FINS1613: Business Finance

University of New South Wales

1

Annuity due

Forms of Organisations and Financial

Managers

The 3 Decisions in Business

Finance

1. The Investment Decision

2. The Financing Decision
3. The Dividend Decision
Types of Companies
Sole
Partnership
Proprietorship
1 owner
2+ owners

1+

= (1 + )
Perpetuity

= (1 + )

1 1 +
1+

Corporation

Many
shareholders
Owner = manager Owners =
Owners =/=
managers
managers
Cheap and simple Cheap and simple Expensive and
to set up
to set up
complicated
Difficult to raise
Difficult to raise
Easy to raise
capital/transfer
capital/transfer
capital/transfer
ownership
ownership
ownership
Unlimited Liability Unlimited Liability Limited Liability
Firm objectives Primary: maximize shareholder
wealth. Secondary: Social/ethical, e.g. environment
Agency Issues When agent has different
priorities to principal they act on behalf on (e.g.
managers and shareholders)
2
Financial Mathematics
Simple interest
=
(1 + )
Compound interest
=
1+
=
1+
Ordinary annuity
1 1 +
=

Uneven cash flows PV of investment = sum of

PVs of all individual cash flows
Effective interest rate
Bond pricing
=

= 1 +

1 1 +

1
+

1+
Interest rate risk r goes up, price at which bond
can be resold goes down BUT income from
reinvesting coupon payments goes up. Risk is
greater for longer maturity
Default risk Bond issuer may go bankrupt
Term structure of interest rates Relationship
between bond yields and terms to maturity
Market expectation hypothesis Yields on
longer maturity bonds reflect market expectations of
future short maturity bonds
Liquidity premium hypothesis Investors
demand higher returns on longer maturity
investments because they are riskier, due to being
more sensitive to interest rate changes
Market segmentation hypothesis Different
rates for different maturities are the result of
different demand from different market segments

Types of Shares
Ordinary Shares
Paid after in liquidation
No fixed dividend
Voting rights
Share valuation

Preference Shares
Paid first in liquidation
Usually receive a fixed dividend
No voting rights

(1 + )
=
( )/(1 + )

3
Methods of Evaluating Projects
Types of investments
Replacement of assets:
o To maintain business
o To improve efficiency
Expansion (into new markets/products)
Safety/environmental (comply with regulation)
Payback period Time until initial investment is
recovered
Discounted payback period Payback period
using discounted cash flows
Net present value (NPV) Sum of present values
of all cash flows including negative cash flow of
initial investment
Internal rate of return (IRR)
Discount rate that would set NPV equal to 0
0+
1 1+
+
2 1+
+
+
1+
= 0
Modified IRR
Version of IRR that removes implicit assumption that
positive cash flows could be reinvested at IRR
=

4
Projecting Future Cash Flows of
Projects
Factors that alter project free cash flows:
Requires fixed assets negative cash flow

 Depreciation dollar value of assets used up

tax liability so is added to projects net income


If interest charges are removed before
discounting, do not remove again when estimating
cash flows
Incremental cash flows Those created if
project goes ahead. Factors affecting incremental
cash flows include sunk costs, existing assets of the
firm and possible impacts of project of other parts of
the firm.
Different types of projects
Expansion project incremental cash flows are
in/out flows the project creates
Replacement project incremental cash flows
are only the extra in/out flows from new asset
Evaluating projects
Initial investment = upfront costs + necessary
in NOWC
Operating cash flows incremental cash flows
over the life-span of the project
Net cash flows each year sum of cash flows in
each area above; used for NPV
Ending a project early Abandon project if NPV
of future cash flows < 0
Corporate risk Risk a project represents for
entire firm. Affects share price and firm stability,
very difficult to measure for just one project as the
firm is involved with many.
Risk that a project represents for entire firm
Important because: influences share price &
firm stability, undiversified shareholders
exposed
Very difficult to measure for just one project as
firms involved with many

Stand-alone risk Risk involved in the project

alone
Important because: highly correlated with other
types of risk eg) corporate and market
Easy to measure; can be done via sensitivity
analysis, scenario analysis, monte carlo
simulation
Market risk
Risk it presents to a well-diversified investor
Important because cant be eliminated by
diversification
Using project risk in capital budgeting
Risk is reflected in capital budgeting by adjusting
discount rate to evaluate risk cash flows risky
project has discount rate
Timing investments Decision tree can be used
to show different results from investing at different
times; choose option with highest positive NPV
Optimal capital budgeting
Optimal capital budget all profitable independent
project + any selected mutually exclusive projects
Steps:
Determine firms discount rate
Scale rate to represent the risk of each division
in the firm
Calculate cash flows and NPV for the firms
accepted projects
Taxation and capital budgeting
Classical approach company pays corporate tax
on earnings, shareholders pay income tax on any
dividends paid double taxing.
Dividend imputation system Government gives
investors franking credits on dividends subject to
double taxation, reducing tax liability
Different types of companies
Fully integrated with tax system and issue fully
franked shares

Not integrated with tax system eg) sole

trader, partnership no franking credits
Partially integrated with tax system partially
franked shares
Re capital budgeting Under classical tax
system, after-tax cash flows should be used to
evaluate projects. Under imputation system, pre-tax
cash flows should be used. Partially integrated firms
must estimate effective corporate tax rate
incorporating franking credits and use this in capital
budgeting.
5
Return and Risk
Expected rate of return
= =
Variance
=

Standard deviation
Portfolio return
Correlation

, =

=
,

( ) / 1

1 , 1
Diversification
Shares generally have a positive correlation that is
less than 1, allowing for (limited) risk reduction by
spreading risk among different shares
(diversification)

Market (systematic) risk eg) r changes, growth

shocks
Firm specific (diversifiable) risk eg) new CEO,
new project
Risk premium for market risk
=

No risk premium for diversifiable risk

The measure of market risk beta
=
+
= ,
Values for beta:
Market return has = 1
Average stock has = 1
> 1 stock more risky than average
< 1 stock less risky than average
Most real stock 0.5 < < 1.5
negative if stock had negative correlation with
market very rare
Capital Asset Pricing Model (CAPM)
SML equation =
+ (
) or
=
+ (
)

is slope of the SML

Beta for a portfolio
=
+ (
)

Obstacles to testing CAPM

Theory is about expected returns, can only
measure and use realised returns to estimate
Theory requires that market portfolio used to
calculate s include all risky assets, including
intangibles (e.g. human capital)
6
Cost of Capital
Motivations for estimating cost of capital
To get hurdle rate
To provide cost of capital for accounting
calculations of Economic Value Added (EVA)
(monopoly regulators aim to set this to 0)
Components of capital
Debt ( )
Preferred shares ( )
Ordinary equity ( )
Debt Pretax cost = market yield to maturity of
issued debt. After-tax cost should be used:
=
(1 )
Preferred shares Pay out a fixed dividend. Cost
is similar to paying interest on debt; divide preferred
share dividend by preferred share price to get rate
=

Equity Use CAPM or dividend discount model

=
+ (
)
=
= ( / ) +
WACC (Weighted average cost of capital)
= =
(1 ) +
+
As the average cost of all company activities, WACC
is an appropriate hurdle rate for evaluating projects
Factors influencing WACC
Investment policy of firm --> riskiness of its
assets - risk = WACC
Market conditions eg) r, average risk premium
Firms capital structure and dividend policy

Tax imputation and WACC

Effective company tax rate and tax subsidy for
debt will be depending on amount of company
tax which is claimed as personal tax
Dividends must be grossed up by the attached
franking credits eg) for cost of equity with DFC,
market/company return for CAPM regression
6.1.1 Types of project risk
Standalone risk cash flow variability
Corporate risk effect of project on total firm
cash flow
Market risk effect on firms market / beta risk
o Market risk is theoretically correct for
maximizing wealth of diversified
shareholder
o Corporate risk relevant to undiversified
shareholder, creditors and employees
o Balance these considerations using
judgements
6.1.2 Project risk adjustment procedures
Subjective adjustment of WACC for projects of
different risk
Evaluate project as if standalone company and
estimate for market risk adjustment
Use one of above to establish cost of capital for
each division and use that for the divisions
projects:
o Pure play find companies that operate
only in the same areas as the division,
estimate and average s --> difficult
o Accounting beta regress divisions ROA
against ROA of companies in similar
markets --> these s are somewhat
correlates, but difficult to get ROAs for
projects that dont exist

7
Capital Structure
Financial leverage use of debt and preferred
stock
Financial risk additional risk resulting from
financial leverage
BEP Basic Earning Power = EBIT / assets
ROE Return on Equity = NI after tax / OE
TIE times Interest Earned = EBIT / interest
To expected ROE, must have BEP > kd,
because if not then interest expense >
operating income produced by debt-financed
assets; therefore leverage income
As debt , TIE because EBIT is unaffected by
debt and interest expense (Int Exp = kdD)
BEP is unaffected by financial leverage
The effects of taxes on capital structure
(Ignoring financial distress)
=
+ [ / ]
i.e.
=
+ PV of annual tax savings
Costs of financial distress firm borrows,
probability it will default
Direct costs liquidation costs (legal,
accounting fees)
Indirect costs lost sales, value for assets in
illiquid markets, managerial time, firm specific
human capital etc
=
+ [ / ]
[

]
Company taxes and personal taxes
1 1
1
=
+
1
where tc corporate tax rate , ts shareholder tax
rate (average div + cap gains rates), td debt tax
rate. Provided [ ] > 0, VL > VU. But with
imputation, no advantage for un/levered firm.
Imputation removes any tax advantage for debt,
other reasons for debt if return > cost

Degree of operating leverage

= 1 +
( / )
Degree of financial leverage
= 1 +
[ / ( + ) ]
Degree of total leverage
=

Optimal capital structure Mix of debt,
preferred and common equity at which share price
is maximised.
The Hamada Equation
=
[1 + (1 )( / )] Note: in CAPM is L
Other factors re target capital structure:
Industry average debt ratio
TIE ratios under different scenarios
Lender / rating agency attitudes
Reserve borrowing capacity
Effects of financing on control
Asset structure
Expected tax rate
Modigliani-Miller Irrelevance Theory Capital
structure is irrelevant to firms value. Assumes
shareholders have same info as managers, no
bankruptcy costs, no taxes.
Signaling theory suggests firms should use debt
than MM suggests. This unused debt capacity helps
avoid stock sales, which stock price because of
signaling effects.
If we assume managers have better info than
outsiders and that managers act in best interest of
shareholders, then management would
Issue shares if they think it is overvalued
Issue debt if they think stock is undervalued
Hence, investors view stock offering as a
negative signal empirically cause share price
to