TIME VALUE OF MONEY DEBT

Simple Interest i = simple interest rate per year Bill Pricing

Interest n = number of years PV = price
Future Value FV = future value at end of term r = interest rate
FV = future value or face value
PV = principal value at beginning
Present Value t = time to maturity if for a certain period do /365
Bond Pricing
Compound Future Value i = per period interest rate PMT = coupon rate per
Interest n = number or compounding periods period x FV
PV = the original principal (dollar amount)
Present Value
i = market rate, YTM etc.
Premium = > FV, Discount = > FV, Par = FV
Effective Rate m = no. of compounding periods a year EQUITY
i = interest rate per period Share Price (no growth)
P = Constant Dividend Amount / Required Return (i)
Ordinary Future Value Present Value n = number of payments
Share price (constant growth)
Annuity i = per period interest rate g = growth rate of dividends
(fixed number PMT = annuity payment D1 = D0 (1+g) dividend at time 1
of payments) P0= value of share at time 0 (PV)
Ordinary Present Value PV = PMT / i (infinite no. of payments)
Perpetuity PV calculates 1 period before the first payment “future” (left formula) “has just paid” (right formula)

RISK AND RETURN – BE CAREFUL TO READ WHAT TYPE E.G. HISTORICAL, EXPECTED AND PORTFOLIO
Market Efficiency: efficient market = prices reflect all available info
- Strong Form Efficient: all info is reflected in the share price, investors cannot use public info to outperform
- Semi-Strong Efficient: all public information reflected in share price
- Weak Form Efficient: trend of technical analysis cannot be used to find undervalued or overvalued shares
Market Risk Beta is 1
Diversification: spreading investment across assets, minimum level of risk can’t be eliminated is systematic.
Security Market Line: relationship between systematic risk and expected return
- Formula: Rf = intercept (Rm – Rf) = slope = rise over run (market risk premium)
Historical Return The beta of a risk free security is
Data 0 and the beta of the overall
market I 1.
Average Return n = the number of observations
ri = return for period i

Standard Deviation Don’t forget to 2 the brackets

= average return
Higher SD = higher risk
Ri = actual return for observation i

Expected Expected Return Pi = profitability of outcome i

(Future Data) Ri = return for outcome i

Standard Deviation Don’t forget to 2 the brackets E(R) = expected return

Ri and Pi is same as above.

Portfolio CAPM (Capital Asset Rf = Risk Free Rate a.ka. govt bond rate
Pricing Model) Higher systematic risk leads to greater Rm = Return on the Market
expected return. B = Beta (amount of systematic risk)
(Rm - Rf) = Market Risk Premium!!
Expected Return E.G. 20%(15.5) + 15%(10) + 30%(12.5) = 11.85% Wi = % of asset i held in the portfolio
(equally weighted means divide by total number of E(Ri) = expected return of asset i
shares) ANSWER IN %
Risk (Beta) Bi = beta of asset i
Wi = % of asset i held in the portfolio

COST OF CAPITAL
D = market value of debt Rd = market return on debt finance
- Use bond pricing formula - interest rate on debt, YTM
- PMT = Debt FV x Coupon Rate Re = market return on equity (%)
The minimum return the firm must earn overall on its existing assets. If it E = market value of ordinary shares - (D1/P0 share price) + g (some g might be 0)
earns more than this, value is created for shareholders. - no. shares issued x share price Rp = market return on pref. shares
Total market P = market value of pref. shares - Dividend per share(sometimes FV x annual
value of the - no. shares issued x share price dividiend %)/Preference share price
firm (weights) tc = company tax rate (usually 30%)

CAPITAL STRUCTURE
Capital structure: mixture of debt and equity used to finance the assets
Homemade leverage: shareholders can adjust the amount of financial leverage by undertaking personal borrowing
Earnings per share Generally, if EBIT is
high and stable, use
debt to improve EPS
and ROE
Calculating breakeven I = INTEREST Not 1
The point at which the
earnings per share (EPS)
is the same between two
financing structures

If expected EBIT > breakeven, debt issue (leverage (debt) increased shareholder wealth)
If expected EBIT < breakeven, no debt issue (debt reduced EPS, shareholder wealth is reduced by proposal)
If expected EBIT = breakeven, indifferent...(leverage would have no change on EPS, therefore shareholder wealth is unaffected – indifferent)

CAPITAL BUDGETING
Internal Rate of Return (IRR): The required rate of return gives an NPV of zero. NPV is equal to 0 when the discount rate used is the IRR. Accept projects with an
IRR greater than the required return as this will mean a positive project value. IRR attaches a percentage value to the return given by a project.
Capital rationing: the situation a firm faces when it has positive net present value pockets but cannot obtain financing for those projects
Hard rationing: when a firm cannot raise financing for a project under any circumstances.
Payback Period: The amount of time it will take until the investment’s stream of cash flows is equal to the cost of investment
Accounting Rate - Accept projects where the ARR is greater or = to the required rate set by the company.
of Return - Measures efficiency of an asset by calculating ratio of income an asset generates to asset’s cost.

Net Present - Shows the monetary return on a given project r = required rate of return
Value Accept projects that have net present value > than 0 CFt = cash flow for time period t
REMEMBER CF0 just means negative whatever initial cashflow REMEMBER TO 2 THE BRACKETS RIGHT For NPV but its an annuity: -CF0 ( 1-(1+r)-n/1+r)
Profitability Shows the profitability of a project per dollar of cost. I.e. A PI = 1 – Indifferent Initial cost,
don’t use
Index project with a 1.17 PI means that the project will have a PI > 1 – Accept the negative
return of $1.17 ($0.17 profit) for every $1 spent. PI < 1 – Reject sign J
Net after tax cash flow: Pre-tax cash flow (1-tc) + Depreciation x tc
Tax on the sale of an asset (WDV – Salvage Value) x tc Book value of asset (WDV) = initial cost – accumulated depreciation
Include Don’t Include
Cash Flows at - Purchase of Plant/Equipment - Sunk Costs (e.g. costs for pervious research)
Start (Yr 0) - Establishment expenses(e.g. installation) Working capital: (in year 0) Increase in inventory is negative, increase in accounts
+ Proceeds from sale of old equipment payable is positive, increase in accounts receivable is negative.
- Investment in working capital (i.e. stock or inventory, accounts receivable etc)
- Market value of assets owned that are to be used in the project - opportunity costs (e.g. * The Tax rate will generally be 30% unless stated otherwise
value of land where a factory is established) **Depreciation is only used as a tax shield - Annual depreciation (straight line) multiplied
by tax rate to find the tax saving which is added to the cash flow total at the end
Cash Flows - Incremental expenses (e.g. a decrease in sales for another product, or increased - Financing costs (i.e. interest costs on the loan used to finance the project)
Over Life (Yr 1 maintenance costs) - Depreciation expenses**
to n) - Operating Costs - Non incremental expenses/revenues (i.e. they would be the same with or
+ Cash sales and incremental revenues without the project - look for word ‘remain’) FIXED COSTS USUALLY INCREMENTAL
- Tax (cash flow x tax rate)* - Dividends paid to investors
+ Tax saving as a result of depreciation expense
Depreciation tax shield = annual depreciation (cost * depreciable life) x tax rate
Annual depreciation = orginal cost.- salvage value / estimated life
Cash Flows at + Investment in working capital (add back expense in Yr 0) *** Depends on whether the salvage value was greater than book value (i.e
End (Yr n) + Sale of assets calculate salvage - book to see whether sale was profitable or not). The book value
- Tax effect on sale (-‘ve if profit is made, +’ve for a loss)*** (profit/loss on sale x tax rate) is the depreciated value of an asset.
= (Salvage value – book value) x tax rate

EXAMPLES
Capital Budgeting
Deciding whether to replace and upgrade their metal
press. They have been advised that the new one Equity
would cost $560,000 and have an estimated useful
life of 5 years. Their existing press has a current book
value of $120,000 and can be sold for $95,000 today.
The cash operating costs of the old press are
$155,000 a year. The new, more efficient, press has
annual operating costs of only $60,000 because it
requires less workers to operate it. The old press is
being depreciated at $24,000 a year and has a
remaining life of five years at which time its scrap
value will be zero. The new press will be depreciated
on a straight-line basis over a 5 year life and is
expected to be sold for $150,000 at the end of 5
years. The ATO have advised for tax purposes the
machine should be depreciated to zero over its 5
year life. If the tax rate is 30% and the discount rate
is 13.5%, should Jacksons Ltd buy the new press?
They will purchase land for $380,000,
demountable buildings for $220,000 and other
equipment for $420,000. When project ends (at
the end of eight years) they expect to sell the
land for $200,000, the buildings for $65,000 and
the equipment for $95,000. The project will also
require an investment in inventory of $95,000 at
the start of the project. The annual cash sales are
estimated to be $1,375,000 and cash operating
costs are estimated to be $895,000.
Management wants to depreciate all assets over
the mine life of 8 years. The taxation office has
provided advice that for tax purposes, buildings
are depreciated over 20 years straight-line to
zero and equipment at 15 years straight-line also
to zero. Land cannot be depreciated for tax
purposes and in this case there are no tax effects
from gains and losses on land. Will the project
prove worthwhile for Tennyson Ltd given that
the required rate of return is 25% pa and the
company tax rate is 30%?
New machine costs $1,500,000 and will be sold
in 10 years for an estimated SV of $200,000. The
new machine would be housed in a small storage
facility that sits on land that could have been
subdivided and sold for $200,000. A study
costing $25,000 was previously taken out to
estimate the potential increase in output the
machine would bring to the company. The tax
allowable depreciable life is fifteen years and the
tax rate is 30%. The annual operating costs were
previously $250,000 and expected to rise to
$750,000 with the new machine. Expected
increase in annual cash sales is $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%.