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Lecture 1

FINM7007 Applied Corporate Finance





Fundamentals of Financial Management
BD Chapters 1,3,4,6,9

1
This Class
Introduction and course outline
Foundations
Present values and NPV rule
No arbitrage
Separation principle
Time Value of Money
Valuation of Bonds and Stocks
2
Financial Management
The study of how financial managers decide
what projects to invest in, and
how these projects should be funded.
Involves the comparison of risky cash flows
through time.
Success is judged in terms of value.
3
The Tasks of Financial Management
Tasks
Investment decision
Financing decision
Risk management
Focus on investment and financing decisions
4
What are the Issues?
Consider:
Toll Holdings management is evaluating an investment of $20 million in
a new complex at Mascot for handling both international and domestic
freight. The project has an expected life of 10 years.
The investment committee proposed to implement this proposal in two
stages, depending upon demand.
The committee also raised the possibility of developing a
complementary freight facility in the UK and US.
Question:
What is involved in evaluating this investment opportunity?
5
Cash Flow Estimation
What are the relevant cash flows associated
with the investment proposal.
How sensitive is the projects NPV to the
projected freight demand?
How do I incorporate this in my analysis?
6
Cash Flow Estimation
What is the possible impact of
competitors?
How do we incorporate this in our analysis?
How do we allow for the development of
freight complexes in both the UK and the
US?
Would the analysis change?
Are the risks facing Toll Holdings any
different?
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The Cost of Capital
What is the cost of capital against which the
project is evaluated?
Estimating the cost of capital
The risk/return trade-off and the CAPM.
Do we do the analysis before or after taxes?
How do we estimate the cost of equity?
What is the appropriate risk-free rate of return?
How is the market risk premium estimated?
How is beta (factors) estimated?
How do we estimate the cost of debt?
What is the appropriate risk-free rate of return?
8
What Form of Financing Should be
Used?
Can Toll Holdings leverage choice its' value?
current funds from debt rather than equity
Is it optimal to rely predominantly on debt
financing?
Is there an optimal capital structure?
What is the impact of taxes?
Can the choice of financing tell the market
anything about the firm and/or the project?
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What Form of Financing Should be
Used?
Can Toll Holdings choice of financing affect the
projects value?
Are the financing and investments decisions
independent?
What of the differences in obligations and issue
costs for the various security types?
Does it matter where the project is sited or
how it is funded?
10
Foundations: NPV
The net present value (NPV) of a project or
investment is the difference between the
present value of its benefits and the present
value of its costs.
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(Benefits) (Costs) = NPV PV PV
(All project cash flows) = NPV PV
The NPV Decision Rule
When making an investment decision, take the
alternative with the highest NPV. Choosing this
alternative is equivalent to receiving its NPV in
cash today.
Accepting or Rejecting a Project
Accept those projects with positive NPV because
accepting them is equivalent to receiving their NPV in
cash today.
Reject those projects with negative NPV because
accepting them would reduce the wealth of investors.


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Foundations: Separation Principle
Financing decisions do not create value but
adjust the timing and risk of cash flows to
meet the needs of the firm or its investors
Value is created by undertaking investment
opportunities
Implication: Evaluate investment opportunties
separately for the decision as to how to
finance them
13
Foundations: No Arbitrage
Arbitrage
The practice of buying and selling equivalent
goods in different markets to take advantage of a
price difference. An arbitrage opportunity occurs
when it is possible to make a profit without taking
any risk or making any investment.
Normal Market
A competitive market in which there are no
arbitrage opportunities.
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Determining the No-Arbitrage Price
Unless the price of the security equals the
present value of the securitys cash flows, an
arbitrage opportunity will appear.
No Arbitrage Price of a Security
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Price(Security) (All cash flows paid by the security) = PV
Example
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Example (cont'd)
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Foundations: Time Value of Money
18
Example (contd)
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Three Rules of Time Travel
Financial decisions often require combining
cash flows or comparing values. Three rules
govern these processes.
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Perpetuities, Annuities,
and Other Special Cases
When a constant cash flow will occur at
regular intervals forever it is called a
perpetuity.
The value of a perpetuity is simply the cash
flow divided by the interest rate.
Present Value of a Perpetuity
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( in perpetuity) =
C
PV C
r
Annuities
When a constant cash flow will occur at
regular intervals for N periods it is called an
annuity.


Present Value of an Annuity
22
1 1
(annuity of for periods with interest rate ) 1
(1 )
| |
=
|
+
\ .
N
PV C N r C
r r
Future Value of an Annuity
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( )
(annuity) V (1 )
1
1 (1 )
(1 )
1
(1 ) 1
= +
| |
= +
|
+
\ .
= +
N
N
N
N
FV P r
C
r
r r
C r
r
Growing Perpetuities
Assume you expect the amount of your
perpetual payment to increase at a constant
rate, g.


Present Value of a Growing Perpetuity
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(growing perpetuity)

=

C
PV
r g
Zero-Coupon Bonds
Zero-Coupon Bond
Does not make coupon payments
Always sells at a discount (a price lower than face
value), so they are also called pure discount
bonds
Treasury Bills are U.S. government zero-coupon
bonds with a maturity of up to one year.
25
Zero-Coupon Bonds (cont'd)
Suppose that a one-year, risk-free, zero-coupon
bond with a $100,000 face value has an initial
price of $96,618.36. The cash flows would be:
Although the bond pays no interest, your
compensation is the difference between the initial
price and the face value.
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Zero-Coupon Bonds (cont'd)
Yield to Maturity
The discount rate that sets the present value of
the promised bond payments equal to the current
market price of the bond.
Price of a Zero-Coupon bond
27

(1 )
=
+
n
n
FV
P
YTM
Zero-Coupon Bonds (cont'd)
Yield to Maturity
For the one-year zero coupon bond:




Thus, the YTM is 3.5%.
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1
100,000
96,618.36
(1 )
=
+ YTM
1
100,000
1 1.035
96,618.36
+ = = YTM
Zero-Coupon Bonds (cont'd)
Yield to Maturity
Yield to Maturity of an n-Year Zero-Coupon Bond
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1
1
| |
=
|
\ .
n
n
FV
YTM
P
Example
30
Example (cont'd)
31
Zero-Coupon Bonds (cont'd)
Risk-Free Interest Rates
A default-free zero-coupon bond that matures on
date n provides a risk-free return over the same
period. Thus, the Law of One Price guarantees
that the
risk-free interest rate equals the yield to maturity
on such a bond.
Risk-Free Interest Rate with Maturity n
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=
n n
r YTM
Coupon Bonds
Coupon Bonds
Pay face value at maturity
Pay regular coupon interest payments
Treasury Notes
U.S. Treasury coupon security with original
maturities of 110 years
Treasury Bonds
U.S. Treasury coupon security with original
maturities over 10 years
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Example
34
Example (cont'd)
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Coupon Bonds (cont'd)
Yield to Maturity
The YTM is the single discount rate that equates
the present value of the bonds remaining cash
flows to its current price.


Yield to Maturity of a Coupon Bond
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1 1
1
(1 ) (1 )
| |
= +
|
+ +
\ .
N N
FV
P CPN
y y y
Interest Rate Changes and Bond Prices
There is an inverse relationship between
interest rates and bond prices.
As interest rates and bond yields rise, bond prices
fall.
As interest rates and bond yields fall, bond prices
rise.
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The Yield Curve and Bond Arbitrage
Using the Law of One Price and the yields of
default-free zero-coupon bonds, one can
determine the price and yield of any other
default-free bond.
The yield curve provides sufficient information
to evaluate all such bonds.
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Valuing a Coupon Bond
Using Zero-Coupon Yields
The price of a coupon bond must equal the
present value of its coupon payments and
face value.
Price of a Coupon Bond
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2
1 2
(Bond Cash Flows)
V

1 (1 ) (1 )
=
+
= + + +
+ + +
n
n
PV PV
CPN CPN CPN F
YTM YTM YTM
2 3
100 100 100 1000
$1153
1.035 1.04 1.045
+
= + + = P
Coupon Bond Yields
Given the yields for zero-coupon bonds, we
can price a coupon bond.
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2 3
100 100 100 1000
1153
(1 ) (1 ) (1 )
+
= = + +
+ + +
P
y y y
2 3
100 100 100 1000
$1153
1.0444 1.0444 1.0444
+
= + + = P
Treasury Yield Curves
Treasury Coupon-Paying Yield Curve
Often referred to as the yield curve
On-the-Run Bonds
Most recently issued bonds
The yield curve is often a plot of the yields on
these bonds.
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Corporate Bonds
Corporate Bonds
Issued by corporations
Credit Risk
Risk of default
42
Corporate Bond Yields
Investors pay less for bonds with credit risk
than they would for an otherwise identical
default-free bond.
The yield of bonds with credit risk will be
higher than that of otherwise identical
default-free bonds.
43
Corporate Yield Curves for Various
Ratings, September 2005
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Valuation of Shares

45
Stock Prices, Returns,
and the Investment Horizon
A One-Year Investor
Potential Cash Flows
Dividend
Sale of Stock
Timeline for One-Year Investor
Since the cash flows are risky, we must discount them at the
equity cost of capital.
46
Stock Prices, Returns,
and the Investment Horizon (cont'd)
A One-Year Investor
If the current stock price were less than this
amount, expect investors to rush in and buy it,
driving up the stocks price.
If the stock price exceeded this amount, selling it
would cause the stock price to quickly fall.
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1 1
0


1
| |
+
=
|
+
\ . E
Div P
P
r
Dividend Yields, Capital Gains,
and Total Returns
Dividend Yield
Capital Gain
Capital Gain Rate
Total Return
Dividend Yield + Capital Gain Rate
The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk.
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1 0 1 1 1
0 0 0
Dividend Yield Capital Gain Rate

1
+
= = +
E
P P Div P Div
r
P P P
A Multi-Year Investor (cont'd)
What is the price if we plan on holding the
stock for N years?
This is known as the Dividend Discount Model.
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1 2
0
2
E E E E

1 (1 ) (1 ) (1 )
= + + + +
+ + + +
N N
N N
Div P Div Div
P
r r r r
A Multi-Year Investor (cont'd)
The price of any stock is equal to the present
value of the expected future dividends it will
pay.
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3 1 2
0
2 3
1
E E E E

1 (1 ) (1 ) (1 )

=
= + + + =
+ + + +

n
n
n
Div Div Div Div
P
r r r r
The Discount-Dividend Model
Constant Dividend Growth
The simplest forecast for the firms future
dividends states that they will grow at a constant
rate, g, forever.
51
The Discount-Dividend Model (cont'd)
Constant Dividend Growth Model
The value of the firm depends on the current dividend
level, the cost of equity, and the growth rate.
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1
0
E


=

Div
P
r g
1
E
0
= +
Div
r g
P
Dividends Versus Investment and
Growth
A Simple Model of Growth
Dividend Payout Ratio
The fraction of earnings paid as dividends each year
53
E
Earnings
Dividend Payout Rate
Shares Outstanding
=
t
t
t t
t
PS
Div
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
Assuming the number of shares outstanding is
constant, the firm can do two things to increase
its dividend:
Increase its earnings (net income)
Increase its dividend payout rate
54
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
A firm can do one of two things with its earnings:
It can pay them out to investors.
It can retain and reinvest them.
55
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
Retention Rate
Fraction of current earnings that the firm retains
56
Change in Earnings New Investment Return on New Investment =
New Investment Earnings Retention Rate =
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
If the firm keeps its retention rate constant, then
the growth rate in dividends will equal the growth
rate of earnings.
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Change in Earnings
Earnings Growth Rate
Earnings
Retention Rate Return on New Investment
=
=
Retention Rate Return on New Investment = g
Dividends Versus Investment
and Growth (cont'd)
Profitable Growth
If a firm wants to increase its share price, should it
cut its dividend and invest more, or should it cut
investment and increase its dividend?
The answer will depend on the profitability of the
firms investments.
Cutting the firms dividend to increase investment will raise
the stock price if, and only if, the new investments have a
positive NPV.
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Example
59
Example (cont'd)
60
Changing Growth Rates
We cannot use the constant dividend growth
model to value a stock if the growth rate is
not constant.
For example, young firms often have very high
initial earnings growth rates. During this period of
high growth, these firms often retain 100% of
their earnings to exploit profitable investment
opportunities. As they mature, their growth slows.
At some point, their earnings exceed their
investment needs and they begin to pay
dividends.
61
Changing Growth Rates (cont'd)
Although we cannot use the constant dividend
growth model directly when growth is not
constant, we can use the general form of the
model to value a firm by applying the constant
growth model to calculate the future share
price of the stock once the expected growth
rate stabilizes.
62
Changing Growth Rates (cont'd)
Dividend-Discount Model with Constant Long-
Term Growth
63
1
E


+
=

N
N
Div
P
r g
1 1 2
0
2
E E E E E
1

1 (1 ) (1 ) (1 )
+
| |
= + + + +
|
+ + + +
\ .
N N
N N
Div Div Div Div
P
r r r r r g
Example
64
Example (cont'd)
65
66
The Discounted Free Cash Flow Model
Discounted Free Cash Flow Model
Determines the value of the firm to all investors,
including both equity and debt holders
The enterprise value can be interpreted as the net
cost of acquiring the firms equity, taking its cash,
paying off all debt, and owning the unlevered
business.
Enterprise Value Market Value of Equity Debt Cash = +
67
The Discounted Free Cash
Flow Model (cont'd)
Valuing the Enterprise


Discounted Free Cash Flow Model
Unlevered Net Income
Free Cash Flow (1 ) Depreciation
Capital Expenditures Increases in Net Working Capital
= t +

c
EBIT
0
(Future Free Cash Flow of Firm) = V PV
0 0 0
0
0
Cash Debt

Shares Outstanding
+
=
V
P
68
The Discounted Free Cash
Flow Model (cont'd)
Implementing the Model
Since we are discounting cash flows to both equity
holders and debt holders, the free cash flows
should be discounted at the firms weighted
average cost of capital, r
wacc
. If the firm has no
debt, r
wacc
= r
E
.
69
The Discounted Free Cash
Flow Model (cont'd)
Implementing the Model
Often, the terminal value is estimated by
assuming a constant long-run growth rate g
FCF
for
free cash flows beyond year N, so that:
1 2
0
2
wacc wacc wacc wacc

1 (1 ) (1 ) (1 )
= + + + +
+ + + +
N N
N N
FCF V FCF FCF
V
r r r r
1
wacc wacc
1

( )
+
| |
+
= =
|

\ .
N FCF
N N
FCF FCF
FCF g
V FCF
r g r g
70
Example
71
Example (cont'd)
72
The Discounted Free Cash
Flow Model (cont'd)
Connection to Capital Budgeting
The firms free cash flow is equal to the sum of the
free cash flows from the firms current and future
investments, so we can interpret the firms
enterprise value as the total NPV that the firm will
earn from continuing its existing projects and
initiating new ones.
The NPV of any individual project represents its
contribution to the firms enterprise value. To maximize
the firms share price, we should accept projects that
have a positive NPV.
73
Valuation Based on Comparable Firms
Method of Comparables (Comps)
Estimate the value of the firm based on the value
of other, comparable firms or investments that we
expect will generate very similar cash flows in the
future.
74
Valuation Multiples
Valuation Multiple
A ratio of firms value to some measure of the
firms scale or cash flow
The Price-Earnings Ratio
P/E Ratio
Share price divided by earnings per share
75
Valuation Multiples (cont'd)
Trailing Earnings
Earnings over the last 12 months
Trailing P/E
Forward Earnings
Expected earnings over the next 12 months
Forward P/E


76
Valuation Multiples (cont'd)
Firms with high growth rates, and which
generate cash well in excess of their
investment needs so that they can maintain
high payout rates, should have high P/E
multiples.
0 1 1
1 E E
/ Dividend Payout Rate
Forward P/E

= = =

P Div EPS
EPS r g r g
77
Example
Problem
Best Buy Co. Inc. (BBY) has earnings per share
of $2.22.
The average P/E of comparable companies stocks
is 19.7.
Estimate a value for Best Buy using the P/E as a
valuation multiple.
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Solution
The share price for Best Buy is estimated by
multiplying its earnings per share by the P/E of
comparable firms.
P
0
= $2.22 19.7 = $43.73
79
Stock Valuation Techniques:
The Final Word
No single technique provides a final answer
regarding a stocks true value. All approaches
require assumptions or forecasts that are too
uncertain to provide a definitive assessment
of the firms value.
Most real-world practitioners use a combination
of these approaches and gain confidence if the
results are consistent across a variety of methods.