!"#$%#&$!

'
!
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
'
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
*
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
%
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
"
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
+
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
,
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!$
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!!
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!&
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!)
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!'
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!*
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!%
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!"
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!+
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
!,
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&$
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&!
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&&
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&)
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&'
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&*
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&%
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&"
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&+
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
&,
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)$
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)!
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)&
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
))
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)'
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)*
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)%
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)"
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
)+
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
),
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
'$
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
!"#$%#&$!'
'!
Percentage Returns
!Measures return taking into account the amount invested
!Usually two components to your return
!Capital gains yield =
! Priceend-of-period Pricestart-of-period
! Pricestart-of-period
!Or, Rt = ( Pt - Pt-1 ) / Pt-1
!This measures the change in the value of the investment
only
Dividend Yield
!In addition to the change in value many investments have
periodic cash flows
!Share investors may receive dividends
!Dividend Yield
!Dt / Pt-1
Combining the formulas
!Rt = ( Pt - Pt-1 + Dt) / Pt-1
Example 1
!AMPs share price at the start of the year was $10 and at
the end was $12. What was the return for AMP?
!Solution
! Rt = ( Pt - Pt-1 ) / Pt-1
! = (12 - 10)/10
! = 2 / 10
! = 0.20 or 20%
!What if AMP paid a 24 cent dividend
! Rt = (12 10 + 0.24 )/10 = 22.4%

Measuring Return
!Can use time value of money principles
!PV = FV(1 + r)-n, or
!PV = CF1(1 + r)-1 + CF2 (1 + r)-2 + ... + CFn(1 + r)-n
!P0 = D/r
!r is the rate of return on the investment
!The average return on an investment is
!R = (r1 + r2 + r3 + !!+ rn) / n or !ri / n
!n = the number of observations
!ri = return for period i
Measuring historical returns
!The average return on an investment is the average of the
historical periodic returns
!Average return can be calculated as
!R = (r1 + r2 + r3 + !!+ rn) / n
! = !ri / n
!where
!n = the number of observations
!ri = the return for observation i
Example 2
!The yearly share prices for a company are:
!2006 $10
!2007 $16
!2008 $12
!2009 $18
!What is the average yearly return?
!2007 return = (16 - 10) 10 = 60%
!Similarly, 2008 return = -25%, 2009 = 50%
!R = (60 + -25 + 50) 3 = 28.33%
Calculating Historical Risk
!Standard deviation =
!where R is the average return
! and Ri is the actual return for observation i
Example 3
!From example 2 what is the standard deviation?
!Returns were 60%, -25%, and 50%
!Average return was 28.33%

Measuring expected return
!Assigning probabilities to different outcomes allows a
measure of the return that can be expected in the long-run
!Expected Return =
!" Probability of Return " Return
!E(r) = "Pi " Ri
! where
! Pi = Probability of outcome i
! Ri = Return for outcome i
Example 4
!An investor believes that the returns for an investment
depends on the state of the economy
!The investor provides the following data:
! Outcome Probability Return
!Strong Economy 0.25 20%
!Weak Economy 0.15 -20%
!No major change 0.60 10%
!E(R) = .25 (.20) + .15(-.20) + .60 (.10)
! = 0.08
! = 8%
Measuring future risk
!Using expected return the risk is still measured by standard
deviation
!standard deviation = #


where
!E(R) = expected return
!Ri = return for outcome i
!Pi = probability for outcome i
Example 5
!An investment has a
!50% chance of yielding 12%,
!30% chance of yielding 15%, and
!20% chance of returning -5%.
!What is the risk and return?
Example 5 solution
!Expected return
!E(R) = 0.5(12) + 0.3(15) + 0.2(-5) = 9.5%
!Standard deviation

! = 7.36%
Example 6 portfolio weights
!An investor has a portfolio of 3 assets
! $20,000 of ANZ shares
! $30,000 of WOW
! $50,000 of CCL
!Total invested is $100,000
!The weights for each investment are:
!ANZ = 20,000/100,000 = 0.20 = 20%
!WOW = 30,000/100,000 = 30%
!CCL= 50,000/100,000 = 50%
Portfolio Return
!Expected rate of return for a portfolio is:
!weighted average of expected rates of return for each
individual asset in the portfolio
!E(RP) = " Wi * E(Ri)
!Wi is % of asset i held in the portfolio
!E(Ri) is the expected return of asset i
!Risk of the portfolio cannot be calculated by using the
weighted average of each assets standard deviation
Expected portfolio return
!An investor has a portfolio of 3 investments
! Asset Investment E(R) Weight
!NCP $10,000 15.5% 20%
!CSR $25,000 10.0% 50%
!BHP $15,000 12.5% 30%
!Total $50,000 100%
!Weight = investment / total investment
!for NCP = $10,000/$50,000 = 20%
!What is the expected return on the portfolio
!E(RP)=15.5%(.2)+10.0%(.5)+12.5%(.3)=11.85%
Capital Asset Pricing Model
!CAPM shows, expected return for an asset depends on
three things
!time value of money. measured by risk-free rate, Rf
!reward for bearing systematic risk measured by the market
risk premium, [E(RM) - Rf]
!amount of systematic risk measured by $
!E(r) = Rf + $(Rm - Rf)
!Higher systematic risk leads to greater expected return
Security Market Line
!SML plots the relationship between systematic risk and
expected return
!All securities/assets must lie on this line.
!All assets in the market must have the same reward-to-risk
ratio (slope of line)
!Reward-to-risk ratio is the market risk premium
!Expected Return
!= risk-free rate + (beta " market risk premium)
Example 7
!A share has a beta of 0.75. The return on the market is 16%
and the risk free rate is 6%.
!What is the expected return on the share?
!Solution
!E(R) = Rf + $(Rm - Rf)
! = 6% + 0.75(16% - 6%)
! = 13.50%
Portfolio Risk
!The risk of a portfolio is the weighted average of individual
betas for each asset in the portfolio
!#P = " Wi * #i
!Wi is % of asset i held in the portfolio
! #i is the beta of asset i
Example 8
!A portfolio consists of the following assets
!Asset % of Portfolio Beta
!BHP 30% 0.80
!ASX 30% 1.10
!RIO 20% 1.50
!TIN 20% 1.60
!What is the beta and expected return of the portfolio plus
return on the market portfolio?
!The risk free rate is 3% and the market risk premium is 6%
Example 8 solution
!Beta of the portfolio
!#P = .30(0.80) + .30(1.10) + .20(1.50) + .20(1.60) =
1.19
!E(r) = Rf + $(Rm - Rf)
!E(Rp) = 3 + 1.19(6)
! =10.14%
!Market risk premium, [E(RM) - Rf]
!E(RM) = 3 + 6 = 9%
Solution Example
!Cash Flows at the Start
!Plant -200,000
!Land Value -350,000
!Inventory -165,000
!Sale of old plant 15,000
!Tax on sale (0-15)30% -4,500
!Total -704,500
Solution Example
!Cash Flows Over the Life
!Sales 550,000
!Costs (220,000)
!Maintenance change ( 20,000)
!Lost Sales ( 55,000)
!Cash Flow 255,000
!Tax @30% (76,500)
!Depreciation tax Savings
!200,000 10 x 30% 6,000
!Net Cash Flow Per Year 184,500
Solution Example
!Cash Flows at the End
!Sale of Plant 45,000
!P/L on Sale (100 - 45)*30% 16,500
!Land 350,000
!Inventory 165,000
!Total 576,500
!Calculation of Written Down Value
!200,000 (5x20,000) = 100,000
Solution Example
!NPV calculation
!NPV = -704,500
! + 184,500 (1-(1.14)-5)/0.14
! + 576,500 (1.14)-5
! = 228,319
!Accept because NPV is positive

Dividend Models
!Current share price is the present value of future dividend
payments discounted at a rate of return
!Share price, constant dividend;
! P0 = Div / Re
!Where, P0= current share price,
! Div = constant dividend payment,
! Re = required rate of return
!To find return
! Re = Div /P0
Dividend Models
!Share price, dividend growth
!P0 = Div1 / (Re - g)
!note Div1 = Div0 (1 +g)
!Where
!Div1 = dividend received next period
!g = constant growth rate of the dividend
!Can estimate g by looking at past history of company
!To calculate return: Re= (Div1 / P0 )+ g
Security Market Line
!Expected return depends on
!The risk free rate of interest: Rf
!The market risk premium: Rm - Rf
!Systematic risk of the asset: $
! Re = Rf + $(Rm - Rf)
!Beta estimated from historical data
!SML can give different figures to Dividend Models
Practice Question 2
!Crown holdings has a beta of 1.5 and currently the market
risk premium is 4%
!The risk free rate is 5%
!What is Crowns return on equity?
!Solution
!Re = Rf + $(Rm - Rf)
!
!
Bond valuation revision
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon amount
!The market interest rate
Cost of Preference Shares
!Current market rate the firm would have to pay if it was to
issue new preference shares
!Cost of Preference Shares is
! Rp = Div / P0
!Where
!Div = the current fixed dividend per share
!P0 = current preference share price
Practice Question 4
!What is the market return on a preference share with a $10
face value, dividend rate of 6.5% pa, if they currently trade
in the market at a price of $4.50?
!Solution
!Annual dividend =
!Rp = Div / P0
! =
!
WACC
!To calculate WACC requires current market values
!Market value of equity =
!current share price * number of shares issued
!Total market value of the firm V = D + E
!Proportion of debt used in the financing the firm is D/V or
D/(D+E)
!WACC must take into account the tax deductibility of
interest
!no tax deduction for dividends
WACC
!WACC = Rd(1-tc)(D/V) + Re(E/V) + Rp(P/V)
!Rd = market return on debt finance
!Re = market return on equity
!Rp = market return on preference shares
!D = market value of debt
!E = market value of ordinary shares
!P = market value of preference shares
!tc = company tax rate
!V = D + E + P
Example 1
!Target Ltd has a market value of equity of $75m and its debt
is currently valued at $25m.
!The cost of equity is 12% and the annual interest rate on
new debt is 10% p.a.
!Targets tax rate is 30%
!What is Targets WACC?
Example 1 Solution
!Value of the firm is 75m + 25m = 100m
!The proportion of
!debt = D/V = 25/100 = 0.25
!Equity = E/V = 75/100 = 0.75
!WACC = Rd(1-tc)(D/V) + Re(E/V)
! = 10%(1 0.3) *0.25 + 12%*0.75
! = 10.75%
Example 2
!Source Market rate Market value
!Bonds 7.50% $12m
!Permanent Debt 7.90% $ 9m
!Preference Shares 8.50% $ 5m
!Ordinary Shares 10.80% $66m
!Total market value $92m
!Company tax rate is 30%
Example 2 Solution
!WACC =
!7.5(1-0.3)(12/92) + Bonds
!7.9(1-0.3)(9/92) + Permanent debt
!8.5(5/92) + Preference shares
!10.8(66/92) Ordinary shares
! = 9.44%
Example 2 Solution
!Source M.V. Weight Market Rate Subtotal
!Bonds 12 13.04 7.5%(1-0.3) 0.6846
!Perm Debt 9 9.78 7.9%(1-0.3) 0.5408
!Pref Shares 5 5.44 8.5% 0.4624
!Ord Shares 66 71.74 10.8% 7.7479
!Total 92 WACC = 9.4357
!Weight = M.V. divided by total of M.V.
!Subtotal = weight times market rate
Break-Even Analysis
!Can be used to measure the impact of different capital
structures and their results on EPS
! EPS is a function of EBIT
! EPS = profit after tax / # of shares
!Considers different financing arrangements
!Ordinary shares, Preference Shares, Debt
!EPS used to measure the effect of different levels of
financial leverage on firm
!Graphical and algebraic techniques used
Graphical Approach
!A graph showing the different capital structures the firm is
considering
!Easy to compare financing choices
!e.g. 25% debt ratio compared to 50% debt ratio
!Prepares several scenarios for each capital structure and
calculates the EPS for each
!Plot EPS for different levels of EBIT for each choice of
capital structure
Example
!A firm is considering a capital structure change. EBIT is
expected to be $30,000
!The firm is currently financed by equity only and has
100,000 shares outstanding at a price of $2 each. The tax
rate is 30%.
!It is investigating a $80,000 debt issue at a 10% interest
rate to repurchase some shares
!The EPS for various levels of EBIT are for each financing
choice are as follows:
Example Current EPS no debt
!EBIT 8,000 20,000 30,000
!Interest
!PBT 8,000 20,000 30,000
!Tax 2,400 6,000 9,000
!PAT 5,600 14,000 21,000
!# of Shares 100,000 100,000 100,000
!EPS $0.056 $0.14 $0.21

Example Proposed EPS with debt
!EBIT 8,000 20,000 30,000
!Interest 8,000 8,000 8,000
!PBT 0 12,000 22,000
!Tax 0 3,600 6,600
!PAT 0 8,400 15,400
!# of Shares 60,000 60,000 60,000
!EPS $0.00 $0.14 $0.257

Example
!EBIT Current EPS Proposed EPS
!$8,000 $0.056 $0.00
! $20,000 $0.14 $0.14
! $30,000 $0.21 $0.257
!EPS is the same when EBIT = $20,000
!Known as the break-even EBIT
!At the break-even point ROE
!ROE = 14000/200,000 = 7% currently
!ROE = 8,400/120,000 = 7% for the proposal
!ROE = PAT/shareholder funds
Algebraic Approach
!Earnings per share can be calculated by
Practice Question 1
!TMNT Ltd currently has $8 million of debt at an interest rate
of 5% pa. Tax rate is 30%.
!The CFO plans a $4 million debt issue to repurchase equity
!The current share price is $40 and there are 400,000
shares issued
!EBIT is expected to be $2,500,000
!Should the CFO proceed with the debt issue?
!What is the Breakeven Point?
Practice Question 1 Solution
! Current Planned
!EBIT $2,500,000 $2,500,000
!INT
!Pre-tax profit
!Tax
!Net income
!No. of shares
!EPS
!EPS can be increased by increasing debt
Break-Even Point
Capital Structure Theory
!Capital Structure is the mix of debt and equity a firm uses to
finance assets
!Theory considers effect financial leverage has on the
market value of the firm
!Market Value of the Firm =
!Market Value of Debt + Market Value of Equity
!V = D + E
!Focus on whether the firms choice of capital structure will
affect the value of the firm
Modigliani and Miller II
!Cost of capital is linearly related to debt ratio
!Cost of equity depends on Ra, Rd and D/E
"Overall cost of capital Ra remains constant
!Business risk - inherent risk of business
!Financial risk - risk created by debt
Example
!Firms U and L are identical. Both have EBIT of $8,000
forever. However, L has $60,000 debt at a 5% rate. Tax is
30%.
! Firm U Firm L
!EBIT 8,000 8,000
!Interest - 3,000
!PBT 8,000 5,000
!Tax 2,400 1,500
!Net Income 5,600 3,500
Example
!Assuming no depreciation
!Operating cash flow
!Firm U 8000 2400 = $5,600
!Firm L 8000 1500 = $6,500
!The extra cash flow to L is because of the tax saving on
interest
!Tax saving = 5% " 60,000 " 30% = $900
!Firm value depends on capital structure
MM I with taxes
!Adjusted the model to consider taxes
!Value of the firm is equal to the value if all equity financed
plus the present value of the tax shield
!= Value if all equity financed + PV of tax shield
!If debt is permanent PV of the tax shield
!= (Tc"Rd"D) / Rd = TcD
!Value of firm is not independent of its capital structure
!Incentive for firms to choose debt
Example
!Blue Ltd is an all-equity firm with a total market value of
$500,000 based on Blue having 25,000 shares issued.
!Management is considering issuing $100,000 of debt at an
interest rate of 7% p.a. and using the proceeds to
repurchase shares.
!Blue estimates the firm's EBIT will be $60,000.
!The tax rate is 30%.
!What is the EPS for each capital structure?
Example Solution
! All equity Debt/Equity
!EBIT $60,000 $60,000
!INT $ 7,000
!Pre-tax profit $60,000 $53,000
!Tax $18,000 $15,900
!Net income $42,000 $37,100
!No. of shares 25,000 20,000
!EPS 1.68 1.86
The Foreign Exchange Quote
!AUD/USD = 0.8964/0.8967
! Sell price
! Buy price
! Terms Currency
! Commodity
Currency
!In FBF we will always talk of exchange rates as a mid-
point
!A single figure avoids any confusion between the
perspective of the buyer and seller
Example
!You wish to go skiing in the US. You want to convert $2,500
Australian dollars into USD
!The current exchange rate is
!AUD/USD = 0.9653
!How many US dollars will you get?
!One Australian dollar = USD0.9653.
!So AUD2,500 equals $2,500 x 0.9653
! = USD$2,413.25
!What if the USD depreciates?
!You need less AUD or get more USD
Purchasing Power Parity
!Absolute PPP
!A product has the same price regardless of where it is
selling
!Gold in the US has same price as in Australia once
exchange rate is allowed for
!If not the case removed by arbitrage
!Relative PPP
!The change in the exchange rate is determined by the
difference in the inflation rates in the two countries
Example - Absolute PPP
!Apples in France cost EUR2 per kilogram
!Apples in Australia cost AUD3 per kilogram
!The exchange rate is 0.61 Euros per dollar
!Apples in France should cost
!PFrance = S0"PAustralia
!where S0 is the spot exchange rate
!PFrance = 0.61"3 = EUR1.83
!There is a profit opportunity so the price of apples and/or
the exchange rate should change
Example Relative PPP
!The Australia-Singapore dollar exchange rate is currently
AUD$1 = SGD$1.2
!The inflation rate in Australia is 3% and 7% in Singapore
!Prices in Singapore relative to Australia are increasing at
7% - 3% = 4%
!Therefore the price of the SGD should fall by 4% relative to
the AUD.
!The predicted exchange rate is AUD$1 = 1.2"1.04 = SGD
$1.25
Interest Rate Parity
!Exchange rate should appreciate or devalue as to equalise
effective realised interest rates between countries
!Equilibrium based on expectation that values of local
currency will fall and offset the difference in interest rates
!If the currency did not depreciate
!borrow at the low interest rate and invest in the high
interest rate country
!Demand and supply change value of currency
Interest Rate Parity Example
!If Aust. rates 8% pa and US rates were 5%
!A devaluation of the A$ against the US$ is expected
!Assume AUD1 = USD1
!Borrow US$1 million at 5%, convert to A$1 million, and
invest at 8%
!At end of the year have A$1,080,000
!And repay US$1,050,000
!Make A$30,000 profit
!Not sustainable - the exchange rate would move
Example of exchange risk
!An importer of USA-grown oranges orders 10,000 kg from
their supplier at a cost of US$2 per kg.
!The order is placed today, but payment is made 60 days
later. The selling price is A$3 per kg.
!The exchange rate is currently A$1 = USD$0.9 and this rate
can be locked-in today.
!What is the profit based on the current exchange rate?
!If the exchange rate was not locked in and the $A dropped
to US$0.80 in 60 days, what is the profit?
Solution
!At the current exchange rate the order cost in each currency
is:
!Cost in $US is 10,000 x $2 = $20,000
!Cost in $A is $20,000/0.9 = $22,222
!Profit = (10,000 x $3) - $22,222 = $7,778
!If the exchange rate were US$0.80
!Then the cost in US$ is 20,000/0.80 = $25,000
!Profit = $30,000 - $25,000 = $5,000
!The loss due to exchange rate movements is $2,778
Tax effect - cash flows during the life
!After-tax cash flow = Pre-tax cash flow(1-tc)
!Ignores effect of depreciation on tax
!Not a cash outflow. But is tax deductible
!Higher depreciation means lower taxes payable
!Depreciation tax savings =Depreciation " tc
!Net after-tax cash flow
!=Pre-tax cash flow(1 tc)+Depreciation " tc
Example 3
!A project is expected to produce pre-tax cash flows of
$10,000 pa and the depreciation charge for tax purposes is
$1,000 pa. The company tax rate is 30%. What is the after-
tax cash flow?
!Solution
! = 10,000(1 - .30) + 1,000(.30)
! = 7,000 + 300
! = 7,300
Tax effect on asset sale
!The sale of an asset incurs a tax effect if the salvage value
and book value are different
!If the salvage value is greater than the book value
!The difference is taxable profit
!If salvage value is less than the book value
!The difference represents a loss
!In each situation a tax-related cash flow occurs
!Tax on sale = (WDV salvage value) Tc
Practice Question 1
!A firm purchased a machine five years ago for $100,000
and it is depreciated over its ten-year useful life. If the
machine is sold today for $20,000 what is the tax effect?
The tax rate is 30%
!Solution
!Annual depreciation =
!Book value today =
! =
!P/L? =
!Tax ________ =
Example 4
!A company is analysing the merits of a new machine.
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Annual cash operating costs are $500,000 and expected
cash sales are $950,000.
!Fixed cash costs will remain at $350,000 pa.
!$350,000 of stock is required in the beginning of the year
and this cost is reflected in operating cost.
!The required return is 8%. Should the company invest in the
new machine?
Break down of Example 4 question
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000
!Cash flow at the start -$1,500,000
!Sold in ten years so 10-year period evaluation
!The tax allowable depreciable life is fifteen years and the
tax rate is 30%.
!Depreciation expense = $1,500,000 15 = 100,000
!Tax savings = 100,000 x 30% = $30,000 pa
Example 4 break down
!The new machine costs $1,500,000 and will be sold in ten
years for an estimated salvage value of $200,000.
!Cash flow in year ten of $200,000
!Book value in year ten
!= 1,500,000 - 10 x 100,000 = 500,000
!Tax effect (500,000200,000) x 30% =90,000
Example 4 break down
!Annual cash operating costs are $500,000
!After-tax cash inflow = $500,000(1 - 0.30)
! = $350,000
!and expected cash sales are $950,000.
!After-tax cash outflow = $950,000(1 - 0.30)
! = $665,000
!Fixed cash costs will remain at $350,000 pa.
!No change in fixed costs so ignore this figure
Example 4 break down
!$350,000 of stock is required in the beginning of the year.
!Cash flow of -$350,000 in year zero and cash flow of +
$350,000 in year ten
!The required return is 8%.
!This is the discount rate for NPV calculation
!Should the company invest in the new machine?
!Let us now construct each cash flow group
!Cash flows at the start/over the life/and end
Example 4 Solution
!Cash Flows at the Start
!Purchase of Plant -$1,500,000
!Inventory -$ 350,000
!Total -$1,850,000
Example 4 Solution
!Cash Flows over the Life (Years 1 to 10)
!Sales $950,000(1-0.3) $665,000
!less Costs $500,000(1-0.3) -$350,000
!Depreciation tax saving
!(1,500,00015)*0.3 $ 30,000
!Total $345,000
Example 4 Solution
!Cash Flows at End
!Sale of Plant $200,000
!P/L on sale (WDV-Sale)*30%
!(500,000- 200,000)*.3 $ 90,000
!Recovery of Inventory $350,000
!Total $640,000
!WDV = 1500000 100000x10 =500000
Example 4 Solution
!Cash flows at start -1,850,000
!Cash flows over the life
Accounting Rate of Return
!Is a measure of efficiency
!Ratio of income to asset
!ARR
!= Average net profit
(initial cost + salvage)/2
!The result is compared to some pre-set return the company
requires
!If above or equal %accept
!If below %reject
Example 1
!A firm can acquire a machine for $18,000 and this will result
in an increase in its net cash flows by $5,600 per year for 5
years. At the end of 5 years the machine has no value.
Assume straight line depreciation of $3,600 per year. What
is the accounting rate of return?
!Accounting profit
!= 5,600 - 3,600 = 2,000 per year
!Average book value
!= (18000 + 0)/2 = 9000
!ARR = 2000 / 9000 = 22%
Example 2
!A firm needs a new delivery truck has three to select from.
Each truck costs $9,000 and all have a three year life.
Which one should the firm select using ARR?
! Project A Project B Project C
!Year Profit NCF Profit NCF Profit NCF
!1 3000 6000 2000 5000 1000 4000
!2 2000 5000 2000 5000 2000 5000
!3 1000 4000 2000 5000 3000 6000
!Total 6000 15000 6000 15000 6000 15000
!Average Profit 6000/3 = 2000
!Accounting Rate 2000/(9000 + 0)/2
!of Return = 44% = 44% = 44%
Example 3
!Using Example 1
!The investment cost $18,000 and the equal yearly cash
flows are $5,600 for 5 years
!Is this project acceptable if the required pay back period is 4
years?
!Solution
!Payback Period = 18,000/5,600 = 3.2 years
!Yes acceptable as under 4 Years
Example 4
!Assume an asset costs 12,000 and produces cash flows of
$4,000 in year one, $6,000 in year 2 and 3 then $4,000 a
year forever.
!When cash flows are uneven you pro rata the last periods
cash flow for the cost to be recovered
!Solution
! Year Cash Flow Cum. Flow No. years elapsed
! 0 -12000 -12000 0
! 1 4000 - 8000 1
! 2 6000 - 2000 2
! 3 6000 4000 + 2/6=2.33years
! 4-> 4000 infinity
!Note last part of asset cost recovered during year 3
Net Present Value
!NPV is the present value of all future cash flows discounted
at the required rate of return less the cost of the initial
investment
!NPV is measurement of the net value of an investment in
todays dollars
!Return also called cost of capital
!Minimum return firm needs to earn
!NPV is a direct application of present value concepts
Net Present Value formula
!r is the required rate of return
!CFt is the cash flow for time t
!I0 is the initial investment in time 0
!NPV is also referred to as
"Discounted Cash Flow (DCF) valuation
NPV Decision rule
!Accept all projects that have a net present value greater
than or equal to zero
!Reject projects that have a NPV < 0
!A zero NPV will
!Pay all returns to debt holders who have lent money to
finance the project
!Pay all expected returns to shareholders who have
invested equity for the project
!Repay the original investment in the project
!NPV is the change in shareholders wealth
Example 5
!Using example 1, what is the NPV if the required rate of
return appropriate for this project is 10%
NPV Summary
!A zero NPV
! earns a fair return
!A positive NPV
!earns more than that required
!Effect on shareholder wealth
!changes by the NPV of the project
Internal Rate of Return
!The IRR is the required rate of return that gives a zero NPV
!Calculation requires use of a financial calculator
!Accept projects with an IRR greater than the discount rate
!Reject projects with IRR < required return
Example 6
!What is the IRR of the investment in Example 1?
!-18000 5600 5600 5600 5600 5600
! |_______|_______|_______|_______|_______|
! 0 1 2 3 4 5
!IRR = 16.8
!If IRR = Cost of capital, NPV = zero
!It is possible to have more than one IRR
!when the cash flow sign changes more than once
NPV and IRR compared
!Both techniques apply the TVM concept
!IRR does not place a monetary value on project, yet NPV
does
!Do shareholders prefer $227,000 or 152%
!However, each can select different mutually exclusive
projects as optimal
!Only NPV will always maximise shareholder wealth
Example 7
!Two projects have the following cash flows
!Year A B
!0 -58,000 -85,000
!1 60,000 10,000
!2 8,000 140,000
!The firm requires all projects to payback within 1 year. The
required return is 19%.
!What is the payback period for A and B?
!What is the NPV of A and B?
!Which projects should be accepted?
Solution Example 7
!Payback period for A
" = 58000/60000 = 0.97
!Payback period for B
"= 1 + 75000/140000 = 1.54
!NPV for A NPV for B
!Using payback period only as the criteria would choose A
but it does not increase wealth
Illustration
! $ mil Project A Project B Project C
!Initial Outlay 15mil 4.9mil 15mil
!Year 1 8 3 10
!Year 2 8 3 10
!Year 3 8 2 3
!NPV at 10% 4.9 mil 1.8mil 4.6mil
!IRR 27.76% 31.43% 29.86%
!If you use IRR which project would you select?
!If you use NPV which project would you select?
!Which project would make your shareholders wealthier?
Rights Valuation
!The price of a share when it trades ex-rights is related to:
!M = current market price
!S = Subscription price of the new share
!N = Number of existing shares which entitles the
shareholder to one new share
!The value of a right
!R = N(M - S)/(N + 1)
!The ex-rights share price
!Px = M - (R / N) or Px = S + R
Practice Question 1
!Hang Two Man Ltd (HTML) is about to expand its
operations and requires additional funding of $2,000,000.
Management has decided to have a rights issue.
!HTML plans to issue the shares at a subscription price of
$2.50 each. HTML has 8,000,000 shares on issue that were
issued at $2.00 each. The shares are currently trading at
$3.05 each.
Practice Question 1 Solution
!How many new shares will HTML issue?
!
!How many shares must a current shareholder own to be
entitled to one new share?
!
!What is the theoretical ex-rights share price?
!R = N(M-S)/(N+1) =
!Px =
Equity Valuation
!Current value of a share is present value of all future
dividend payments
!P0 = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3
+ D4/(1 + r)4 + !
!Where
!P0 = the value of the share at time zero (PV)
!Dt = the expected dividend payment at period t
!r = the discount rate (i)
Constant Dividend Model
!If dividends remain constant
!Valuation becomes a perpetuity problem
!PV = PMT / i
!or in the case of shares
! P0 = D / r
!Where
!P0 = the value of the share at time zero (PV)
!D = value of constant dividend (PMT)
!r = the appropriate discount rate (i)
Example 2
!A company has just paid a dividend of $.50 and it is not
expected to change
!The current share price is $4.50
!What is the required return that investors require to invest in
this company?
!Solution
! P0 = D / r
!to get r = D / P0
! r = $.50 / $4.50 = 11.11%
Constant Growth Model
!If dividends are expected to change at the same (constant)
rate, and the rate is less than the discount rate, then the
share price is given by
! P0 = D1 / (r - g)
!where
!g is the growth rate
!D1 is the dividend at time 1
!(next years dividend) D1 = D0 (1 + g)
Example 3
!A company just paid a dividend of $0.70
!Its required return is 25%
!The company expects its dividends to grow by 8% pa
indefinitely
!What is the share price?
!Solution: P0 = D1 / (r - g)
!P0 = .70(1 + .08) / (.25 - .08)
!P0 = 0.756 / 0.17
! = $4.44
Example 4
!DVD Ltd. expect to pay a dividend next year of $0.50
!The firm plans to increase the dividend by 12% a year
forever
!You require a 40% return
!What is a fair price for DVD Ltd. shares?
Example 4 Solution
!D1 = 0.50
!g = 12%
!r = 40%
!P0 = D1 / (r - g)
!P0 = 0.50 /(0.40 - 0.12)
! = $1.79
Example 5
!A firm will pay its first dividend of $0.50 in exactly four years
time
!Dividends are then expected to increase by 12% a year
indefinitely
!If you want a 40% return, what is a fair price?
Example 5 Solution
!g = 12%, r = 40%, D4 = 0.50
!Using P0 = D1 / (r - g)
!P3 = 0.50 / (0.40 - 0.12) = 1.79
!Now calculate P0 using PV = FV(1+i)-n
!P0 = 1.79(1.40)-3 = 0.65
Example 6
!Papas Pizzas would like to know its theoretical share price.
!The company believes it will be able to pay a dividend of
$0.25 at the end of the first year, $0.30 in the second year
and $0.36 in the third year
!Thereafter, the dividend grows at 4% p.a.
!If investors require a 14% return, what is a fair price for a
slice of Papas Pizzas?
Example 6 Solution
0 0.25 0.30 0.36 4%=>
|____|_____|_____|_____|_____|_____|_ !
0 1 2 3 4 5 6
!For the growing dividend work out present value using
constant growth model to get value of dividends at
beginning of year 4 (end year 3)
!Using P0 = D1 / (r - g)
!P3 = 0.36(1.04) / (0.14 - 0.04) = 3.744
Example 6 Solution
!Year cash flow PV formula PV
! 1 0.25 (1.14)-1 0.2193
! 2 0.30 (1.14)-2 0.2308
! 3 0.36 (1.14)-3 0.2430
!perpetuity 3.744 (1.14)-3 2.5271
!Total present value 3.2202
Question
!Baker Cake is planning on paying a dividend of $0.60 a
share next year. They expect to increase this dividend by 20
percent per year in both years 2 and 3 and by 10 percent in
year 4. Which one of the following is the correct method of
computing the dividend for year 4?
!A) $.60 x [(2 x 1.2) + 1.1]
!B) $.60 x (1.2 x 1.1)2
!C) $.60 x (1.2 + 1.2 + 1.1)
!D) $.60 x (1.22 x 1.1)
!E) $.60 x (1.22 x 1.14)
!The answer is
Valuing Short-term Debt
!Securities with a term less than one year are usually
discount securities
!No explicit interest paid. Interest is the difference between
face value and purchase price
!Valuation:
! PV = FV (1 + rt)
!PV = present value, or price
!FV = future value, or face value
!r = interest rate
!t = time to maturity
Example 1
!What amount of funds will the drawer of a bill receive today
if the bill is a 180 day and a $100,000 face value. The
market rate is 8% pa.
!Solution
!PV = FV / (1 + rt)
!PV = 100,000 / (1 + 0.08 * 180/365)
! = $96,204.53
!Price of security increases as term to maturity shortens
!PV/price approaches - Future Value/Face Value
Parts to Value a Bond
!Valuing a bond requires
!The number of periods to maturity
!The face value
!The coupon payment
!The market interest rate
!The coupon payment is the coupon rate multiplied by the
face value
!Valued using an annuity
!The market interest rate, or YTM, fluctuates
Bond Valuation
!Timeline for a bonds cash flows
Example 2
!What is the price of a bond that was issued two years ago
and has eight years to maturity?
!Coupons are paid half-yearly and a coupon payment was
made today.
!The coupon rate is 5% pa and the current market yield is
6% pa.
!The face value is $200,000
Example 2 Solution
!Number of payments per year = 2
!Coupon PMT = 200,000 * 5% / 2 = 5,000
!Years to maturity = 8
!number of compounding periods = 8 x 2 = 16
!Market yield? = 6%/2 = 3%
!FV= 200000; PMT= 5000; i=3; n=16
Bond values and yields
!In the previous example the bond price is less than the face
value. This is known as a discount bond.
!As the market rate is greater than the coupon rate, then
market price is less than face value
!If the market rate is less than the coupon rate then the bond
trades at a premium
!market price > face value
!Par Bond = market price equals face value
Example 3
!What is the price of a $100,000 bond that has 5years until
maturity. It has a coupon rate of 5% p.a. payable semi-
annually if the yield?
!A) Is 6% p.a. compounding semi-annually
!B) Is 5% p.a. compounding semi-annually
!C) Is 4% p.a. compounding semi-annually
!Step 1: Calculate the coupon payments and term
!Coupon Pmts =$100,000 x 5% 2 = $2,500
!Term = 5 x 2 = 10
Example 3 Solution
"n=10; i=?; FV=100,000; PMT=2,500
!A) Price at 6% = $95,734.90
!If coupon rate < Yield then Price < Face value
!Discount Bond
!B) Price at 5% = $100,000.00
!If coupon rate = Yield then Price = Face Value
!Par Value Bond
!C) Price at 4% = $104,491.29
!If coupon rate > Yield then Price > Face Value
!Premium Bond
Yield to maturity
!A bonds price, coupon rate and maturity date are easily
observed
!However, the yield is not so easily found
!Yield to maturity (YTM) is the discount rate which equates
the present value of all future coupon payments and the
face value with the market price
Example 4
!A bond with a face value of $100 matures in five years. The
current price is $96.50 and the annual coupon payments are
$12.50. What is the YTM?
!Solution 100
!-96.50 12.50 12.50 12.50 12.50 12.50
!|________|________|________|________|________|
!0 1 2 3 4 5
!FV= 100; PMT= 12.50; n=5; PV= -96.50; i = ?
Example 5
!A bond investor owns a corporate bond that has nine years
until maturity. When the bond was first issued it had 15
years until maturity.
!Coupons are paid annually
!What is the bond price if
!The coupon rate is 8% pa
!The current market yield is 5% pa
!The face value is $500,000
!A coupon payment was made today
Example 5 Solution
!Number of payments per year = 1
!Coupon PMT = 500,000 * 8% = 40,000
!Years to maturity = 9 = n
!Market yield = 5%; i = 5%
!FV= 500000; PMT= 40000; n=9; i= 5
Profitability Index
!Shows relative profitability of project or present value of
benefits per dollar of cost
!Also known as the benefit-cost ratio
! PI = (NPV + initial cost)/ initial cost
!Sometimes used for selecting projects under capital
rationing
!PI = 1 - Indifferent
!PI > 1 - Accept
!PI < 1 - Reject
Example 8
!A company has six projects with a total initial cash outlay of
$1.6m. However, it has a budget constraint of $600,000.
Which projects should be accepted?
!Project Initial Cost NPV
! A 200,000 28,000
! B 200,000 20,000
! C 200,000 15,000
! D 200,000 35,000
! E 400,000 45,000
! F 400,000 22,000
Example 8 Solution
!Initial Cost NPV PI = (NPV+I)/I Rank
!A200,000 28,000 228/200 = 1.14 2
!B200,000 20,000 220/200 = 1.10 4
!C200,000 15,000 215/200 = 1.08 5
!D200,000 35,000 235/200 = 1.18 1
!E400,000 45,000 445/400 = 1.11 3
!F 400,000 23,000 422/400 = 1.06 6
!Selection of projects that maximises NPV is
!D + A + B = 83,000
!whereas D + E = 80,000
Terminology
!To solve financial mathematics problems we need to
understand the terms used
!PV = present value, or principal
!i = interest rate, later we use r
!n = number of periods, later we use t
!FV = future value
!PMT = periodic payment
!Normally you require three variables to find the fourth
Future value with simple interest
!FV = PV + INT
!FV = future value at end of term
!PV = principal value at beginning
!INT = interest in dollar terms over the time
period
!INT = PV " i " n
!i = simple interest rate per year
!n = number of years
!FV = PV + PV " i " n
! = PV(1 + i " n)
Present Value with simple interest
!The formula can be rearranged to calculate present values
!PV = FV / (1 + i " n)
!This can also be used to price short-term financial
instruments
!This is covered more in lecture 4
Future Value
!Applying the formula many times gives
!FV = PV(1+i"1)"(1+i"1)"..... "(1+i"1)
!which is equivalent to:
!FV = PV(1 + i)n
!where
!i = the per period interest rate
!n = the number of compounding periods
!PV = the original principal
Example 3
!Mavis deposits $1,000 today in a savings account that pays
interest once a year
!How much will Mavis have in three years time if the interest
rate is 12% pa?
1000
|______|_______|________|

0 1 2 3
!To answer the question you need to identify what you have
been given
!Interest rate; term; PV or FV
Example 3: Using the formula
!FV = PV ( 1 + i )n
! = 1000(1 + 0.12)3
! = 1404.93
! Or, expressed another way
!FV = 1000(1.12)"(1.12)"(1.12)
! = 1120"(1.12) "(1.12)
! = 1254.40"(1.12)
! =1404.93
!Using a Financial calculator
!PV=1000; n=3; i=12; (PMT=0) FV=?
Present Value
!Rearranging the future value formula gives the formula for
the present value
!PV = FV ( 1 + i )n
"or
!PV = FV ( 1 + i )-n
Example 4
!You own a bank fixed term deposit that guarantees to pay
you $230,000 in six years time, however you are not
prepared to wait.
!What amount of cash would you receive today if someone
will buy the fixed term deposit today?
!The buyer applies a discount rate of 20% pa

0 1 2 3 4 5 6
Example 4 Solution
!What information have you been given?
!FV = 230,000
!i = 20%
!n = 6
!PV = FV ( 1 + i )-n
! = 230,000 (1 + 0.20)-6
! = $77,026.53
!Using a Financial calculator
!FV=230000; n=6; i=20; (PMT=0) PV=?
Frequency of Compounding
!Interest rates are normally quoted as per annum
!But the compounding frequency is not always annual
!A nominal rate is the rate you can observe in the market
!If the compounding period is not annual the rate must be
qualified
!16% pa, compounded monthly
!This nominal rate is not the same as 16% return pa
Example 5
!What is the compounding rate for each time period for a
18% nominal annual interest rate with monthly
compounding?
!Solution
!The number of compounding periods each year is 12
!Rate per period = 18% 12 = 1.5%
Effective Annual Rates (EAR)
!An effective rate is an interest rate that compounds annually
!To convert a nominal rate to an effective rate
!EAR = (1 + i)m - 1
!where
! m = number of compounding periods per year
! i = interest rate per period
Example 6
!Which interest rate is higher?
!12.5% annual interest rate, compounded half- yearly, or
!12.3% annual interest rate compounding monthly
!Convert both nominal rates to EARs
!EAR = (1+ i)m - 1 EAR = (1 + i)m - 1
!= (1+.0625)2 -1 = (1 + .01025)12 1
!= 12.89% = 13.02%
Example 7
!Marge is planning for an overseas trip.
!Marge already has $7,000 to deposit today and will invest a
further $10,000 in six months time.
!What is the accumulated value in two years?
!The interest rate is 7.5% pa compounded half-yearly.
!7000 10000 FV?
! |_______|______|______|_______|
! 0 1 2 3 4
Example 7 Solution
!i = 7.5% 2 = 3.75%
!n= 4 periods for the $7000 and 3 for $10,000
!FV7000 = 7000(1+0.0375)4 = 8,110.55
!FV10000 = 10000(1+0.0375)3 = 11,167.71
!Marge has $19,278.26 in two years
!Using a Financial calculator
!PV=7000; n=4; i=3.75; (PMT=0) FV=?
!PV=10000; n=3; i=3.75; (PMT=0) FV=?
Example 8
!A company has the opportunity to buy an asset today for
$70,000
!The company expects to be able to sell this asset in three
years for $87,500
!The appropriate return is 9.5% pa.
!Should the firm buy the asset?
Example 8 Solution
70,000 87,500 |______|______|
______|
0 1 2 3
!i = 9.5%
!PV= 87500/(1+0.095)3 = 66,644.71
!The firm should not buy the asset
!Using a Financial calculator
!FV=87,500; n=3; i=9.5; (PMT=0) PV=?
Example 10
!Thunderbirds Production Company (TPC) is offering
investors an opportunity to invest in its movie production
business
!TPC is asking investors to invest $5,000 now and $4,000 in
two years time
!TPC has projected the cash inflows from its movie to
investors would be $6,000 in year four, $2,500 in year six
and a final amount in year eight of $2,000
Example 10 Solution
!PV of Year 0 cash flow -5,000 = -5,000
!PV of Year 2 cash flow -4,000(1.2)-2 = -2,778
!PV of Year 4 cash flow +6,000(1.2)-4 = 2,894
!PV of Year 6 cash flow +2,500(1.2)-6 = 837
!PV of Year 8 cash flow +2,000(1.2)-8 = 465
!Total of Present Values -3,582
!Thunderbirds are no go!
!Fin. Cal steps for year 4
!FV=6000; n=4; i=20; (PMT=0) PV=?
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146