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Fin105 Lecture 6 Notes

The Capital Market Line (CML) Not the SML!



o Line from RF to L is capital market line (CML)
o x = risk premium = E(R
M
) - RF
o y = risk = s
M

o Slope = x/y =[E(R
M
) - RF]/s
M

o y-intercept = RF

Slope of the CML is the market price of risk for efficient
portfolios, or the equilibrium price of risk in the market.
Relationship between risk and expected return for
portfolio P (Equation for CML):




Returns distribution for two perfectly negatively
correlated stocks ( = -1.0)


Returns distribution for two perfectly positively
correlated stocks ( = 1.0)


Variance of a naively diversified portfolio of N assets
- Portfolio variance consists of two parts:
Diversifiable (non-systematic) risk and market
(systematic) risk
- The market rewards only systematic risk
because diversification can get rid of non-
systematic risk

If an investor chooses to hold a one-stock portfolio
(exposed to more risk than a diversified investor),
would the investor be compensated for the risk they
bear? NO!
- Stand-alone risk is not important to a well-
diversified investor.
- Rational, risk-averse investors are concerned
with
p
, which is based upon market risk.
- There can be only one price (the market return)
for a given security.
- No compensation should be earned for holding
unnecessary, diversifiable risk.
- Therefore is the most appropriate measure of
stock volatility.

Capital Asset Pricing Model (CAPM)
- Model linking risk and required returns. CAPM
suggests that there is a SML that states that a
stocks required return equals the risk-free
return plus a risk premium that reflects the
stocks risk after diversification.
- r
i
= r
RF
+ (r
M
r
RF
)b
i

- Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a
well-diversified portfolio.

Beta coefficient and its Calculation
- Measures a stocks market risk, and shows a
stocks volatility relative to the market.
- Indicates how risky a stock is if the stock is held
in a well-diversified portfolio.
- Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
- Run a regression of past returns of a security (y-
axis) against past returns on the market (x-axis).
- The beta of a portfolio is the weighted average
of each of the stocks betas.

Market Risk Premium
- Additional return over the risk-free rate needed
to compensate investors for assuming an
average amount of risk.
- It depends on the perceived risk of the stock
market and investors degree of risk aversion.



p
M
M
p
RF R E
RF R E o
o

+ =
) (
) (
Security Market Line
o Beta measures systematic risk
- Measures relative risk compared to the
market portfolio of all stocks
- Volatility different than market
o All securities should lie on the SML
- The expected return on the security should
be only that return needed to compensate
for systematic risk


CAPM/SML concepts are based upon expectations, but
betas are calculated using historical data. A companys
historical data may not reflect investors expectations
about future riskiness.

Fin105 Lecture 7 Notes

See how the effective return varies between
investments with the same nominal rate, but different
compounding intervals.
EAR
ANNUAL
10.00%
EAR
QUARTERLY
10.38%
EAR
MONTHLY
10.47%
EAR
DAILY (365)
10.52%

Can the effective rate ever be equal to the nominal
rate?
- Yes, but only if annual compounding is used,
i.e., if M = 1.
- If M > 1, EFF% will always be greater than the
nominal rate.

Example of Constructing an Amortization Table


- Constant payments
- Declining interest payments
- Declining balance

Fin105 Lecture 8 Notes

Zero and Very Low Coupon Bonds
o Disadvantage:
- Issuer faces large cash outflow in excess of the cash
inflow when the bond was issued
o Advantages:
- Cash outflows dont occur with zero coupon bonds
and are relatively low level with low coupon bonds
- Strong investor demand tends to bid up prices and
yields are bid down.
Bond Ratings: Evaluating Default Risk
- Higher ratings = higher prices = lower yields.
Cheaper to raise capital
Effect of Call Provision
- Issuer can refund if rates decline. That helps
the issuer but hurts the investor.
- Thus borrowers will pay more (interest) and
lenders require more.
Sinking Fund
- Reduces risk to investor, shortens average maturity.
- But not good for investors if rates decline after
issuance.
Handling Sinking Fund Provisions
o Call x% of the issue at par, for sinking fund purposes.
- Likely to be used if r
d
is below the coupon rate
and the bond sells at a premium.
o Buy bonds in the open market.
- Likely to be used if r
d
is above the coupon rate
and the bond sells at a discount.
Company would choose the lowest cost way. It will call
them if the bonds are selling for more than $1,000. It
will buy them if they are selling for less than $1,000

Efficient Market
- The values of all securities at any instant fully reflect
all available public information, which results in the
market and the intrinsic value being the same.
Yield to Maturity (YTM)
- YTM and expected rate of return are used
interchangeably when referring to bonds.
Bond Valuation: Three Important Relationships
1. Interest Rates and Bond Value
- The value of a bond is inversely related to
changes in the investors present required rate of
return (the current or market interest rate).
- As interest rates increase (decrease), the value of
the bond decreases (increases).
- The market value of a bond will be less than the
par value if the investors required rate of return
is above the coupon interest rate, but it will be
YEAR BEG BAL PMT INT PRIN END BAL
1 $1,000 $ 402 $100 $ 302 $698
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL $1,206 $206 $1,000
valued above par value if the investors required
rate of return is below the coupon interest rate.
2. Bond Values Over Time
- At maturity, the value of any bond must equal
its par value.
- If r
d
remains constant:
- The value of a premium bond would
decrease over time, until it reached $1,000.
- The value of a discount bond would increase
over time, until it reached $1,000.
- A value of a par bond stays at $1,000.
3. Long-term bonds have greater interest rate risk
than do short-term bonds.

Sensitivity of Bond Price to Interest Rate Changes
- How much the price changes due to a change in
yields depends on the maturity of the bond
- The longer the bond, the greater the change in price
- Thus t- bonds have a lot on interest rate risk. T-bills
have very little.
- There are more periods over which to discount the
CFs at the new yield

When is a call more likely to occur?
- In general, if a bond sells at a premium, then (1)
coupon > r
d
, so (2) a call is more likely.
- So, expect to earn:
- YTC on premium bonds.
- YTM on par and discount bonds.

Definitions
|
|
.
|

\
|
+
|
|
.
|

\
|
= =
=
=
CGY
Expected

CY
Expected
YTM return total Expected
price Beginning
price in Change
(CGY) yield gains Capital
price Current
payment coupon Annual
(CY) yield Current


Interest Rate and Reinvestment Rate Risk
o Interest rate risk affects the value of the bond.
o Reinvestment rate risk affects the income of the bond


Fin105 Lecture 9 Notes

Estimating g or Growth Rate
- Growth comes from:
- Infusion of capital Financing, debt, common stock
- Internal growth Management retains some or all
of the firms profits for reinvestment in the firm

g= ROE x r

1. g = the growth rate of future earnings and the
growth in the common stockholders investment in
the firm
2. ROE = the return on equity
3. r = the companys percentage of profits retained =
profit retention rate = plowback rate

Corporate Valuation Model
- Also called the free cash flow method. Suggests the
value of the entire firm equals the present value of the
firms free cash flows.
- Remember, free cash flow is the firms after-tax
operating income less the net capital investment.
FCF = EBIT(1 T) Net capital investment
- Find the market value (MV) of the firm.
o Find PV of firms future FCFs
- Subtract MV of firms debt and preferred stock to get
MV of common stock.
MV of common stock = MV of firm MV of debt and
preferred
- Divide MV of common stock by the number of shares
outstanding to get intrinsic stock price (value).
o P
0
= MV of common stock / # of shares

Firm Multiples Method
- Analysts often use the following multiples to value
stocks: P/E, P/CF, P/Sales
- EXAMPLE: Based on comparable firms, estimate the
appropriate P/E. Multiply this by expected earnings to
back out an estimate of the stock price.
- Analysts often use the P/E multiple (the price per
share divided by the earnings per share) or the
P/CF multiple (price per share divided by cash flow
per share, which is the earnings per share plus the
dividends per share) to value stocks.

The entity value (V) is:
o the market value of equity (# shares of stock multiplied
by the price per share)
o plus the value of debt.
- Pick a measure, such as EBITDA, Sales, Customers,
Eyeballs, etc.

Short-term
AND/OR
High-coupon
Bonds
Long-term
AND/OR
Low-coupon
Bonds
Interest rate risk Low High
Reinvestment rate risk High Low
- Calculate the average entity ratio for a sample of
comparable firms. E.g. V/EBITDA, V/Customers
- Find the entity value of the firm in question. For
example,
o Multiply the firms sales by the V/Sales multiple.
o Multiply the firms # of customers by the V/Customers
ratio
- The result is the total value of the firm.
- Subtract the firms debt to get the total value of equity.
- Divide by the number of shares to get the price per
share.

Market Equilibrium
- In such, stock prices are stable. There is no general
tendency for people to buy versus to sell; i.e. expected
returns must equal required returns:

r
s
= D
1
/P
0
+ g = r
s
= r
RF
+ (r
M
- r
RF
).

How is Equilibrium Established?
1. If ^r
s
= D
1
/P
0
+ g > r
s
, then P
0
is too low (a
bargain). Buy orders > sell orders; P
0
bid up;
D
1
/P
0
falls until D
1
/P
0
+ g = ^r
s
= r
s
.
2. If ^r
s
= D
1
/P
0
+ g < r
s
, then P
0
is too high (bad
deal). Buy orders < sell orders; P
0
drops; D
1
/P
0

raises until D
1
/P
0
+ g = ^r
s
= r
s
.

Summary
- In equilibrium Expected rate of return must equal
the required rate (CAPM)
- Thus in equilibrium the market price must equal the
theoretical price

Why do stock prices change?
^
g r
D
P
i

=
1
0

1. r
i
could change: r
i
= r
RF
+ (r
M
- r
RF
)
i
; r
RF
= r* + IP
2. g could change due to economic or firm situation.
3. D could change

What if r
s
or g change?
g g g
r
s
4% 5% 6%
9% 40.00 50.00 66.67
10% 33.33 40.00 50.00
11% 28.57 33.33 40.00

Fin105 Lecture 10 Notes

Should our analysis focus on before-tax or after-tax capital
costs?
- Stockholders focus on A-T CFs. Therefore, we should
focus on A-T capital costs, i.e. use A-T costs of capital
in WACC. Only r
d
needs adjustment, because interest
is tax deductible.

Book-Value Weights Balance sheet, i.e. historical
Market-Value Weights
- Calculation of market-value weights is very similar to
the calculation of the book-value weights
- The main difference is that we need to first calculate
the total market value (price times quantity) of each
type of capital
- Market values represent the current amount of
securities outstanding; more appropriate

The YTM on outstanding L-T debt is often used as a
measure of r
d
.

Why is the yield on preferred stock lower than debt?
- Preferred stock will often have a lower B-T yield than
the B-T yield on debt.
- Corporations own most preferred stock, because
70% of preferred dividends are excluded from
corporate taxation.
- The A-T yield to an investor and the A-T cost to the
issuer are higher on preferred stock than on debt.
Consistent with higher risk of preferred stock.

The Cost of Equity Capital

Because stockholders can reinvest the dividend in risky
financial assets, the expected return on a capital-
budgeting project should be at least as great as the
expected return on a financial asset of comparable risk.

Advantages of CAPM Approach
1. Explicitly adjusts for systematic risk
2. Applicable to all companies, as long as we can
compute beta
Disadvantages of CAPM Approach
1. Have to estimate the expected market risk premium,
which does vary over time
2. Have to estimate beta, which also varies over time
3. We are relying on the past to predict the future,
which is not always reliable

Review: Estimating g or Growth Rate
g = ROE x r
4. g = the growth rate of future earnings and the growth
in the common stockholders investment in the firm
5. ROE = the return on equity
6. r = the companys percentage of profits retained =
profit retention rate = plowback rate

Estimating the Growth from History We use arithmetic
mean or Geometric Mean. Theoretically, the geometric
mean should provide a more accurate g (because of
compounding), the arithmetic mean is considered superior
for forecasting.

Advantages and Disadvantages of Dividend Growth Model
- Advantage easy to understand and use
- Disadvantages
1. Only applicable to companies currently paying
dividends
2. Not applicable if dividends arent growing at a
reasonably constant rate
3. Extremely sensitive to the estimated growth rate
an increase in g of 1% increases the cost of
equity by 1%
4. Does not explicitly consider risk

Can DCF methodology be applied if growth is not
constant?
- Yes, non-constant growth stocks are expected to
attain constant growth at some point, generally in 5
to 10 years.
- May be complicated to compute.

Issuing new common stock may send a negative signal to
the capital markets, which may depress the stock price.

Flotation Costs
- Flotation costs depend on the firms risk and the type
of capital being raised.
- Flotation costs are highest for common equity.
However, since most firms issue equity infrequently,
the per-project cost is fairly small.
- The amount of flotation costs are generally quite low
for debt and preferred stock (often 1% or less of the
face value)
- For common stock, flotation costs can be as high as
25% for small issues, for larger issue they will be
much lower


Fin105 Lecture 11 Notes

Strengths of PBP
1. Time limit: known cash timing requirement or threat
of obsolescence
2. Useful when expected future CFs in later periods are
uncertain
Weaknesses of PBP
1. Poor comparability
2. Weak link to value creation (not in absolute or
relative dollars)

NPV is the superior criterion: Basic Principle: Accept only
investments that increase shareholders wealth!

IRR and NPV
- If NPV is (+), IRR will be greater than the required rate
of return
- If NPV is (-), IRR will be less than required rate of
return
- If NPV = 0, IRR is the required rate of return.

Reasons Why NPV Profiles Cross
- Size (scale) differences the smaller project frees up
funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds, so a
high WACC favors small projects.
- Timing differences the project with faster payback
provides more CF in early years for reinvestment. If
WACC is high, early CF especially good, NPV
S
> NPV
L
.

Reinvestment Rate Assumptions
- Assuming CFs are reinvested at the opportunity cost
of capital is more realistic, so NPV method is the best.
NPV method should be used to choose between
mutually exclusive projects.

Fin105 Lecture 12 Notes

Project CFs
- Estimating a projects impact on a firms future CFs is
a crucial part of the investment decision. Some basic
principles need to be followed when estimating a
projects CFs:
1. An incremental basis
2. An after-tax basis
3. Indirect effects should be included
4. Costs should be measured as opportunity costs
and not based upon historical or sunk costs
- The capital budgeting decision is essentially based
upon a cost/benefit analysis.
- The cost of a project is called the net investment.
- The benefits from a project are the future cash
flows generated. We call these the net cash flows.

Net Investment
- The net cash outflows required to ready a project for
its basic operation; the net investment includes:
1. Cost of any assets
2. + Delivery costs
3. + Installation costs
4. + Any required increase in net working capital
5. A-T salvage value from replaced assets

Net Cash Flows
- These are the future CF generated from a project
once it commences operation. The net CF are
expected to continue throughout the projects
economic life.
- The net CF for each year is:
1. A Earnings before taxes x (1 T)
2. + A Depreciation
3. - A Net working capital
- And A Earnings before taxes is estimated by:
4. A Sales revenue
5. A Operating expenses
6. A Depreciation
- Interest expense is generally not included in the net
cash flows since it will be taken into account later
through the firms required rate of return.

Terminal Non-operating Cash Flow
- These are special one-time CFs that only occur at the
end of a projects life. They are added to a projects
last net CF. They include:
1. A-T salvage value of the projects assets
2. Return of any increased NWC

Computation of A-T Salvage Values
- Taxes owed on salvage value depend upon the
salvage price relative to the assets book value.
- As assets book value is the assets original acquisition
cost minus accumulated depreciation.
- If an asset is sold for its book value then no taxes are
owed.
- If an asset is sold for more than book value, then
taxes are owed on this excess.
- If an asset is sold for less than book value, then taxes
are reduced. The loss acts as a tax shelter, reducing
taxes by an amount equal to the firms marginal tax
rate times the deficit.

Example: Proposed Project
- Total depreciable cost
o Equipment: $200,000
o Shipping and installation: $40,000
- Changes in working capital
o Inventories will rise by $25,000
o Accounts payable will rise by $5,000
- Effect on operations
o New sales: 100,000 units/year @ $2/unit
o Variable cost: 60% of sales
- Life of the project
o Economic life: 4 years
o Depreciable life: MACRS 3-year class
o SV: $25,000
- T: 40%
- WACC: 10%

Determining Project Value
- Estimate relevant CFs
o Calculating annual operating CFs.
o Identifying changes in working capital.
o Calculating terminal CFs: A-T SV and return of
NWC.

Initial Year Net Cash Flow
- Find ANWC.
o in inventories of $25,000
o Funded partly by an in A/P of $5,000
o ANWC = $25,000 $5,000 = $20,000
- Combine ANWC with initial costs.
Equipment -$200,000
Installation -40,000
ANWC

-20,000
Net CF
0
-$260,000

Determining Annual Depreciation Expense
Year Rate x Basis Deprec.
1 0.33 x $240 $ 79
2 0.45 x 240 108
3 0.15 x 240

36
4 0.07 x 240

17
1.00 $ 240
*Due to the MACRS -year convention, a 3-year asset is
depreciated over 4 years.

Annual Operating CFs

Terminal CF

Q. How is NWC recovered?
Q. Is there always a tax on SV?
Q. Is the tax on SV ever a positive cash flow?

Should financing effects be included in CFs?
Recovery of NWC $20,000
Salvage value 25,000
Tax of SV (40%) -10,000
Terminal CF $35,000
- No, dividends and interest expense should not be
included in the analysis.
- Financing effects have already been taken into
account by discounting CFs at the WACC of 10%.
- Deducting interest expense and dividends would be
double counting financing costs.

Should a $50,000 improvement cost from the previous
year be included in the analysis?
- No, the building improvement cost is a sunk cost and
should not be considered.
- This analysis should only include incremental
investment.

If the facility could be leased out for $25,000 per year,
would this affect the analysis?
- Yes, by accepting the project, the firm foregoes a
possible annual CF of $25,000, which is an
opportunity cost to be charged to the project.
- The relevant cash flow is the annual A-T opportunity
cost.
o A-T opportunity cost:
= $25,000(1 0.4) = $15,000

If the new product line decreases the sales of the firms
other lines, would this affect the analysis?
- Yes. The effect on other projects CFs is an
externality.
- Net CF loss per year on other lines would be a cost to
this project.
- Externalities can be (+) (in the case of complements)
or (-) (substitutes).

If this were a replacement rather than a new project,
would the analysis change?
- Yes, the old equipment would be sold, and new
equipment purchased.
- The incremental CFs would be the changes from the
old to the new situation.
- The relevant depreciation expense would be the
change with the new equipment.
- If the old machine was sold, the firm would not
receive the SV at the end of the machines life. This is
the opportunity cost for the replacement project.

Stand-Alone Risk usually measured by or CV.
Corporate Risk is a function of the projects NPV and
and its with the returns on other firm projects.
Market Risk it is measured by the projects and it
considers both corporate and stockholder diversification.
Advantage of Sensitivity Analysis
- Identifies variables that may have the greatest
potential impact on profitability and allows
management to focus on these variables.

Disadvantages of Sensitivity Analysis
- Does not reflect the effects of diversification.
- Does not incorporate any information about the
possible magnitudes of the forecast errors.

If there is expected inflation of 5%, is NPV biased?
- Yes, inflation causes the discount rate to be upwardly
revised.
- Therefore, inflation creates a downward bias on PV.
- Inflation should be built into CF forecasts.

Annual Operating Cash Flows, If Expected Inflation = 5%


If the firms average projects have CV
NPV
ranging from 1.25
to 1.75, would this project be of high, average, or low risk?
- With a CV
NPV
of 2.0, this project would be
classified as a high-risk project.
- Perhaps, some sort of risk correction is required
for proper analysis.

Is this project likely to be correlated with the firms
business? How would it contribute to the firms overall
risk?
- We would expect a (+) with the firms aggregate
CFs.
- As long as is not perfectly positive (i.e. = 1), we
would expect it to contribute to the lowering of
the firms overall risk.

If the project had a high with the economy, how would
corporate and market risk be affected?
- The projects corporate risk would not be directly
affected. However, when combined with the
projects high stand-alone risk, with the
economy would suggest that market risk is high.

What subjective risk factors should be considered before a
decision is made?
- Numerical analysis sometimes fails to capture all
sources of risk for a project.
- If the project has the potential for a lawsuit, it is
more risky than previously thought.
- If assets can be redeployed or sold easily, the
project may be less risky than otherwise thought.

1 2 3 4
Revenues 210 220 232 243
Op. costs (60%) -126 -132 -139 -146
Deprec. expense -79 -108 -36 -17
Oper. income (BT) 5 -20 57 80
Tax (40%) 2 -8 23 32
Oper. income (AT) 3 -12 34 48
+ Deprec. expense 79 108 36 17
Operating cash flows 82 96 70 65
Fin105 Lecture 14 Notes

Working capital policy It is deciding the level of each
type of current asset to hold, and how to finance
current assets.

Working capital management It is controlling cash,
inventories, and A/R, plus S-T liability management.

Risks vs. Costs Trade-Off (Conservative Approach)
- L-T Financing Benefits
o Less worry in refinancing S-T obligations
o Less uncertainty regarding future interest costs
- L-T Financing Risks
o Borrowing more than what is necessary
o Borrowing at a higher overall cost (usually)
- Result
o Manager accepts less expected profits in
exchange for taking less risk.

Comparison with an Aggressive Approach
- S-T Financing Benefits
o Financing L-T needs with a lower interest cost
than S-T debt
o Borrowing only what is necessary
- S-T Financing Risks
o Refinancing S-T obligations in the future
o Uncertain future interest costs
- Result
o Manager accepts greater expected profits in
exchange for taking greater risk.

Summary of Short- vs. Long-Term Financing
Financing Maturity
Asset Maturity
S-T L-T
S-T (temporary)
Moderate risk-
profitability
Low risk-profitability
L-T (permanent)
High risk-
profitability
Moderate risk-
profitability

Lower collections would lead to higher borrowing
requirements.

Inventory Costs
- Types of inventory costs
1. Carrying costs storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
2. Ordering costs cost of placing orders,
shipping, and handling costs.
3. Costs of running short loss of sales or
customer goodwill, and the disruption of
production schedules.
- Reducing inventory levels generally reduces
carrying costs, increases ordering costs, and may
increase the costs of running short.

Terms of Trade Credit [Example]
- A firm buys $3,000,000 net ($3,030,303 gross) on
terms of 1/10, net 40.
- The firm can forego discounts and pay on Day 40,
without penalty.
18 . 219 , 8 $
365 / 000 , 000 , 3 $ purchases daily Net
=
=

- Payables level, if the firm takes discounts
o Payables = $8,219.18(10) = $82,192
- Payables level, if the firm takes no discounts
o Payables = $8,219.18(40) = $328,767
- Credit breakdown

Nominal Cost of Trade Credit
- The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain $246,575 in extra
trade credit:
r
NOM
= $30,303/$246,575
= 0.1229 = 12.29%
- The $30,303 is paid throughout the year, so the
effective cost of costly trade credit is higher.
12.29%
period Disc. taken Days
days 365

% Discount 1
% Discount
r
NOM
=

=


Effective Cost of Trade Credit
- Periodic rate = 0.01/0.99 = 1.01%
- Periods/year = 365/(40 10) = 12.1667
- Effective cost of trade credit
% 01 . 13 1 ) 0101 . 1 (
1 rate) Periodic (1 EAR
1667 . 12
N
= =
+ =


Add-on Interest
- The firm can borrow $100,000 for 1 year at an 8%
nominal rate.
- Interest = 0.08 ($100,000) = $8,000
- Face amount = $100,000 + $8,000 = $108,000
- Monthly payment = $108,000/12 = $9,000
- Ave. loan outstanding = $100,000/2 = $50,000
- Approximate cost = $8,000/$50,000 = 16.0%
- To find the appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000 (like an annuity).

Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575