Topic 1

7. You can finance a business using equity and debts. Debts are getting loans etc. Lenders have senior claims against the assets of the company which means if a company goes down, the lenders have one of the first takes at getting their money back. Equity are from owners and have residual claims. 8. New Zealand has a single tax system but in USA there is a double tax system 9. Main Focus of this course. 10. Maximising wealth is doing decent and honest things to increase the share price. Maximising the profit of the company does not necessarily increase the wealth of the company. The share price of a company fluctuates everyday because of supply and demand. Stock prices reflects future performance. Wealth is the expected value of the company however profit is the historic performance. BOD do not own shares and therefore are independent from the business. ENRONs share price dropped from $90 to 45 cents x 0.74 billion shares = $66.3 billion loss in market value which was started only to offset the $2.2 billion loss they were trying to hide 12. Financial managers talk to investors to raise funds. They then have a say into which assets are best for the company. Operating decisions are made and then cash is generated. Financial investors determine how much should be paid to investors and how much should be reinvested into the business. 13. Firms talk to investors or investors invest in firms. Investors investing in the financial market is direct investment. (check the recording 10.30). Buying shares from a broker is a direct investment. Indirect investment is when you want to buy shares but you are not sure about your purchase as we are not sure about whether a company is going to be profitable in the future. An alternative is going through financial intermediaries are professionals who help select stocks for you. There are more hedge funds in New Zealand than Shares nearly triple. An example is term deposit where you put money into the business and at the end of the period you receive money as a product. The product the bank gets are stocks so therefore indirectly investors are the owners of shares but the bank are the institutions that actually own them, The benefit of this is that if you have limited funds for investing, you may not have enough money to directly invest into a firm. Finanical intermediaries take many small amounts of smaller investments, accumulate them and have a large amount of money to invest on investors behalf. 17. Diversification and risk transfer is 18. We focus most on cash, not profit.

Topic 2
7. Compound % represents the % of the total cash flow.

8. Compounding interest grows at an increasing rate 9. The higher the interest rates the larger the level of the compounding component. At any point in time, the compounding % for a higher interest is higher than a lower interest. The higher the interest rates, the higher the growth rate. 10. When there is a lower interest rate, the future value is lower as well. 11. This shows how much we need to reach $100 over a specified period of time. At r=3% you need to start with $40 however at r=12% you need less than $10 21. Note we do not count PV = 0 An ordinary annuity assumes that the first payment occurs at the end of the period with no c at n=0 22. An annuity due assumes that the first payment occurs immediately with no c at n i.e. the very last period 24. We dont know the future value of a perpetuity as we dont know when it will end. Theoretically there is no future value for an perpetuity 26. First year cash flow is 0 but n = 2, 3, 4 is $4,000 We take the original amount and discount one period back. First you you get the present value as at n=1 then you discount it again to PV 28. Bonds are dominated by Banks Stocks attract more investors both big and small The $90 is called a coupon and is in compensation of inflation and interest 30. However, if the interest increases to 10%, the PV decreases 32. When r=10%, then the PV = $1000 i.e. when r = coupon, par = price 33. All points using a par value of $1000 and a coupon rate of 10% will always pass through 10% If the coupon rate is more than the market interest rate then it will attract more investors. The inverse is true as well 35. The bond price of the premium drops slowly til it reaches the par value as the maturity is reached 36. YTM is still an r, but this r makes the present value of the cashflows (the coupons + the final maturity) equal to its price. If the bond is the at market price, then the YTM will be the interest rate YTM is what % I will be earning if I bought the bond at the price being offered to me. When we sell the bond, we look at the realised rate of return, which is what we actually earned as opposed to what was promised when we purchased the bonds. Like the nominal interest rates and inflation goes up then our real interest rate is different.

If Bonds are priced at the correct price, then the YTM = IRR 37. We can sum these because they are at the same point in time 38. Since we are holding the bond til maturity, there is no change in the bond price. We are calculating the coupon income 42. The buyer only cares how much he/she will receive, not how much the past owner has been given. We must calculate everything as of today. We only care how much we are going to receive. 43. Greater than the YTM as the we did not discount the final 1090 at a rate of 9% but rather at the market rate of 5% which meant that the PV was higher than if discounting at 9% As the interest rate of the bond drops, the bond price moved up. People will only expect a $50 return from $1000 but the coupon will give $90 which means that this bond will be in high demand 45. If we have $1000 now and we earn 2000 at r=7 at the end of year 10, if we discount by 7% which is the required rate of return then theoretically, these two (1070 and 2000) will be exactly the same. However, this is assuming that the nominal interest rate does not change. This assumption is okay for one or two years but as we look longer into the future, making the assumption that the r = 7 over 10 years is a big risk. The CPI will fluctuate a lot over 10 years especially compared to the rreal. If we say that that r should be 7% for 10 years then we are making a risky assumption. People adjust interest rates based on their expectations of future inflations future interest rates. 1) 46. Did not explain 2) 1) bonds carry more risk, the longer we Invest. We could invest 1 year over and over if this was the case. We also have to delay our consumption for that amount of time we cant withdraw our money if its in a 10 year bond. Require a premium for this hindrance. 2) Borrowers want money to be definitely available. Not having enough money may disrupt the operation of the company 47. Thus, over time, the short term rate would increase due to inflation but the long term rates would increase more due to the liquidity premium. Liquiduty premium is when the investor demands higher r for having their money locked in for a longer period of time so the pink one represents the interest rate in the market over time 48. AAA is secure and therefore the default risk is low. If this is the case, then the investor will not require a higher interest rate. This is why the Government bonds are the lowest. 53. Liquidity to get money for whatever you may want. Without Secondary market, it would take a long time to find buyers for the shares.

Issuers would not be able to find buyers for their shares knowing that their buyers would not be able to sell their shares to anyone but the original company 55. We can use the P/E ratio only when the price of the share is reliable or available. When companies release their IPO, they can look at similar sized businesses in the same industry and take a average of their P/E Ratios and compare it to our business. 58. This is just a take from the normal Cashflow model. However n is undefined as a firm can last forever - there is no maturity date for the stock. We have to assume the dividend will continue to be paid. Required Rate of return is the return the investors want to have if they invest in this stock 59. We assume the growth is constant so if we get $1 div this year at a growth rate of 10% we expect 10% more every year. 60. Assuming the dividends grow which is constant over time. R is the required rate of return by the investors g is called the dividend growth rate This is called the Gordon model and it only applies if the growth rate is constant (e.g. g=10%) forever. 61. Last year dividend, dividend just paid or last paid dividend refers to d0, next year is d1. 62. If the dividend does not grow i.e. g=0 then we adjust the formula. This is the intrinsic value of the stock If all earnings are paid as dividends then we can use the second formula 63. Example: if competitors start to affect your profits so you do not have abnormal profits anymore and your growth rate falls and becomes average. G1 cant use the Gordon Model as the growth is not constant forever. Get the PV of the first three dividends G2 is the second growth rate. V(D4-D) is the discounted dividends from year 4 onwards. This PV is not at time 0 yet. 65. We use D0(1+g1)m because we are growing from the previous year to the next year WE ARE DEALING WITH GROWTH!! 67. *He said something important here, around 30 mins into the lec on 14th march* 68. We use the Gordon Model for D4 and use this figure to estimate the value of all dividends from year 4 onwards. We then have to discount this back to today. 69. Need to reinvest in order to maximise wealth and build future prospects this is normal for start ups

We multipy by (1+g)t-1 because we need to predict the value of the dividend in the future. 70. GREEN - Discount Rate to find its value as of today ORANGE used to predict the value of the dividends in the future RED Brings the initial dividend (which is all we know) up to speed to the Nth year BLUE is the new growth rate, that is, the second growth rate PINK the continuous dividend, Gordon Model 73. Growth means your wealth is increasing. We need dividends for this model and if we dont have this (because there is retained earnings) we cant use the DDM model. However this is only one of the models we can work with like the P/E ratio. In cases were D0 = 0 for the foreseeable future then analysts must look into the books and see the cashflows. If the company was paying dividends, it would have been coming from cash but this cash is being used elsewhere now. At the end of the day, CF determines how successful the managements implementation is. FCFE is Free CF For Equity (that is available to equity investor does not mean it needs to be distributed, but these cashflows could have been dividends) 74. ROE EPS / Book equity per share (value equity from the book i.e. Balance Sheet. Book value equity is not Market Value and are hardly ever the same. Book Value is the historical value and Market value fluctuates) Plowback ratio (1 Payout Ratio) 75. E1 = Expected Earnings ($5 per share) ROE is what the company can return to investors. They invest on your behalf and return 20% r = Required rate of return from investors for a similar investment. Here the firm is doing better that what the investors are expecting WE ASSUME THE GORDON MODEL (the constant growth model) As seen from the slide, as the plowback rate increases, the price of the stock increases. Investors are happy for the company to reinvest their money at the ROE as it is higher than r, which is what the market is offering and what the investors are expecting. If they were given the money themselves, then they would not be able to receive 20% returns and would have to only be happy with 12% i.e. r. If the investors receive money, they need to invest that money themselves however here the management is doing that on their behalf. This is assuming that management make full use of their money.

If the firm is doing better than investor, then investor will give value to that as their money will grow faster this appreciation is reflected in the higher price 76. Case 1: Intrinsic value of the stock does not change regardless of the change in ROE Case 2: The intrinsic value is exactly the same as Case 1. There is no appreciation of Managements efforts as stockholders are able to invest their returns and earn the same amount anyway. The 4.8% does not mean much. 78. ROE > r to make any sense. 79. DDM model gives a different answer to the P/E ratio model. DDM gives ~$31 whereas the P/E ratio is $27. It is up to which one you think is the best

Topic 3
3. But you should be confidence in your calculations of the stocks There is price fluctuation which means that you may intend to buy at 25$ but end up buying at something higher. 4. r is given different values in different circumstances Opportunity Cost of Capital is the same for all the firms that undertake a particular project. A company can have multiple projects and each have varying degrees of risk. The constant is the project as it will have a specific risk regardless of who invest in it. When its easy to get Capital, the opportunity cost is low 5. Mutually exclusive = cant have a AND b 6. r = Opportunity Cost of Capital 7. Implicit Assumption that the amount we will save forever is a perpetuity 9. At first instance it seems that B is better for us however B has a shorter lifespan which means that at the end of year 2, we should have to replace B. 12. Soft Rationing is monitored internally by the organisation. Agency issues management wont always spend money in the right ways so the BOG will set Hard Rationing is monitored by the economy where there is no funds available for the company in the market. 13. Pick L, then M, then J (lower cost) then N 14. If we go for 3 as opposed to 2, as we get 0.4 in our pockets which we have to reinvest as money held does not give us any returns. We would have to find investments that give a return as much the opportunity cost of capital or else we would actually be losing money. However we should go with number 3 if we need the money right now like paying wages etc.

15. *GOLDEN RULE* ALWAYS CHOSE THE ONE WITH THE HIGHEST NPV L >> M >> J 16. If the discount rate increases, the value of anything falls. 17. Stocks are made of the value of the assets and the PVGO. The company is not growing therefore payout is 0% so we look at earnings, not dividends and is also a perpetuity. $4/0.2 = $20 Stock price - $20 = $10 PVGO 18. Always go with NPV though. The IRR is the return that the project will generate for the company 20. As your Discount Rate increases, the NPV falls. When the NPV = 0, the corresponding rate is the IRR. 21. D is lending which is like a stock or bond. 22. The more CF sign changes, the more IRRs you will get. 23. If its a lending project than the MIRR should be > r If its a borrowing project than the MIRR should be < r 24. IRR is biased towards better returns earlier in its life. However we should also look at the annual cost per year (NPV/PVAF) 26. How long till I get my initial investment back. 27. This is good to use when the future of the company is uncertain. NPV is not affected by the Payback rule 29. Cash is more important than profits as we can use cash to honour any debts we have, profits are abstract. Company can be profitable but default on its debts 30. Do we have the same CF if we dont take the project? If we dont take the project, does the cash still flow into the company? If there is than the incremental CF is 0. Indirect Effects: We must consider the loss of sale a new product has on a old product if they are in competition. Opportunity Costs: If we dont take a project that used sunk costs, then you will lose that cost as well as the project. We dont take that into account. 31. Change in Net Working Capital: an increase in inventory is recovered a year after the last year of operation realistic assumption. Regardless of assumptions, if you go for the first one, you need to

state that. Increase in WC uses cash, WC will change throughout the projects life and will only be recovered at the end of the period. Overheard Costs Shut Down Costs 32. Real * Inflation = Nominal Real = Nominal / Inflation FV / 36. Current Assets does NOT include the Cash Account therefore as debtors drop, WC will drop = cash inflow 37. *Total tax figure we actually paid in the year If tax is 30% then finally we will always end up having to add 0.3 * Depreciation. This is the net result. 38. We need to look at the CHANGE in WC, not the WC itself. An INCREASE is an OUTFLOW. Only 1679 is recovered within year 5 and we make an assumption that the rest is at the end of year 6. The reason why the salvage value is in year 6 (a year after the operations have finished) is the assumption that we will take a year to sell our machinery Depreciation 39. INCREASE in WC are cash OUTFLOWS Since NPV > 0 i.e. the costs are outweighed by the income from the project, the company should go ahead with this project. 42. What if our assumptions are different to what we think they are 43. Simulation Analysis: Instead of making individual changes, you can have a distribution of changes in sales, then a distribution of changes in variable costs and multiply them by each other. This is done on excel 45. The top table is saying what are we changing there are 12 changes. The bottom table is the result of one of the changes in the top table. Note that changes in variable aspects of an analysis has a greater impact on the NPV than fixed (e.g. Initial Investment) 46. The effects on our store if a competitor opens a similar store 47. When Accounting BE is 0, NPV BE < 0. If we breakeven next year then our NPV < 0 because the $$ generated next year will be less than the $$ generated now. 48. Use the finefodders example, the initial investment was $5400 and the PVAF8%,12yrs is 7.536

Initial Investment = [((VC% * Sales) FC) * After-Tax Rate + Depreciation] * PVAF Sales = ((Investment / PVAF Depreciation) / After-Tax Rate + FC) / VC% As we can see, the required sales for NPV BE is higher than the Accounting BE 50. DOL is the rate at which fixed costs affect profits if sales change. For x change in sales, the % in EBIT is 5.45x - this is hard to tel whether this is high or low, we would have to look at competitors in the same market or past performance of the company over the past years. 51. *** We need to consider options in the future that the CF stream can change which addes a complexity to our scenario. Any cashflow we estimate are predictions of the future. 52. Growth Option is like moving to China because of the proespects of cheaper costs Abandon Option is like prematurely closing down something and moving back to mitigate losses Flexibility Option is like when we can buy a more expensive machine that allows us to make different types of products Timing Options like investing in real estate. If we wait for a couple years, the cost of real estate would be higher and development costs would be lower