Formula Sheet (FS)

Shareholder Value and the cost of capital

Capital Budgeting:

The dividend growth model (DGM) approach (Return on equity):

1
Prime cost rate:
effective life
Prime cost method: initial cost prime cost rate
Diminishing value rate: prime cost rate 2 (Note: you multiply this by the previous years depreciation)
Incremental Earnings before Interest and Taxes (EBIT) = Incremental Revenue Incremental Costs
Depreciation
Income Tax = EBIT Corporate Tax Rate
Incremental Earnings (Net income) = (Incremental Revenues Incremental Costs Depreciation) (1
Tax Rate)
Tax savings from depreciation = Depreciation expense Tax Rate
Net working Capital (NWC) = Current Assets Current Liabilities
= Cash + Inventory + Receivables Payables
Change in net working capital =

NPV CF0
t 1

CFt

1 r

Accounting Break-even:

e.g.

($

($

$ )

= Dividend Yield + Capital Gain Yield

Average annual return of a security:

Variability of returns

( )=

SD(R) = =

[(R1 ) + +(
( )

SD(R) = =

( )
E[ R] R f

) ]

Where: Cost of equity=

Cost of Debt=

)=

Cost of Preference Share=

Notation:
E = market value of equity = number outstanding shares times price per share
D = market value of debt = number outstanding bonds times bond price

+ +
(

= Cx

= 100%)

V E D V A

U
M&Ms Proposition I: L
M&Ms Proposition I (With tax shield): VL VU PV (Interest Tax Shield)

Value of interest tax shield:

++

) T= sample size (years)

Leveraged equity cost of capital:

Static trade-off theory:

Derivative Securities

+(

Where D/E = debt equity ratio

E[ R ]

Portfolio Expected Return (Weighted avg): ( ) =

(
Portfolio variance:
=
+
+2
,
Where:
( ) is the variance of returns for the portfolio.
1,2 is the correlation of returns for asset 1 and asset 2.
= the
proportion of funds invested in asset 1.
= the standard deviation of returns for asset 1.
Covariance:

Rf=Risk free rate of return

Coefficient of variation= CV

Correlation:

Weighted average cost of capital (WACC) =

Expected return: ( ) =
Where: pi=probability of state of economy, Ri=rate of return at state
Volatility = measure of risk, determined by variance and standard deviation
( )=
( ( )) Sum of (probability of ecnmc state-asset return in ecnmc state)^2
Sharpe ratio = S

+
2
Where: I = annual interest payment, PV = par or face value of the debenture, NP = net proceeds of the
issue = market price less costs, N = the number of years to maturity of the debenture

Financial Leverage and Capital Structure Policy

Where: P = share price at beginning of period,

t
P = share price at end of period ,
t+1
D = dividend received at end of period
t+1

Approximation of Yield to Maturity (return on debt R D):

Cost of debt = RD= Bond value

Risk and Return:

Weights
E/V = percent financed with equity
D/V = percent financed with debt

= 450

FC = Fixed costs, D = depreciation, P = Price per unit, v = cost per unit (wholesale price)

Cost of preference shares:

V = market value of the firm = D + E + P (

Gain/Loss = Salvage value [cost total depreciation]

The Security market line (SML) Approach:

=
+
(
)
Where: =equity beta, Rf = risk free rate, RM=Market rate of return, (RM-Rf)=market risk premium

)+

)+. . +

Lecture 6 - Capital Budgeting

The capital budgeting process
1. Forecasting projects revenues and cost (we will not be covering this)
2. Incremental Earnings the amount by which a firms earnings are expected to change as a results
of an investment decisions (convert earnings to cash flows).
3. Incremental Cash Flows the incremental cash flows for project evaluation consist of any and all
changes in the firms future cash flows that are a direct consequence of undertaking the project.
4. Stand-alone principle evaluation of a project based on the projects incremental cash flows.
Step 2 - Forecasting incremental Earnings
Incremental Revenue and Cost Estimates
The evaluation is on how the project will change the cash flows of the firm
Thus, focus is on incremental revenues and costs

Incremental Earnings before Interest and Taxes (EBIT) = Incremental Revenue Incremental Costs
Depreciation NOTE: EBITDA is before Depreciation and Amortization is factored
Step 2- Forecasting Incremental Earnings: Operating Expenses versus Capital Expenditures
Assets purchased entail a negative cash flow.
A depreciation expense is recorded each year over the accounting life of the asset.
Straight-Line (Prime cost) Depreciation total cost of asset/effective life
Note: shipping/delivery and installation costs are capitalised as part of the assets purchase price.
Depreciation is a non-cash expense of running a business.
Depreciation is the way that the cost of the asset is claimed over the economic life of the asset.
The only cash flow effect is the effect on the taxable income from claiming depreciation as a
deduction.
There are two methods of depreciation:
1. Prime cost method initial cost prime cost rate
2. Diminishing value method diminishing value rate previous years depreciation
Depreciation will affect amount of tax paid known as depreciation expense tax shield
Taxes
Marginal Corporate Tax Rate - The tax rate a firm will pay on an incremental dollar of pre-tax
income. Income Tax = EBIT Corporate Tax Rate
The Final Incremental Earnings Forecast [See Incremental Earnings (Net Income) on formula sheet]
Step 3 Cash Flow Estimation
Convert to FCF first and then conduct investment decision analysis such as NPV, IRR
In order to evaluate a capital budgeting decision, the firms available cash flows must be found out
The incremental effect of a project on firms available cash = incremental free cash flow (FCF).
Two important steps: 1. Add back depreciation 2. Consider changes in Net working capital
Step 3 - Converting the Earnings to Free Cash Flow: Step 1 - Add Back Depreciation
Depreciation expense in not a cash flow but taxable earnings = taxes, which are a cash flow
Add back depreciation to the incremental earnings to recognise the fact that we still have the cash
flow associated with it.
Depreciation cost is not a real cash cost but the government allows tax deduction for some kinds
of fixed cost (e.g., depreciation, interest expenses) e.g. 30% of each $ of depreciation
Depreciation tax savings = Depreciation Tax Rate
Step 3 - Converting the Earnings to Free Cash Flow: Step 2 Net Working Capital (NWC)
See Formula sheet for formula CACL = Net working capital
If positive, then additional working capital is needed expansion. If negative, WC is being cashed
out (contraction or increased efficiency).
At the end of the projects life, inventory will be liquidated, and accounts receivable and accounts
payable will be settled. Thus investment in NWC will be returned by the end of the projects life.
Other factor to consider that may affect incremental cash flows:
Sunk costs (no effect do not consider)
Opportunity costs (cash flows could be generated from an alternative use include)
Side effects (should be considered if project causes a change in profits and net cash flows)
- Cannibalisation, -ve externality, cash flows; synergic, +ve externality cash flows
Financing costs ( do not subtract interest expense or dividends do not consider)
Gain or loss on disposal (do consider gain results in excess depreciation)
Replacement projects (do consider operating costs=income=tax=cash flows)

Project Analysis and Evaluation

Scenario analysis ask what if questions. E.g. what if sales were 3000 units instead of 4000
Sensitivity analysis shows in NPV or IRR in response to a a variable (e.g. unit sales)
- Steeper sensitivity lines show greater risk. Small changes result in large changes in NPV.
- Weaknesses: shows no likelihood of the change, ignores relationships b/n variables
- Benefits: Identifies dangerous variables, gives break even information
Accounting break-even - The sales level that results in a zero net profit for the project (See FS).

Lecture 7- Risk and Return

Realised return is the total return that occurs over a particular time period.
Past returns from an investment in a given share can be worked out (See 1st formula on FS)
Average annual return is simply sum of annual returns/number of years
Variability of returns the bigger the variance, the greater actual returns tend to differ from avg.
Expected return [E(R)] accounts for the prob. of operating in a certain economic state (See FS)
Sharpe ratio (See FS) shows extra return for choosing asset with extra volatility/risk. higher=better
Coefficient of Variation compares volatility to amount of expected return. Lower = better tradeoff
Two asset portfolio is a weighted avg return depending on proportion of funds invested in each

Risk depends on individual share and relationship between their returns

-

Correlation: strength and direction of the linear relationship between two variables
Covariance: A measure of the degree to which returns on two risky assets move in tandem

Lecture 8: Shareholder value and the Cost of Capital

The cost of equity, RE , is the return required by equity investors given the risk of the cash flows
from the firm going to equity. 2 methods: Dividend Growth Model & Security Market Line approach
Dividend Growth Model (DGM) and Security Market Line (SML) formulas, see formula sheet
Preference shares dont have voting rights and receive fixed constant dividend ever period.
Can be valued as perpetuity (See FS)
The cost of debt is the required return on firms debtestimated by calculating YTM on exst. Debt
Yield to maturity (YTM) - return that an investor would receive if they held the debt until maturity.
It is the discount rate that makes the present value of all future payments equal to its market
price. YTM an be approximated using formula in formula sheet.
WACC is the average of a firms equity and debt costs of capital, weighted by the fractions of the
firms value that correspond to equity and debt, respectively.