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SUMMARY
1.1 Finance: A Quick Look
The four main areas of finance are:
Corporate Finance Business Finance
o Making corporate decisions.
Raising capital
Investment decisions from managers point of view
Maximizing firm value
Distributing earnings to shareholders
o Financial firms are referred to as the sell side of the market
o Investment banks
Investments
o Deals with financial assets, such as equity(shares) and debt
Pricing of risk and determination of returns
o Financial firms involved are referred to as the buy side of the market.
o Superannuation funds, hedge funds, investment management and brokerage firms
Financial Institutions
o Businesses that deal in financial matters.
o Commercial side: Originations and extensions of loans to businesses
o Consumer side: Originations and extensions of mortgage loans or other personal loans.
o Determine whether an extension to a loan is warranted based on financial position and performance.
o Insurers determine risks and the insurance premiums for that risk.
International Finance
o International aspects of corporate finance, investments and financial institutions.
o Political risk, exchange rate risk, commodities and international market risk, international business
and market conditions.
o Multinational corporations and financial institutions with overseas operations.
1.2 Business Finance and The Financial Manager
When starting a business you have several financial decisions to make, the most important ones include:
Investment amount and type of investments to make determine size, profits, risk, liquidity
Financing how the firm will raise money affect financing costs and financial risk (Capital
Budgeting)
How everyday finance matters are going to be addressed, i.e. collecting money from debtors, etc
(Capital Structure)
Dividend how much of profits are given out as dividends vs. retained (Working Capital Management)
The role of financial managers are to answer these questions:
The top financial manager within a firm is usually the chief financial officer (CFO)
Business Finance deals with the decisions made by corporate treasury and capital expenditures.
Capital budgeting:
The process of planning and managing a firms long term investment decisions.
Management aims to identify whether long term investments are profitable or not
Determine the size of cash flow, the timing of cash flows and the risk of future cash flows.
Capital structure:
The mixture of debt and equity maintained by a firm.
How the firm obtains the financing it needs to support its long term investments.
How much should the firm raise, what are the least expensive sources of funds for the firm.
Working Capital:
A firms short term assets and liabilities
Managing the firms working capital is a day-to day activity that ensures the firm has sufficient
resources to continue its operations and avoid costly interruptions.
o How much cash, inventory
o Sell on cash or credit to customers
o Source of short term financing (Where and How)
1.3 Forms of Business Organisation
Types of companies:
Sole proprietorships:
o A business owned by a single individual
o Simple to establish, few regulations, owners keeps all profits., avoid corporate income tax
o Difficult to raise large capital, unlimited liability, only lasts as long as owner, transfer of
ownership is difficult
Partnerships:
o Owned and run by two or more people informal or legally binding
o Cheap and easy to establish
o General partners have unlimited liability, limited partners have limited liability
A limited partner do not have much say in how the business is run
o Difficult to raise capital, only lasts as long as owner, difficult to transfer ownership
Corporations:
o A business created as a distinct legal entity owned by one or more individuals or entities.
Has the same rights as a person can borrow money, own property, sue/d, enter
partnerships, etc
o Unlimited life, easily transfer ownership, limited liability, easy to raise capital
o Liable for corporate tax, and then dividends are taxed when paid to shareholders, difficult to
setup as legal formalities are lengthy and costly
Charter includes: name, purpose, share amounts, directors, whether shares are issued to
new investors or existing owners.
o Owners are separate to management.
Managerial Compensation is dependent on firm productivity and firm profitability. Further, managers
are given stock in a company and thus reducing the agency problem (they will act in the best interest
of the shareholders because they are shareholders).
Control of the firm Control rests with shareholders. Shareholders can engage in a proxy fight to
replace existing management. Management can also be replaced by M&A activity (particularly
acquisitions), whereby well managed companies acquire poorly managed ones, and former managers
are often left jobless.
Stakeholders:
Entities apart from shareholders or creditors that has a claim on the cash flow of the firm.
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In financial markets it is debt and securities that are bought and sold
o = (1+)
The process of finding the present value of a sum of money is called discounted cash flow (DCF)
valuation
o The discounting rate is the rate used to calculate PV in FV cash flows
1
2
3
+
+
++
2
3
(1 + )
(1 + )
1 + (1 + )
1
: = (1 (
) )
1+
: = ((1 + ) 1)
1+
: =
(1 (
) )
1+
1
= (1 (
) ) (1 + )
1+
: =
((1 + ) 1)(1 + )
PV for Perpetuities
=
Period Rate
The rate charged by the lender in each period
o To convert APR into periodic
=
1 + 365
[1
]
+
(1 + )
(1 + )
Bonds are debt investment instruments. A corporation that issues a bond is the borrower/debtor, while
the bearer is the lender or creditor
Debt does not represent ownership interest in the firm
The interest payment is the cost of using debt as a source of funds.
o Having debts creates risk for financial failure
Bond Characteristics
Maturity: short v intermediate v long term
Placement: private v public
Issuer: corporations v governments
Security: secured v unsecured
o In the event that the issuer defaults the investors have a claim on the issuers assets that will
enable them to get their money back.
Seniority: senior v junior
o Preference in position over other lenders
Credit Rating: investment grade v low grade junk bonds
Issuer exercisable features: callability, covenants
o Ability to repurchase bond before maturity, part of the trust deed limiting certain actions.
Exotic Features: convertible, floating, and others
o Bond can be swapped for shares, adjustable coupon payments.
1 + = (1 + )(1 + )
1 + 1
1+
1
2
0 =
+
+ +
=
2
(1 + )
(1 + )
1 + (1 + )
=1
10
(1 + )
+1
=
Note:
=
o Dividend yield return from dividends
o Capital gains yield growth rate
1
+
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10.1 Returns:
Financial Market
The financial market is the place where you can raise capital
o It determines the prices of bonds and stocks
Understanding this can help make better decisions pertaining the financial market.
o There is a trade-off between risk and return
o The higher the risk, the higher the expected return.
Dollar Returns:
The return on an investment expressed in dollar terms as:
o Dollar Returns = Dividend Income + Capital Gain/Loss
Capital gains is the difference between the price received when sold and price when bought
Percentage Returns
Total % Return = Dividend yield + Capital Gain Yield
+1 + +1
+1
=
+1
=
12
=1
= [(1 + )] 1
=1
13
=1 (1 + )
Advantages
Meets all decision rule criteria
NPV is consistent with firms objective of maximizing shareholders wealth
Preferred method
Decision Rule
Accept the project if the AAR is greater than the target rate
Advantages
Easy to calculate
Required information is readily available
Disadvantages
Not a true rate of return
Time value of money ignored
Uses an arbitrary threshold
Based on book values, not market values
8.4 The Internal Rate of Return (IRR):
Decision Rule
Accept the project if IRR is greater than the required return
IRR and NPV
IRR and NPV lead to identical decisions iff
o Conventional cash flow first is negative, rest is positive
o Independent project
If there is a conflict, USE NPV
Multiple IRR
Non-conventional cash flows lead to multiple IRRs
o Another cash flow begins after the initial outflow
IRR is no longer useful in this case
Mutually exclusive projects
Using IRRs becomes a problem because the timing and size of cash flow becomes important
At some required return the NPVs will crossover and one project will suddenly become more appealing
than the other.
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Advantages
Easy to understand
Knowing a return is intuitively appealing
If the IRR is high enough dont need to calculate required return
Disadvantages
Can produce multiple IRRs
Cannot rank mutually exclusive projects
Modified IRR
Helps control problems of IRR
Discount approach
o Discount future outflows to present value and add to initial outflows
Reinvestment method
o Compound all cash flows except the first forward to the end
Combination method
o Discount outflows to present and compound inflows to the end
Discount rates are externally supplied
MIRR v IRR
MIRR avoids multiple IRRs
Managers prefer rate of return comparisons and MIRR is better for this
Different ways to calculate MIRR
o Which one is best?
Interpreting MIRR becomes harder
8.5 The Profitability Index:
The profitability index is defined as the present value of future cash flows divided by the initial
investment
Measures the value created per dollar invested
=
Decision Rule
Accept project is PI>1.0
Advantages
Closely related to NPV
Useful when funds are limited
Disadvantages
The profitability index does not consider the scale of the project, which can lead to incorrect
comparisons of mutually exclusive projects.
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18
19
=
We must adjust for NWC because:
o We make sales on credit and match it with an appropriate expense, however this is not
necessarily when the cash comes in
o There is a timing difference between accounting revenues/expenses and cash inflows/outflows
The NPVs we calculate are just estimates, there is little certainty in the accuracy of the estimate and
hence we must conduct further analysis.
Typically a positive NPV is a good sign that we should take up the project, though we need to further
look at:
o Forecasting risk
How sensitive the NPV is change in cash flows
The more sensitive the greater the forecasting risk
o Sources of value
Why does this project create value
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[1 (1+) ]
() =
=1
Expected return is the return you would expect to get if you repeat s process many times
() = [ ()]2
=1
11.2 Portfolios
Portfolio
Group of assets such as shares and bonds held by an investor
o Portfolio weight percentage of the total value of portfolio in a particular asset.
The risk and return of a portfolio are entirely determined by the risk and return of the individual assets
that make up the portfolio.
Portfolio Expected Returns
The portfolio expected return is weighted average of the expected return of each asset in the portfolio
=1
. ( )
Where:
o Wj is the portfolio weight of asset j
o Rj is the return of asset j
o M = total number of assets
The expected return on a portfolio can also be calculated by determining the portfolio return in each of
the future states and then computing the expected value as we did for individual securities.
( ) =
=1
. ,
Where:
o i= particular state out of the possible n states
o is the probability that state i can occur
o is the expected future return of the asset if state i occurs
o n = total number of possible states
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Portfolio Risk
We first find the expected portfolio return, then compute the portfolio return standard deviation using the
same formula as individual assets:
( ) =
=1
. ( )
() = [, ( )]
=1
=1
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The CAPM defines the relationship between risk and return for any asset.
[ ] = + [ ]
This means that returns come from either:
o Compensation on time value of money,
o Assets risk premium, [ ]
[ ]
If the portfolio is the market portfolio then the SML slope changes to:
= [ ]
o Since = 1
SML Graph
R (%)
[Required return]
Undervalued
Overvalued
Risk ()
=1
Key Terminology
Expected return return market expects from the asset in the future calculated from price and
expected cash flows IRR
Realized return past return received by investors in the asset mean of actual previous returns
Required return return calculated from theory based on assets market risk
12.1 The Cost of Capital:
Cost of Capital & Required Return:
Investors in the market invest to attain financial gains. The investment generates capital for the firm.
Since investors expect return on their money, this represents the cost of capital.
The cost of capital is the return the capital must generate in order to compensate investors.
If the return exceeds the cost of capital, then the project has generated adequate returns increased firm
value.
o This only occurs when the return exceeds what the financial market offers for projects with
similar risk (betas)
Implications of cost of capital
A project must offer a greater return the greater the systematic risk in the project.
o Greater systematic risk project must be assessed more harshly.
Thus the higher the beta, the higher the discount rate.
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+1
1
=
+
Advantages
o Simple to use
Disadvantages
o Can only use for dividend paying firms
o Only work if the dividend grows at a constant rat
o Sensitive to growth rate hard to estimate
o Doesnt explicitly adjust for risk
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0 =
27
The WACC is the correct project discount rate if the project has the same market risk as the companys
existing business
The WACC is not the correct discount rate for projects with different market risk
Consistently using the WACC for projects with different risk will decrease firm value and increase firm
risk.
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15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital
Venture Capital
Financing for new, often high risk start up projects.
Entrepreneurs at their early stage may seek finance from business angels
o Individuals who provide funds for early development of new high risk ventures
Similarly they may seek finance at a later stage from venture capitalists mezzanine level financing
Although there is an active venture capital market, the access to venture capital is very limited as they
have a lot of criteria
Venture Capitalists
Venture capitalists are typically wealthy investors, VC firms and institutional investors(managed funds)
In the event of liquidation venture capitalists rank ahead of other equity holders.
Since new ventures are of high risk, most of them fail and VCs lose a lot of money, hence they get first
priority upon liquidation.
VC may choose to cash out if they realize enough financial gains or if future prospects look dim.
Choosing a Venture Capitalist
Financial strength is important
Style is important
o Will they be involved in day to day activities or will they watch from behind
References are important
o How successful was the VC with previous investments
o How much knowledge do they have of the industry
Contacts are important
o Can they provide important customers, suppliers and other industry contacts
Exit strategy is important
o Since most VC are not long term investors, how and under what terms will the VC cash out of
the business.
15.2 Selling Securities to the Public: The Basic Procedure:
1. Obtain approval from the board of directors
2. Prepare and lodge a disclosure document, called a prospectus, with the Australian Securities &
Investments Commission (ASIC).
a. If its a public offering, a prospect must also be lodged with the Australia Securities Exchange
(ASX)
3. Revise the prospectus to obtain final approval from the ASIC and ASX. This occurs during the
registration period, which is the period from the lodgment of the prospectus to its approval and
registration.
4. Selling efforts get underway once the final prospectus is approved by the ASIC and the ASX.
Prospectus
Financial information
History of the company
Qualifications of the directors and management
Description of the proposed financing and its uses
The purpose of the prospectus is to inform and education prospective investors of the company.
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15.3 Initial Public Offering (IPO), Rights Issues and Private Placements:
Initial Public Offering
The initial issue of securities offered for sale to the general public on a cash basis
Issuing shares for the first time
Also refers to a company going public
Rights Issue
In a rights issue the firm offers existing shareholders the opportunity to buy additional shares in the
company.
Rights are issued on a proportional basis to the investors existing holdings.
If the rights are renounceable then the existing shareholders have the option to sell.
Private Placements
Privately placed equity or debt has no filling requirements
Registration costs are lower no prospectus, registration
Issue costs are lower less buyers and no underwriter
Life insurance companies, pension and mutual funds are the major suppliers
Easy to negotiate in case of default or restructuring
Higher yields due to lower liquidity
From the issuers view, it is a trade-off between higher yields v better renegotiation and lower flotation
costs
Best suited for small/medium sized firm since flotation costs tend to be higher for such firms
15.4 Underwriters
Underwriters are bankers that work on an issue and usually buy up unsold securities subject to certain
condition at an agreed price
o It can be a single or group (syndicate) of underwriters
The spread is the difference between what the underwriter pays and the offer price
o The offer price is the actual price the issue is sold to investors
Selling period is the period of time in which underwriters agree not to sell securities for less than the
offer price
Firm Commitment
Also known as standby underwriting. The underwriter buys any unsold securities at the close of issue,
assuming full financial responsibility for any unsold securities.
The offer price is carefully considered by the underwriters to manager their risk of having to buy unsold
shares
Most common
Best Efforts
The underwriter sells as much of the issue as possible but does agree to buy all the unsold securities.
Role of Underwriters
Intermediaries between a company selling securities and the investing public
Help market and price the new securities
Help sell the new securities
They are paid the spread usually a proportion of the total value of shares sold.
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Debt v Equity
Issuing debt is significantly much cheaper than equity.
However advantage may be offset by an excessively high yield
Seasoned Equity Offerings (SEO)
Prices drop typically by 1-3%
o Issuing equity signal that the stock price will drop in the future
Nobody sells shares when they know price is still going up
Semi strong market
o Market timing shares are sold when they are overvalued
o Profitable firms should finance operations via debt
Why use stocks if they are going to rise in value and increase cost of capital.
13.1 The Capital Structure Question:
Capital Structure
A companys choice of the mix of debt and equity that makes up the total firm value.
Financial Leverage
The extent to which a company has debt and has obligations to pay interest
It is measured by:
o The debt to equity ratio
o The debt to value ratio
Market leverage uses market values
Book leverage uses book values
13.2 The Effect of Financial Leverage:
Effect of Financial Leverage
Financial leverage amplifies the effect of changes in sales on return on equity(ROE) and earnings per
share(EPS)
Debt financing makes the equity of the firm more risky.
o The impact of when the firm is doing poorly is much worse than when the firm is doing well.
Break- Even EBIT
This is the level of EBIT that results in the same EPS for debt and no debt financing.
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MM Proposition 1
Consider two identical companies with the same operating cash flow every period, except firm L is
levered and firm U in unlevered then:
= =
MM Proposition 2
A firms cost of equity capital is a positive linear function of its capital structure
o Financial leverage
Cost of capital for firm U:
= =
Cost of capital for firm L:
= = +
= + ( )
= + ( ) + ( + ( ) )
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= + (1 + ) ( )
= (1 + (1 ) )
(1 ) +
Define to be the unlevered cost of capital, when D/E = 0, (this is just cost of equity)
= +
( ) (1 )
Direct Costs
The costs that are directly associated with bankruptcy, such as legal and administrative expenses.
Indirect Costs
The costs of avoiding bankruptcy filing incurred by a financially distressed firm
o Disruptions in operations
o Loss of employees
o Damage to firms reputation
o Foregone investment opportunities
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Changes to MM Theory
Tax saving increase with financial leverage
Cost of financial distress increase increases with financial leverage
There is a trade-off between tax saving and increased cost of financial distress
13.6 Optimal Capital Structure
Static Theory of Capital Structure
A firm borrows up to a point when the tax benefit from an extra dollar in debt is exactly equal to the cost
that come from the increased probability of financial distress.
Optimal Capital Structure
The optimal amount of debt that increases the firm value
o This is the point at which money from tax benefit is offset by cost from financial distress.
= + ( ) ( )
(1+ )
In reality the difference between the dividend and ex-dividend share price is the after tax dividend
o = (1 ) +
Clientele Effects
Argument that shares attract particular groups, based on dividend yield and the resulting tax effects.
o Some investors prefer low payouts
o Other investors prefer high payouts
Changing dividend policy result in different investors
o It does not affect the value of stock
Signalling: Information Content of Dividends
Dividends becomes an important form of communication about firms future prospects
Managers tend to have better information about the firm that outside investors (market is semi-strong)
Empirical Evidence on Dividend Announcements
Announcement of dividend increase/decrease are related to rise/fall of stock price
Unexpected announcements of dividend increase/decrease have more significant effect on stock price
o Most significant effect on stock price comes when non-dividend paying stocks announce
nitiation of dividend payments