projects match the risk of the divisional project
o Calculate the B of project only by using the B pure play firm
o Use the pure play beta (a comparable company / project) and remove their capital
structure risk to isolate for a capital structure / risk neutral beta
o Use division’s / project’s capital structure, debt / equity
 3. Estimate the weights for the division and use these to calculate the division’s beta
o Use the capital structure neutral beta of the pure play and add your division’s capital
structure to find the beta of your division
 4. Calculate Divisional cost of equity using B of division
o Use divisional beta to find cost of equity
 5. Calculate divisional WACC
o Use cost of equity to find WACC of project / division
 Purpose: get the B equity for your division
 1. Get a pureplay public firm  find the Bequity of PP  remove financial/capital structure risk
from Bequity of pure play  get Basset
o Pureplay = is only in one line of business
o Find beta equity for the pure play  usually on Bloomberg it’ll be beta of the equity,
levered beta
 Total Risk = beta equity, levered beta:
o 1. Business risk = operation, industry risk  beta of the assets, unlevered beta
 Without debt, what is the risk?
 Levered beta always > unlevered beta
o 2. Financial risk = capital structure risk (from using debt), higher debt = higher financial
risk
 If your company is in the same business as the other pureplay, you both should have the same
business risk, same unlevered beta, but different capital structure
 2. Use beta asset from first step, add financial risk of your division
 1. Basset = Bequity of PP / (1+(1-t)(D/E)
o 1.2 /(1+(1-0.35)*0.6 = 0.8633
 2. Bequity for division = Basset x (1+(1-t)(D/E)) = 0.8633 x (1+(1-t)x0.5) = 1.1007
 3. Requity for division 11% +1.1007 x 9% = 20.91%
 4. Assume after tax cost of debt = 10%
o WACC for div = 10% x (D/V) + 20.91% x (E/V)
o = 10% x (5/15) +20.91% x (10/15)= 17.27%
o D/E = 0.5 = 5/10
o D = 5, E = 10
o V = D + E = 15
 PP firm = D/E = 0.6. Sometimes in exam, they’ll give you the D/V instead
o Ex. D/V = 0.6, then n you have to figure out D/E
o D/V = 6/10
o E = V-D = 4
o D/E = 6/4
  1. Burger king = 0.75 /1+(1-0.34) x 0.004 /0.096 = 0.73
 2. McDonalds = 0. 835
 3. Wendy’s = 0.918
o Average beta asset = 0.8279
 2. Take beta of equity for division = 0.8279 x (1+(1-0.34) x (0.5/1) = 1.10097
 3. R equity for division = 0.04 + 1.10097 x 0.084 = 13.25%

The Adjusted Present Value Method


 Vl = APV = Vu + T x D
 Vl = value of levered firm
o Value of the firm adjusted for the effects of leverage / debt
 Vu = value of unlevered firm
o Value of the firm prior to accounting for effects of leverage / debt
 Interest tax shield = annual D x i x T
o Debt x interest x tax rate
o Find the PV of the interest tax shield = PV Of D x i x T
o = PV Of D x I x T = (D x i x T) / i = T x D
 i = before tax cos of debt (discount rate)
 The discount rate is before tax cost of debt because the after-tax cost of debt
accounts for the tax savings
 If there is a growth rate = D x I x T / (I – g)
 Here, the tax savings are already accounted for in the numerator
 T = 0.4
 EBIT = 1000
 1) no debt EBT = EBIT – interest = 1000
o Interest = 0
o Tax = 1000 x 0.4 = 400
o NI = 1000(1-0.4) = 600  $$ to stockholders, $ to capital provider = $600
 2) have debt = $1000, i = 10%
o Interest = 1000 x0.1 = 100
o EBT = 1000 -100 = 900
o Tax = 900 x0.4 = 360
o NI = 900 (1-0.4) = 540  $ to shareholders
o $ to capital providers = $540 + 100 interest = $640
 We care about the $$ to debtholders and equity holders
 o Difference in $ to capital providers = $640 - $600 = $40 = interest tax shield = difference
in tax
o The difference is the value increase
o Also the difference in tax  interest tax shield
 Debt creates an interest expense, which reduces your EBT, tax is reduced, and you pay less tax
which is transferred to the entire company
 Interest tax shield = amount of interest x tax
o = 100 x 0.4 = $40
o = (1000 x 0.1) x 0.4 = $40
o Amount of interest = amount of debt x interest rate

Example

? = Vl = Vu + PV(interest tax shield)

 Vu  take the unlevered FCF = FCFF = 5

 g = 4%
 R0 = Discount rate = unlevered cost of capital = cost of equity in an unlevered firm = cost of
unlevered equity
o R0 = 0 debt, not debt at all, just equity
o Cannot use the cost of levered equity = 12.3% since the firm has both debt and equity
 Levered cost of equity = cost of equity adjusted for the effects of leverage / debt
o R0 = rf + B unlevered (rm-rf)
 12.3% = rf + B levered (rm-rf)
o 12.3% = 4% + 1.66(5%)
o B levered = B equity = 1.66
 B unlevered = B levered / 1+(1-t)(D/E) = 1.66/(1+(1-0.4)x1 = 1.0375
 Discount rate = 0.04 + 1.0375(0.05) = 0.091875
  Vu = 5 / (0.091875 - 0.04)
o Growing perpetuity
o = 96.3855
o $5m is already the first year cash flow (expected), meaning you don’t multiple by growth
rate
 Interest of first year = 95.24 x 0.085 = 8.1
o Interest in tax savings in first year = 8.1 x 0.4 = 3.24
o 3.24 / (r-g) = 3.24 /(0.085 – 0.04) = 72
o R in this case = cost of debt
 Vl = 96.3855 + 72 = 168.3855
o Based on the APV approach
 Using the WACC approach
o WACC method is just using WACC formula with constant cost of debt and equity and
then using that WACC to discount FCF to get firm value
o WACC = 0.085(1-0.4)(1/2) +0.123(1/2) = 8.7%
o VWACC = 5/ (0.087 – 0.04) = 106.383
o The WACC method underestimates the value of the firm because of the proportions of
debt and equity are fixed
o Using the APV approach, it takes care of the debt increase
 In this question, debt is increasing 4% every year, which means WACC
decreases in the future
 “debt will grow at same rate as cash flows”
 Therefore, the WACC should be lower than 8.7%, which increases the value of
the firm
o Ex. In the future I’m retiring my debt, debt is decreasing  WACC Increases  Value of
firm decreases
 WACC is overestimated
 Debt increasing overtime
o WACC method will underestimate firm value
 Debt decreasing overtime
o WACC method will overestimate firm value
 Debt fixed  use WACC method

Summary

 WACC approach is better suited for when debt and equity are fixed and constant
o Ex. Company might employ a target D/V ratio
 APV is well suited when the capital structure is changing but the amount of debt on a period-by-
period basis is known
 Combining both approaches:
o Stage 1 (yr1 – 5) = capital structure changes
 Use APV approach
o Stage 2 (yr 6 to terminal) = make the assumption that capital structure is stable
 Proportions are fixed
  Use WACC approach
o Add up two values  try practice questions

Cost of Equity

 B equity = B levered = B unlevered / (1+(1-t)(D/E))

 D+E = Vl = Vu + T x Debt
o Value of a company levered = unlevered value + tax shield
o Levered value always greater than unlevered value
o Leverage (debt) has allowed the firm to have a tax shield
 (D/(D+E))B debt + E/(D+E)B equity = (Vu / Vl)B asset + (T*D)/Vl B debt
 E/(D+E)*B equity = Vu / (D+E) * B asset  E*B equity = Vu * B asset
o Vu = Vl – T*D = D +E 0 T*D = E +(1-T)D
o Divide both sides by E  B Equity = (1+(1-t)(D/E))*B asset

CAPM

 Hurdle rate = rf + risk premium aka spread

 CAPM = equity return = risk free rate + Beta x expected market risk premium
 Risk free asset
o Actual return = expected return (there is no uncertainty)
o No default risk
o Must be:
 1. Issued by government
 2. ST assets are less risky
o Risk free rate should be in the same currency that CFs are estimated in
o We use the treasury (t-bill) rate as the risk free rate
 3 month treasury bill
 For currencies where no liquid treasury bill market exists, interbank rates such as LIBOR and
EURIBOR rates are used
 If there is no default entity:
o 1. Adjust local currency government borrowing rate for default risk, removing default
spread from government bond rate
 In Nov. 2013, the Chinese RMB government bond rate was 4.30% and the local
currency rating from Moody’s was Aa3 and the default spread for Aa3 is 0.6%.
Then, Risk free rate in RMB = 4.30% - 0.6% = 3.7%
 Risk free rate = gov borrowing rate – default spread of currency rating
 Subtract default spread of local currency rating from government borrowing /
bond rate

What moves T-Bill Interest Rates

 1. Economic conditions
 o Better economy = higher T Bill
 2. Inflation
o Higher inflation = higher T Bill

How to estimate equity risk premiums

 Equity market risk premium = market returns – risk free rate

 Market returns = S&P, TSE
 To estimate the ERP
o Obtain annual market returns from each year from 1950 to 2023 and annualized T bill
rates
o Calculate the risk premium for each year, then find the ERP average over the # of years
 Historical data for emerging markets might be hard to find or inaccurate. Instead, find the
ERP:
o ERP for country = ERP for US + country risk premium CRP
o Start with bond default spreads ex. AAA default spread = x.x%
 Rating based default spread
 Ex. Default spread based on local currency sovereign rating
 Ex. Sovereign CDS default spread
o Scale bond defaults spreads to get country risk premium, considering stock markets are
more volatile than bond markets
 Stdev Country equity market / Stdev country bon market = 1.5/1 = 1.5
 Adjust bond spread up by 1.5 to get CRP
 Market risk premium
o Rm – rf
o 3 ways:
 1. Historical
 Ex. Stock market returns, TSE, S&P 500
 Rm = market returns = change in index price
o = Index t – Index(t-1)/Index (t-1)
 2. Perceived
 Survey results ex. Of CFOs on each quarter
 
 3. Implied
 Bad market = higher risk premium
 Good market = lower risk premium
 Ex. After a stock market crash, you demand a higher return as there is
much uncertainty in the market
 Takeaway: market risk premium goes the market

Implied equity risk premium

 P0 = 1848.36 = (84.16 x 1.0428) /(1+r) + (84.16 x 1.0428)^2 /(1+r)^2 + (84.16 x 1.0428)^3

/(1+r)^3 + … (84.16 x 1.0428)^5 /(1+r)^5 + Div6 / (r-0.025) x (1/(1+r)^5
 o Dividend5 = 84.16 x 1.0428^5
o Dividend6 = Dividend 5 x 1.025
 R is the unknown
 R for S&P 500 = discount rate = rm
 R = implied market return
 Solve for r on excel using goalseek, implied return = 7.55%
 Implied market risk premium = 7.55% - 0.06% = 7.49%
 On exam:
o You may be asked to write the equation
o Or you plug in r to plug it into the equation and choose the right r
 Constant growth rate = constant 4%, what is the market risk premium
 1848.36 = 84.16 x 1.04 / (r-0.04)  r = 8.74%

Calculating ERPs in Emerging Markets

 2 ways
 1. CRP
o Start with local currency rating and use rating based default spread
o Multiply rating based default spread by CRP (country risk premium – ex. 1.5 assume
equity is 1.5 times more volatile than bonds)
o Add the CRP + US ERP
 2. Credit default Swap Spread
o Find the country’s current CDS spread
o Subtract out US CDS spread
o Add CRP to US ERP
Beta

 Determinants of beta
o Product type
 Industry effects
o Operating leverage
 Proportion of total costs of the firm that are fixed
 % change in EBIT / % change in sales
 Related to the cost structure (fixed vs. variable costs)
o Financial leverage
 % change in EPS / % change in EBIT
 All related to debt and interest expense

Disney example

o EITHER USE AVERAGE METHOD OR YEAR APPROACH

 Average = % change in sales / # of years = 13.64 + … + 6.54 / 10
 Average = % change in EBIT / # of years = 49.21 … + 6.62 / 10
 Operating leverage = 14.82 / 5.31 = 2.79
 OR operating leverage 2004 = 49.21/ 13.64 = 3.61 … operating leverage 2013 = 6.62 / 6.54 =
1.101
o Average the answers from each year = 3.17
 Operating leverage answer will differ based on the method you use

Estimating Beta

 Raapl = Rf + B (rm-rf)
 o = Rf – B*rf + B*rm
o = (1-B) rf +B* Rm
 (1-B)rf = a
 B=b
 Excel function = slope(all y, all x)
 B = 0.6375
 Rm = x = R^2 = systematic / market risk
o Regression = slope
 Y = a + bx
 Y = (1-B)rf + B(rm)
 Ri = Y = stock returns of firm i
 The slope = beta of a stock, measures the systematic risk of the stock
 R^2 is the proportion of the risk of a firm that can be attributed to market risk
o If return follows closely to the market, meaning of the company’s risk can be explained
to the market  R^2 is high, close to 1
o R^2 = systematic or market risk / total risk
 1 – R^2 is the proportion of the risk that is attributed to firm specific risk

Equation 1: Theory model = Rtheory = Raapl = (1-B)rf + B*Rm

 Same as Ri = Y = a + bx
 Derived from CAPM

Equation 2: Actual data regression = R = a + b * Rm

 Regression
  If actual > theory  a > rf(1-B)  stock did better than expected
 If actual < theory  a < rf(1-B)  stock did worse than expected
 Jensen’s alpha
o Actual – theory = a – rf(1-B)
o If positive  stock did better, meaning actual > theory

 Add back the dividend as part of the return during an ex-dividend month

Equation 2 – equation 1 = R actual – R theory = a – (1-b) Rf = intercept – (1-b)rf = jensen’s alpha

  Jensen’s alpha measures stock performance
 Positive Jensen’s alpha = stock did better than expected during regression period
 Negative Jensen’s alpha = stock did worse
 Regression will not be tested, but you should know the implication
 Ex. We have this regression result, R^2 = 0.7339
o What does the 0.7339 mean?
o That is the proportion of risk attributed to the market
o How do you calculate Jensen’s alpha?
 Make sure the return interval is consistent (ex, monthly, yearly)
 Ex. T-bill rate is usually given annually, must convert to monthly
 After you’ve calculated the monthly Jensen’s alpha, you must convert it back to
annualized to find the annualized excess return

Bottom Up vs. Top Down Beta

 The top-down beta for a firm comes from a regression

o Focusing macroeconomic and market cycles
 The bottom-up beta can be estimated by pure play approach
o Focusing on company fundamentals rather than macroeconomic and market cycles
o Unlever and relever

P37-P38 – not required

 Pure play involving cash to firm value ratio will NOT be tested

 Bl = 1.3 x (1+(1-0.25)x 5.23%) = 1.351

o Find levered beta using unlevered beta
 Rs = 0.035 + 1.351 x 0.0694 = 0.1288
o Levered cost of equity
  Market risk premium is same as equity risk premium
o Different from market return
o In a market return question, you have to subtract by the risk-free rate to get the
implied market risk premium
o Will be tested on exam
 Total risk
o Systematic risk = market risk
 B of tesla Cov(tesla return, market return) / variance(market return)
o Idiosyncratic risk = firm risk
 For well diversified firms / portfolios ex S&P 500
o Idiosyncratic risk is negligible

Beta of Private Companies

 Estimating betas from regressions does not work for assets that are not publicly traded because
there are no stock prices or historical returns that can be used to compute regression betas
 Therefore, you cannot use a top down approach and must use a bottom up approach
o Basically regressing the stock returns against market returns

o
 For non-traded assets, use the bottom-up betas based on comparable firms
 BUT Beta is not an adequate measure of risk for a private
o The owners of most private firms are not diversified so you have to adjust the beta
 Using beta to arrive at a cost of equity for a private firm will underestimate the cost of equity
for the private firm as it doesn’t take into account firm specific firm
  Total risk = market beta / correlation of the sector with the market, where correlation with the
market = square root of Rsquared of the regressions that are used to obtain regression betas for
comparable public firms
 Total risk = total beta = levered market beta of private firm (derived from comparables) /
square root of R
o 0.8558 / square root of 0.26 = 1.6784

The Beta of a Portfolio

 The beta of a portfolio is the market weighted average of the betas of the individual investments
in the portfolio
 Ex. Beta of a mutual fund is the WA of the betas of the stocks and other investments in portfolio
 The beta of a firm after a merger is the market value WA of the beats of the companies involved
in the merger
 Ex. (Beta of stock A x weight of stock A) + (beta of stock B x weight of stock B) …

What is Debt

 General rule: debt generally has:

o Commitment to make
fixed payments in the future
o The fixed payments are tax deductible
o Failure to make the payments can lead to either default or loss of control of the firm to
the party to whom payments are due
 Debt should include:
o Interest bearing liability (ST or LT)
o Lease obligation, whether operation or capital

Estimate Market Value of Debt from Book Value for Interest Bearing Debt

 Cost of debt has to be estimated in the same currency as cost of equity and cash flows in the
valuation
 1. If the firm has bonds outstanding and the bonds are traded:
 o The YTM on a long term straight bond = pretax cost of debt
 2. If YTM is not available:
o If the firm is rated, use the rating and a typical default spread in bonds
o Then add the default spread to risk free rate
o Pre-tax Cost of debt = default spread on bond (according to rating) + risk free rate
 3. If the firm is NOT rated
o 1. It has recently borrowed long term from a bank, use the interest rate on the
borrowing OR
o 2. Estimate a synthetic rating for the company, and use the synthetic rating to arrive at
a default spread and cost of debt

 Ex. Disney rating  A

 Disney long term default spread = 1.12% (30 yr)
 Risk free rate = 1.44%
 Before tax cost of debt = 1.44% + 1.12% = 2.56%
 After tax cost of debt = 2.56%*(1-0.2863) = 1.827%
o Use entertainment industry tax rate or marginal tax rate
  You can attribute a synthetic rating based on their interest coverage ratio
o How many times their operating income can cover their interest expense
o Higher = better
o Ex. Disney interest coverage = 22.57x
 Large cap
 Attributed rating = AAA
 1. Find default spread for AAA companies and add risk free rate to get pre tax
cost of debt
 2. Apply tax rate to get after tax cost of debt

Market Value of Debt

 

Market value of equity = market price x # of shares outstanding

 V = PV of future cash flows

Market value of debt = market price of debt x # of debts (ex. Bonds)

 V = PV of future cash flows that includes 1. interest/coupon, and 2. principal

o 349 / (1+r)+ 349/(1+r)^2 … 349/(1+r)^n +14,288/(1+r)^n
o Market value of debt = 13028 = 349 x (1-1.0375^-7.92)/0.0375 + 14288 / (1.0375^7.92)
 R = yield to maturity = before tax cost of debt = 3.75%
 Stock price go up, yield to maturity goes down
 Average maturity n
o = 0.5 x (1452/ 12139) + 2 x (1300/ 12139)+ … + 500/(12139) x 29 = 7.92 years
o Total amount = 1452 + 1300 + … 950 + 500 = 12139
 Market value of equity = 5 x 20 = 100
 MV convertible = 120
 V = 100 + 120 = 220
 Annual coupon = 100 x 0.02 = 2
 WACC = rs (E/V) + rd(D/V)(1-t)
o Debt has a market value of $120 but it is convertible, which means it has equity
features, meaning it is riskier than straight debt
 o The 5% of cost of debt only represents straight debt
o Market value of straight debt portion in convertible
 = 2/(1.05)+… +2/1.05^10 + 100/(1.05)^10 = 2 x (101.05^-10/0.05 +
100/(1.05^10) = 76.83
o Market value of stock option part in convertible = 120 – 76.83 = 43.17
o Correct WACC = 10%((100 + 43.17)/220) + 5%*(76.83/220)(1-0.4)

Cost of Preferred Equity

 Cost of preferred equity = Dividend yield = preferred Dividend / preferred stock price = cost of
preferred equity
o Cost of pref equity = div yield = ((coupon rate x FV)/ current price of preferred stock)
o Annual Dividend = coupon rate x face value of preferred stock
 Market value of preferred equity = # of preferred shares x current price of preferred stock
 WACC = rs x 2/v +rps x PS/V + rd(1-T)*(D/V)
 V = S + PS + D

Example 1

 Face value = 25
 Coupon rate = 6.7%
 Most recent price of preferred equity = 25.13
o Preferred stock is priced at a premium
 Dividend yield = 25 x 6.7% / 25.13
o = dividend yield / price of preferred equity

Example 2

 Coupon rate = 6.875%

 Dividend frequency = quarterly, but all coupon rates are annual
 Face value = 6.875 / 6.875% = 100
o Annual dividend / Coupon rate
o Many times, preferred stock has face value of $25, $100 or $1000
 Annual dividend = 6.875
 Price of preferred equity = 100.15
 Dividend yield = 6.875 / 100.15 = 6.8647%
o Face value x coupon rate / most recent preferred equity price
o Face value = dividend / coupon rate
o Face value x coupon rate = dividend
o Dividend is ANNUAL

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Capital Structure

 Objective: maximize value of the company

 Balance sheet
 o Asset
 Take positive NPV project
o Debt + equity
 What mix of debt vs. equity will provide the max firm value?
 To answer this, we need to fix the LHS (assets) – no new project

Three cases

 1. Modigliani and Miller: In a perfect world without taxes and no bankruptcy costs
o Proposition 1: Value of firm
 VL = Vu with no taxes
 Firm value is a constant under this MM world
o Proposition 2: Cost of capital
 ro = cost of capital for all equity firm
 ro = WACC, constant
 cost of equity for an all-equity firm
o Cost of debt will be constant
o Re will be dependent on debt/equity ratio
 Take the formula
 Higher debt to equity, more debt, higher cost of equity
 Business risk (operational risk) comes from the LHS of balance sheet
(assets), but in this case its fixed and constant. The equity will bear
higher business risk.
 Equity is more concentrated (if leverage increases)
 Cheaper debt = higher risk = higher risk for equity holders
o Increasing use of cheaper debt will increase cost of equity
o Net change in WACC will be 0
 2. Modigliani and Miller: world with taxes, no bankruptcy costs
o Vl = Vu + T x D
o Proposition 1: Firm Value
 Total available with leverage – total available without leverage = tax shield
 Tax paid with leverage (higher) – tax paid without leverage = tax shield
 More debt used = more value created
o Proposition 2: cost of capital
 VL > VU
 VL = EBIT(1-T)/WACC
 VU = EBIT(1-T)/ro
 Numerator will be the same
 WACC < ro (cost of capital of all equity firm)
 WACC is downward sloping as debt increases
 WACC and debt go in opposite directions
 o Will be given on final exam sheet
o If question on exam includes no taxes, just plug 0 for taxes, T, in formulas
o Rwacc < r0
 WACC will always be lower than r0 as WACC Includes debt, which lowers the
cost of capital (WACC)
 3. Realistic world, with taxes and bankruptcy costs
o Costs of financial distress
 Costs incurred when company has trouble payment fixed financing costs
(interest)
 Direct costs = bankruptcy expenses
 Indirect costs = ex. Loss of customer trust, loss of valuable employees
 Probability of financial distress
 Higher operating or financial leverage leads to higher probability of
financial distress
 Better corporate governance = lower probability
o Proposition 1: firm value
 Vl = VU + T x D – PV (financial distress costs)
 Tradeoff between:
 1. Benefit of using debt  tax savings
 2. Cost of using debt  distress
 Value of the company is an inverted U shape
 Maximizing firm value is in the middle, where you find the optimal
capital structure
Static Trade Off Theory

 Tax shield + cost of financial distress

 At some point: value added by tax shield < value reducing costs of financial distress = optimal
capital structure

 The top curve shows the tax shield gains, if there were no bankruptcy costs  VL increases as %
debt increases
 The bottom curve shows the tax shield gains and bankruptcy costs  VL increases as % debt
increases up to a certain point, then bankruptcy costs lower the levered value as the amount of
debt gets too large
o Vl = EBIT(1-t)/WACC
 When Vl is maximized, WACC is minimized
o Proposition 2: cost of capital
 WACC curve is a U shape, opposite direction of firm value curve
 Y-axis: cost of capital, x-axis: D/E
 First statement is correct
o WACC = rs x E/V + rd x D/V
o Wacc is constant
 Statement 2: wrong
 Agreement with one only

 Corporations pay taxes on their profits after interest payments are deducted
 Therefore, interest expense reduces the amount of corporate taxes
 o This creates an incentive to use debt
 Interest reduces their net income, reducing the taxes they pay
 Therefore, though NI is lower with leverage, the total available to all investors is higher (interest
expenses are paid to debtholders before taxes, which is why total available to all investors,
because of interest payments is higher)
o Difference between total available to all investors = tax shield = T x int pmts
o Interest tax shield: reduction in taxes paid due to the tax deductibility of interest
 = corporate tax rate x interest payments
o Gain = reduction in taxes with leverage: $225.4 mm - $210.7 mm = $14.7
 25.59% x $57.9 = $14.7 mm
 Interest pmts are recorded without tax which is why T x Int pmts = gain
 The reason why we are using interest tax shield rather than tax shield from debt is because we
want to show the interest savings for the current period, and the total amount available to all
security holders at a certain point in time
o To calculate the value of the levered firm, we have to add the entire tax shield from
debt which is why Vl = VU + D x T
o This is more from a cash flow perspective
 The cash flows a levered firm pays to investors is higher than what they would pay without
leverage by the amount of interest tax shield
o Cash flows to investors with leverage = cash flows to investors without leverage +
interest tax shield
o WACC decreases as % of debt increases
o Higher % of debt = lower WACC
o Optimal capital structure = 100% debt (doesn’t work in practice due tot eh risk of
bankruptcy)

Quiz

 Market value of debt

 Capital structure – more concept and understanding, not really calculations

Value of all equity firm = net income / cost of equity

 EBIT = 3
 R0 = 16%
o WACC in an all-equity firm
 Tc = 35%
 Q1: Vu = annual CF/discount rate = EBIT(1-T) / R0 = 3(1-0.35)/0.16 = 12.1875
o Assume MM with with tax - No interest
 Q2:
o Total financing remains unchanged
o They use debt to repurchase stock
o LHS (asset side) of BS is fixed
o Value of the firm = Vl = Vu + TD = 12.1875 + (0.35 x 4) = 13.5875
o Value of the equity = value of firm – D = 13.5875 – 4 = 9.5875
 NOT just the Vu from Q1 + 4mm repurchased
 = 12.1875 - 4 = 8.1875 = unlevered equity
 Value of unlevered firm – debt = value of unlevered equity
 This is the unlevered equity, we need levered equity
 We need to account for the tax benefit
 Note that value of levered equity > value of equity after recap
 This is because of the tax benefit
o Question 2 Steps:
 1. Find VL using Vu from last question and adding tax shield
 Vl = Vu + TD
 T = 0.35
 Debt = $4m
 2. Find value of levered equity by subtracted debt from Vl
 Vl = D + E (levered)
 Vl = 13.5875 = $4 + E
  E = $9.5875
 Note: value of levered equity is not the same as value of unlevered equity
 Unlevered equity comes from Vu  Vu = 12.1875 - $4m = $8.1875
 Levered equity comes from Vl  Vl = 13.5875 - $4m = $9.5875
 Q3:
o Cost of equity before recap: Re = R0 = WACC = 16%
o Method 1: cost of equity after recap = Re = R0 + (R0 – Rd) = 0.16 + (0.16 – 0.09)(1-0.35)
(4/9.5875) = 1.79%

o
 Must know the R0
o Method 2: Alternative solution where we don’t need R0 to find Re
 Equity = annual cash flow / discount rate = (EBIT – rd x D)(1-t)/Re
 9.5875 = ((3-0.09 x 4)(1-0.35))/Re, Re = 17.9%
 Plug E and annual cash flow to find Re
 Q4: what is the WACC after recapitalization?
o WACC before recap: 16%
o WACC after recap:
 Method 1: WACC = rs x E/V +rd(1-t)D/V) = 17.9%(9.5875/13.5875) +0.09(1-0.35)
(4/13.5875) = 14.35% < R0 = 16%
 If R0, Rd, Rs is given but EBIT is not given
 Method 2: WACC = R0(1-(tD/Vl)) = 0.16(1- (0.35(4)/13.5875)) = 14.35%
 If EBIT is given, but does not require R0, Rd, or Rs
 First multiply txD / VL then subtract 1
 Method 3: WACC = EBIT(1-t)/Vl = 3(1-0.35)/13.5875 = 14.35%
 Vl = EBIT(1-t) / WACC
 Solve for WACC
 Tax rate = 30%
 Q1: Aquarius
o EBIT = 0.6
o D/E = 0.6
o D=2
o WACC?
  No R0, Rs or Rd
 WACC = 0.6(1-0.3)/5.33 = 7.87%  answer: B
 We use Vl since there is currently debt ($2)
 D/E = 0.6/1
 E = D/0.6 = 2/0.6 = 3.33
 Vl = D + E = 2 + 3.33 = 5.33
 Q2: Bema’s WACC after debt finance repos / recapitalization

o
o After recap
 D/E = 0.6
 Before tax Cost of debt = 6%
o Before recap:
 EBIT = 0.6
 R0 = WACC = 10%
 All equity
o Since we are given R0, we should use the according formula
 WACC after = R0 (1-tx*D/Vl)) = 0.1*(1-(0.3 x 6)/16)))= 8.875%
 D/E = 0.6 = 6/10, V = 6+10 = 16
 D/Vl = 6/16
 FIRST DO 1-0.3
 FIRST DO 0.3 X 6/16, then subtract by 1
 Q3: Garth’s cost of equity, Re after debt issuance

o
o Before recap
  EBIT = 0.4
 All equity, R0 = 10%
o After recap
 Issue debt of $1m to buy back equity
 D=1
 Rd = 6%
 Since we have the R0 and Rd, we can plug into formula
 Method 1: Re = R0 + (R0 – Rd)*(1-t)*(D/E)
 Re = (0.1 – 0.06)*(1-0.3)*(1/2.1) = 11.33%
 E = value of levered equity = 2.1
 Vu = EBIT(1-t)/R0 = 0.4(1-0.3)/0.1 = 2.8
 Vl = Vu + TD = 2.8 + 0.3 x 1 = 3.1
 E = 3.1 – 1 = 2.1
 Method 2: E = (EBIT – rd D)(1-t)/ re
 Re = (EBIT-rdD)(1-t)/E
 Re = (0.4 – 0.06 x 0.1)(-0.3)/2.1 = 11.33%
 Value decline when debt is repaid = Vl = D + E – (debt repaid x tax rate)``

 WACC after repayment = Ro = unlevered cost of equity / capital

 WACC levered = 15%
 Use Vl = $4m of debt + $20m of equity
o Using Vl since this is what we’d use when calculating WACC with leverage

 Find WACC by using the debt to equity ratio

o Convert D/E to D/Vl in WACC formula

 Use WACC to find Vl

 Trade off theory

o Vl = Vu + tD – PV (costs of financial distress)
o Trading off the benefit (tax benefit) and the cost of using debt
o Optimal debt to valuation ratio
o Implications:
 1. There is an optional debt to equity ratio, typically greater than 0 but less
than 1
 V – y axis, D/V, x axis, inverted U shape, there is target optimal
 2. Profitable companies use more debt
 More income = more taxes = tax benefit is more beneficial for the firm
= therefore company should use more debt
 2. Financial slack (FCFs) may not be good because it increases agency cost of
equity
 Managers may use money for their own personal benefit ex. Buy
personal jets
 This is called agency costs
 Pecking order theory
o When companies use financing, they use the cheapest financing and then go up the
ladder to the next cheapest financing
o Start with cash, then debt, then equity
 o Implications (opposite from trade off theory)
 1. No target debt equity ratio
 2. Profitable firms use less debt
 If company is more profitable, they will use more cash flow and less
debt
 3. Financial slack is good
 FCF is good so they can use more of it
 Both theories are valid, different companies use different theories

Personal Taxes

 EBIT  firm pays interest expenses  EBT  pay corporate tax  net income  pay to
shareholders or RE
 o NI
 1. Payout to shareholders
 1. Dividends
o Shareholders pay dividend tax = Tdiv
 2. Repurchases
o Company buys stocks = shareholders sell stock back to the
company
o Shareholders pays capital gain tax = TcG
 2. Keep as retained earnings
o Firms pay interest expense
 Debt holders receive interest income
 Therefore, debtholders must pay tax on interest income, which is the same rate
as that on ordinary income = Tinterest
o At the corporate level, using debt is better because it gives you capital advantage
o But at the personal level, using debt is a penalty
 Generally, Tint > Tdiv, TcG
 How is personal tax reflected?
o Suppose personal tax rate increases:
 Debtholders receive lower after-tax interest income
 Shareholders receive lower after-tax equity income
o Because the income debt and shareholders receive is lower, they will demand higher
return  which means a higher cost of capital for the firm
o Ex. Debt = $100, I = 10%, Tint = 20%
 Situation A: Tint = 20%  Debtholder after tax income = 100 x 0.1 x (1-0.2) = 8
 Situation B: Tint = 50%  Debtholder after tax income = 100 x 0.1 x (1-0.5) = 5
o Since tax increased, debtholders are not happy since they’re not making the same
amount as before, therefore, they will charge a higher interest rate
 Situation C: Tint = 50%, I = 15%  Debtholder after tax income = 100 x 0.15 x (1-
0.5) = 7.5
 If debtholders tax increases, they will raise interest rates as a result – how can we quantify the
impact of both personal and corporate level tax?
o Vl = VU + Tc x D
o Tc = corporate level taxes
 Using debt: With interest: EBIT(1- tint)
 Using equity: Without interest: EBIT(1-Te)
o Te = Tdiv + Tcapitalg / 2
o Te = equity tax
 How much better is using debt, relative to using equity? AKA What is tax advantage of debt
considering both corporate and personal taxes?
 o = EBIT (1-Tint) – EBIT(1-Tc)(1- TE) / EBIT(1-Tint)
o = T* = 1 – (1-Tc)(1-Te) / (1-Tint)
 VL = Vu + Tc x D – PV(Bankruptcy costs), where Tc = 26.5%
 VL = Vu + T* x D – PV(Bankruptcy costs), where T* = 9%
 Generally:
o Tc > T*
o Tint > TE
o 1-Tint < 1 – Te
 Divide both sides by 1- Tint  1 < (1-Te )/ (1 – Tint)
 Multiply both sides by (1-Tc)  1-Tc < ((1-Tc)(1-Te) / 1- T int)
 = - (1-Tc) > - (1-Tc)(1-Te)/ (1-Tint)
 Add 1 to both sides  1-(1-Tc) > 1-((1-Tc)(1-Te)/(1-Tint))
 1-(1-Tc) = Tc
 1-((1-Tc)(1-Te)/(1-Tint)) = T*
 Therefore Tc > T*
2013 T* for BC = 1 – (((1-Tc)(1-Te))/(1-Tint)) = -0.0151

 Tc, Corporate tax = 25%

 Te = 23.8%
 Tint = 43.7%
 T* = tax advantage (effective tax advantage for debt)

If most investors are high income investors, then using debt a big penalty
Tax Savings with Different Amounts of Leverage

 I = 10%
 High leverage  debt = $10,000
 Excess leverage  Debt = $11,000
 In both case 1 and 2, even though you’re using more debt, you don’t get additional tax savings
 Cutoff point: maximum amount of debt D to enjoy tax benefit / without excess leverage = EBIT /
i = $1000 / 0.1 = $10,000 \
 D x i = interest = EBIT
 D = EBIT / i, i = % interest, NOT DOLLAR AMOUNT
o If you use more debt than the max amount, you will end up having a tax penalty due to
additional costs (ex. Bankruptcy)
o D x i = interest = EBIT
 If uncertain, choose an interest expense that is lower but still get optimal level of tax savings for
$1000 with risk

 Marginal cost is upward sloping (will be given on exams)

 Marginal benefit is downward sloping
o Hard to quantify
 o Line is not straight, there’s a kink

 Optimal level of debt is where MB = MC

 Too little debt (RHS)  MB is greater than MC, meaning that we should use more debt
 Too much debt (LHS)  MB is less than MC, meaning that we should use less debt
 Firm value is highest at optimal level of debt

 Trade off where tax benefit of debt = cost financial distress

 Optimal debt = D*
 VL = Vu + TD – PV(financial distress)
o Financial distress is hard to quantify
  MB = marginal benefit, MC = marginal cost
 At D*  MB = MC
o MB represents marginal benefits of tax savings
 MB = tax shield (incremental interest x tax rate)
o MC represents marginal cost of bankruptcy costs
 On LHS, MB > MC
 On RHS, MB < MC

 Note: graph is drawn wrong

 When Interest = $10, the MB = $0
 Tax rate = 0.35 since $1 of interest will give you tax savings of $1 x 0.35 tax rate = 0.35

Without (no) carryforwards  loss

Interest EBIT – interest Tax Difference

0 10 – 0 10 x 0.35 MB = 0.35
1 10 – 1 9 x 0.35 MB = 0.35
2 10 – 2 8 x 0.35 MB = 0.35
…8 10 – 8 2 x 0.35 MB = 0.35
10.1 10 – 10.1 0 MB = 0
 Exactly at EBIT = $10 , where interest = EBIT, the marginal benefit is 0
 When interest > EBIT, there is no marginal benefit

With carryforward
 Interest EBIT = $10 – interest Tax Difference
0 10 – 0 10 x 0.35 MB = 0.35
1 10 – 1 9 x 0.35 MB = 0.35
2 10 – 2 8 x 0.35 MB = 0.35
…8 10 – 8 2 x 0.35 MB = 0.35
11 10 -11 -1 x 0.35 MB = 0.32
The $1 loss is applied
to the next year
(additional tax benefit)
12 10 -12 -2 x 0.35 MB = 0.29
 When interest = $11  Apply the -$1 to $1 loss to next year (t+1), reduce yr 1+t by 0.35, PV =
0.35/1.1 = 0.32
 When interest = $12  Apply the -$2 to $2, loss to next year (1+2), reduce yr t+2 by 0.35, PV =
0.35/1.1^2 = 0.29
 The additional loss is applied to further future years

X* = optimal amount of interest (over BV of assets)

 With no carryforward, x* should be less or equal to the kink

o Any debt greater than the kink will yield 0 tax benefit
 With carryforwards, any debt beyond the kink continues to generate tax savings, making the
optimal level of interest higher
o As long as the marginal benefit > marginal cost, you should continue to use debt
 Use debt as long as MB > MC
  T = 0.4
 EBIT = 5
 Slope =
 MB = y = 2x
 X* = 0.4/2 = 0.2
 MC = y = Slope = rise / run = 0.4 / 0.2 = 2x

To find the intersect (x*)

 If you have y-int, and the slope

 You equal y-int to the slope  y-int = slope
 Y = 0.4 = 2x
 X = 0.2

Pg. 65 to end of chapter  NOT REQUIRED

Payout
 Declaration date = announcement date
 Payment / payable date = the day the dividend will be paid
 Record date = determines who gets the dividend and who doesn’t
o Ex. November 17th
o At the end of November 17th, Microsoft will look at shareholders on their list
o Only the shareholders on the list get paid the dividend
o If you buy stock on November 15, 16 or 17th, you will not get the dividend as it takes a
couple days for the transaction to go through
o It takes 2 days for the transaction to settle
 Ex dividend date = without dividend date
o If you purchase dividend prior to ex dividend date, you will receive a dividend
 When given record date, you should be able to solve ex dividend date
 Only business days
 Settlement cycle date: September 5th, 2017
o After this date, the ex-dividend date was shortened to 1 business day prior to record
date
o Now settlement cycle is shortened to 2 days, not 3 days
  Option 2: payout earnings as dividends and raise money through issuing additional common
shares for the project
o $20,000 in earnings  paid as dividends
o $20,000 / 10,000 shares outs = $2 dividend
o Ex dividend share price = $18 ($20 - $2)
o Now issue # of shares that will give you $20,000
 $20,000 / 18 per share = 1111.11 to obtain $20,000 in financing
o Shareholder value = $18 x (10,000 + 1111.11 shares outs) = $200,000

Why Dividends Does not Matter?

 Investors who want more income:

o Construct their own dividends by selling their shares for cash
 Investors who want less income:
o Hold stock and receive dividends, use dividends to buy more shares
 NO taxes or transaction costs
  Ignore last question “in the real world…” Before payout

Market Price EPS P/E Shareholder wealth

Before $30 $0.8 30/0.8 = Consider a shareholder who
payout 37.5x holds 1 share
Wealth = 1 x $30 = $30 (stock)
After Total value / # of SO = $0.8 $20 / $0.8 = After div:
payout: $3000 / 150 = $20 Remains 25x $10 div (cash) + $20 (1 share)
Dividend OR initial price – div/sh = unchanged = $30
$30 - $10 = $20
After 3000 / (150 – 50) = $30 Total earnings = $30 / $1.2 = 1.if she tenders the share 
payout: $0.8 x 150 = $120 25x $30 x 1 = $30 (cash)
Repurchase $120 / 100 shares 2. if she keeps the share 
 after repo = $1.2 $30 x 1 = $30 (stock)
 Total market value before: = $30 x $150 = $4500
 Total value after: = $4500 - $1500 = $3000
 Dividend
o Dividend per share = $1500 / 150 shares outs = $10
o EPS remains unchanged
 Profit and earnings are not changed
 # of shares don’t change
 Repurchase
o 3000 market value / (150 shares outs – 50 shares repurchased) = $30
o # of shares to be repurchased = $1500 / $30 = 50
o Under perfect market conditions, if we purchase buybacks at current market price, the
stock price remains unchanged
o EPS changes
 # of shares goes down so EPS increases
 Total earnings = $0.8 x 150 shares outs = $120
 Share repurchases artificially increase EPS since it lowers the # of shares outs,
which is why companies love repurchases
 Total shareholder wealth remains unchanged

Topic 5: Payout – Slides NOT Covered

 P. 61, 64, 65
 P. 92-93, 102-105

Dividend Advantages and Disadvantages

 Advantage: Dividend preference

o Investors prefer having cash, and receiving a dividend rather than capital gains
o Capital gain from stock appreciation seems more uncertain because stock price could
drop
o Dividend is less risky than the same amount of capital gains
o Bird in hand argument
o Result: companies that pay dividends are viewed less risky, and therefore have a lower
cost of equity and higher stock prices than a company that does not pay dividends
 Disadvantage: Taxes on dividends and capital gains
o Dividends are taxed higher than capital gains
o If an investor doesn’t sell their stock, they could defer their capital gains stock forever
o This gives an incentive for investors to prefer repurchases rather than dividends
 When a company repurchases shares, investors are essentially selling their
shares back to the company, which means that it’ll be subject to capital gain tax
o The higher tax rate on dividends makes it less desirable for firms to issue dividends
  If a firm raises money by issuing shares (selling stock to investors, investors buy
the stock), when the firm returns the money back in dividends, investors may
receive less than their initial investment because of the higher tax on dividends

Optimal Dividend Policy with Taxes

 If dividend tax > capital gains tax  investors will make more from repurchases
  firm value for firm with repurchases > firm value for firm with dividends
o Tax savings will increase the value of a firm that uses share repurchases rather than
dividends
 If dividend tax > capital gains tax  do NOT pay dividend  optimal dividend policy
o Trend: Payment of dividends from companies has declined in last 30 years, where
repurchases have increased
o Note: Decline in repurchases during economic downturns
 Dividend puzzle
o Firms continue to issue dividends despite their tax disadvantage

Clientele Effect

 Clientele effect due to:

o Tax considerations
o Requirement of institutional investors
 Some mutual funds, banks, insurance companies only invest in dividend paying
companies
 Institutional investors focus on high dividend paying companies or only invest in
companies who pay dividends
 Trust and foundations have laws where only dividends can be distributed to the
beneficiaries
o Investor preferences
 Some investors prefer dividends and emphasize on only spending their
dividends, not the principle
 Clientele effect: because of investor preferences, tax considerations and institutional investor
requirements, issuing dividends will either repel or drawn in investors
o The company must take into account these factors when deciding how to distribute
income to shareholders

Tax Clienteles

 Preference on repurchases over dividends depends on if capital gains tax < dividend tax
 Taxes vary by region, income level, registered account (pension or retirement savings have no
tax)
 Companies can attract different groups of investors based on their payout policy
 The whole market will drive A and B to be equal to each other
 No arbitrage  A – B = Price difference = P(inc) – P(ex) = Div x (1-Td) / (1-TcG)
o Net profit = Div(1-Td) + (Pex – Pinc) (1- TcG) = 0
 Pex = sell price
 Pinc = purchase price
 T* = effective dividend tax rate = Td – TcG / (1-TcG)
o If TcG = 0, T* = Td

 Additional tax paid by the investor per dollar of receiving a dividend rather than paying capital
gains tax
  2003 T* = 0.3134 – 0.2321 / (1- 0.2321) = x

Tax Differences Across Investors

 Based on:
o Jurisdiction
o Income level
o Type of account or institutional investor
o Investment horizon
 Therefore, different investors will have different preferences on dividends
 US
o State taxes differ by state
o Foreign investors have 30% withholding tax on dividends
o Retirement savings account, pension fund, nonprofit endowment  not subject to
capital gain or dividend taxes
o Corporations that hold stock can exclude 70% of dividends from tax, but not with capital
gains
 Canada
o Provinces taxes differ by province
o US investors on Canadian stocks are subject to 15% withholding tax, and vice versa
o RRSP, RRIF (registered retirement income fund), TSFA are not subject to taxes
o Corporation that hold stock can exclude 100% of their dividends from taxes, but not
with capital gains
 Retirement, pension, tax free savings accounts, nonprofit endowments are not subject to taxes

Clientele Effects

 The dividend policy of a firm reflects the tax preference of its investor clientele
 $1 dividend after tax = $1 (1- 0.28) = $0.72
 $0.87 capital gains = $0.87(1-0.15) = $0.74 (this is better)

 TcG = 0.2
 Change in price = Div x (1-Td)/(1-TcG)
o Change in price = Div x 0.7  0.7 = (1-Td)/(1-TcG)
o Plug in for Td = 0.44
 Stock price drops by 70% of dividend = 0.7 x Div
  Change in price = Div x (1-Td)/(1-TcG)  Div  (1-Td)/(1-TcG) = 1
 Td – TcG
o Marginal investor  Td = TcG or tax exempt investors

Question 1

 $1 div after tax = $1 - $(1- x 0.3 x0.4) = $0.88

 $x CG  after tax - $x(1-0.4) = $0.6x
o What $ of capital gains will equate to $1 of dividend
o 0.88 = 0.6x, x = 1.47
o It will take $1.47 of pretax capital gains to get the same after tax amount of dividends
 Dividend has a much lower tax rate
  This company is also an investor and receive dividends from their investments just like any
regular shareholder

Question 2

 Change in price = Div x (1-Td)/(1-TcG) = Div x (1-0.12 / 1-0.4) = 1.47 x Div

 Td = 0.12  1 – 0.88
 Therefore, stock price drop is more than the amount of the dividend

Signaling

 NI
o Retained earnings  for future growth or keep as cash
o Payout  could mean NI increased (good thing) or future growth declined (RE is
sufficient, bad thing)
 Investors cannot observe the future growth potential, they do know the numbers (NI and
payout)
o They use the payout to figure out what is going on with the company
o Ex. If payout increase, it could mean their income increased or their net income is not
increasing but retained earnings is fine

 1: Almost never say “always”  there is always an exception, say “generally” instead
 2: Dividend decrease is typically a bad thing
 Answer: B, both are wrong

Signaling and Share Repurchases

 Buy low, sell high – same thing applies to a company when they buy and sell
 Firms tend to buy back/repurchase its own stock when the stock is undervalued
o Shareholders will interpret share repurchases as the stock being undervalued  share
repurchase is a good signal  stock reacts positively at share repurchase events
 Firms tend to sell/issue its own stock when the stock is overvalued
o Shareholders interpret stock issuance as the stock being overvalued  share
repurchase is a bad signal  stock reacts negatively at share issuance events


 Repurchase at $30
o With asymmetric information
o # of share repurchases = 600/30 = 20
o Shares outstanding after = 200 – 20 = 180
o Total (true) value after buyback = value before – payout = ($35 x 200 shares) – 600 =
6400
o Price after = 6400 / 180 = $35.56
o Price increases after share repurchase, the # of shares decreases, stock is more
concentrated, share price is now higher
o Initially you bought it at a cheaper price, when it was undervalued at $30, which means
you can buy back more for the same amount
 If waited  new information would be reflected into the market  the market price = $30
o No asymmetric information
o Repurchase at $35, the more expensive price
o Now you can only buy back fewer shares  # share repurchases = 600 / 35 = 17.14
o Share outs after repurchase = 200 – 17.14 = 182.86
 More diluted, price is lower
 Price after = 6400 / 182.86 = $35
 Company keeps the cash  t+1 20 x 1.05 = 21  pay to shareholders
o Payout cash ($20) to shareholder  shareholder invests on their own  t+1 20 x 1.05 =
21
o Indifferent under perfect market conditions
 Tax disadvantage
o Cash and debt in corporate finance is the opposite
o Debt is the borrowing, cash is negative debt in corporate finance
o Debt creates tax benefit, meaning cash will create a tax disadvantage
o If firms retains cash, it must pay corporate tax on the interest it earns
o Double taxation
 Company pays tax and investor also pays tax
 If the firm paid the cash to its shareholders instead, they could invest it and be
taxed only on the interest they earn
 Agency costs
o Too much cash is not good for the company  will lead managers to invest in empire
building
o Managers will use excess cash for their own benefit  FCF problem

 All equity firm Vu = $250m

 Cash: $300
 FCF = $150 / year
 Could put cash in new project that will increase FCF by 10%
 0. Do not expand – base case
o V = $150 / 0.07 discount rate + 300 cash = 2443
o P = 2443 / 250 = $9.77 (per share)
o 1. Use cash to expand
 V after = (150 x 1.1) / 0.07 = 2357
 Do not include the $300 since it is already used to fund the expansion
 P after = 2357 / 250 = $9.43
 Stock price and total value declines
 Decline in total value = $2443 - $2357 = $86
 = price change = (9.71 - $9.43) x 250 = $86
 = NPV = -300 + (150 x 0.1)/ 0.07 = -$86
o 2. Use cash to repurchase shares
 # of shares = $300 / 9.77 (base case price) = 30.71
 # of shares outs after = 250 – 30.71 = 219.29
 V after = 150 / 0.07 = 2143
 300 is paid out and should not be included
 P after repurchase = 2143 / 219.29 = $9.77
 Solve agency costs through repurchasing shares
 Too much cash is bad  firm should pay it out

 Answer is B
 Not necessarily constant, regardless of earnings volatility
 It can still change but its not a dramatic change – dividends are smoothed out
 Example
o Q1: 0.5
o Q2: 0.5
o Q3: 0.55
o Q4: 0.55
 No signaling effect
 Clientele effect – tailored to prospective clients
 NOT M&M (since it is not related to the market)
 Answer is C

 E0 = 3.5
 E1 = 4.5
 D0 = 0.7
 Target payout ratio = 0.35
 N = 5 year period
 We want to adjust the dividend so that the dividend is keeping up with the earnings, but the
adjustment is not dramatic, it is more slow
o Change in earnings = 4.5 – 3.5 = 1
o Change in div = 1 x 0.35 = 0.35
o This 0.35 increase is too dramatic, so we need to smooth is out over 5 years
o 0.35 / 5 years = 0.07
o D1= 0.7 + 0.07 = 0.77
o Earnings increased by 30%, but the dividend is stable so it is adjusted much slower than
the earnings increase

 E0 = 2
 D0 = 0.4
 E1 = 2.8
 Target payout ratio = 0.3
o Change in earnings = 2.8 – 2 = 0.8
o Change in div = 0.8 x 0.3 = 0.24
 Dividend increase would be too high
o Change in div per year = 0.24/5 = 0.048
 Slow down the dividend increase, spread out by 5 years
o D1 = 0.4 + 0.048 = 0.448
 E0 = 4
 Div = 0.3
 E1 = 5.2
 Target payout ratio = 30%
 Div1 = 0.39
o Change in earnings = 5.2 – 4 = 1.2
o Change in dividend per year = 0.39 – 0.3 = 0.09
 Over how many years can you bring the dividend to its expected amount
o Total Change in div = change in earnings x payout ratio = 1.2 x 0.3 = 0.36
o Change in div per year = total change in div / x = 0.09
 X = 0.036 / 0.09 = 4 years

 Payout ratio is constant = Div / Earnings

 NI = retained earnings (step 1) + payout (step 2)
 Required capital project = $900 (need $900 to do this project)
o 60% financed to raising debt = $900 x 0.6 = 540
o 40% financed to raising equity = $900 x 0.4 = 360
 Issuing new equity is expensive  not issuing new equity
 Therefore, we will finance equity through retained earnings (think of retained
earnings as the company’s internal equity)
 0 floatation costs = 0 transaction costs (cost of issuing debt or equity)
 Capital structure  Debt: equity = 6:4
 Earnings = 500 + retained earnings + payout
 Earnings = earnings – payout (whats needed from RE to fund project instead of issuing new
equity)
o Payout = 500 – 360 = 140  answer is A
 If we change the required capital project to $2000
 60% financed to raising debt = $2000 x 0.6 = 1200
 40% financed to raising equity = $2000 x 0.4 = 800
o Capital structure  Deb t: equity = 6:4
o Earnings = 500 + retained earnings + payout
 Payout = 500 – 800 = 0 payout is 0
 Answer is C

 1. Determine amount of retained earnings required  identify the project requirement cost
 o Need to find the hurdle rate / cost of capital of the project to decide which project to
take on
o WACC = hurdle rate = (0.07 x 0.35) +( 0.12 x 0.65) = 10.25%
 Cost of equity is 13.5% for issuing new common stock, 12% for cost of retained
earnings
 DO NOT USE 13.5%, this is for the company issuing new equity
 For residual policy, we do not issue new equity, we always use internal
equity (retained earnings)
o Based on WACC, choose project A, B, and D
 Total project $ = 2.5m + 1m + 0.5m = 4
 65% equity = 4 x 0.65 = 2.6
 35% debt = 4 x 0.35 1.4
o Net income = $4 – 2.6 = 1.4
o Payout ratio = 1.4 / 4 = 35%  Answer is A

Residual Dividend Model

 Advantages
o Simple to use
o Management can make capital investments without considering the need to payout a
certain amount of dividends
 Disadvantages
o Dividends are unstable
o This might be seen as risky for investors, and increase the firm’s cost of capital
 Answer is A

 Company is using stable policy

 Average payout ratio = 65%
 Share outs = 8
 Net income = 28
 Capital spending = $5
 D:E = 1:1
 3 policies
o 1. Stable
 B since A and C are excluding to the other dividend policies
o 2. Constant
 Div pe share = ($28 x 0.65) / 8 shares outs = 2.28
 The company is not following constant payout
 NOT the answer
o 3. Residual
 Capital spending = $5  meaning retained earnings = $5 x 50% retained equity
(internal equity) = 2.5
 Payout = 28 -2.5 = 25.5
 Dividend per share = 25.5 / 8 = 3.19
 NOT the answer